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Undercapitalization

One of risky behaviors of entrepreneurs


Published:

Gene Baldwin

Small business owners routinely underestimate the capital needs of growth by not fully understanding the “soft costs.”

The failure rate for small business is high, yet despite these risks, small-business ownership continues to be a desirable goal for many Americans.

Even with all the advantages of franchising, and much due diligence on the part of both the franchisor and franchisee, some franchisees fail. There are three common problems of unsuccessful franchisees: They are undercapitalized, they lack the necessary management skills to be successful and the franchise is a poor fit for them or the city in Which they plan to operate. 

In my experience, undercapitalization is the biggest reason franchisees fail. Many operators simply cannot or will not carve out sufficient ownership to allow their business to be properly capitalized. Entrepreneurs are risk takers. They do not want a financial partner looking over their shoulder while making a substantial return on their invested capital. An undercapitalized business is vulnerable during its startup

phase. If the financial projections do not materialize as the spreadsheet says they will, then big problems occur.

Businesses can also become undercapitalized through rapid expansion. Small business owners routinely underestimate the capital needs of growth by not fully understanding the "soft costs." It is easy to get a handle on the hard costs of land, building and equipment. It can be a daunting challenge to calculate the costs of hiring and training new employees, pre-opening marketing, and startup losses while sales ramp up to break even levels. The costs of the distraction of opening a new location can take its toll on the rest of the operation.

Another way franchisees can become undercapitalized is when the business owners withdraw excess cash from the business and thus do not leave sufficient capital to either withstand an economic downturn or reinvest in its business. I had one franchisee tell me with a straight face the reason he took all the money out of his business was to diversify his investments. All those horses were not the best diversification I had ever seen.

The second most important factor in the demise of franchisees is lack of management skills. Many entrepreneurs are personally capable, but very incapable of getting things done through other people. This inability shows up most often in the small business owner not being able to attract and retain quality employees. Many entrepreneurs want to either micro-manage employees or abdicate duties rather than delegate them. Sadly, errors in selecting and managing people often lead to ineffective operations and unprofitable results. If hiring decisions are bad enough, mismanagement or outright fraud is common.

The final most important factor in the demise of franchisees is the owner selecting a franchise system that does not fit them or the market they wish to serve. Most people do not do well when they stray from their core competencies and training. Many people simply do better when they use the skills in which they have been trained. For example, engineers and accountants may be better suited to franchises that center on technical services and may not fare so well in franchises that require sales skills. Many people allow the lure of small-business ownership to blind them to a frank assessment of their own skills and abilities. It is also possible that the franchise being purchased just does not work well in the market chosen by the franchisee. Even though it is the job of the franchisor to understand the potential of its franchise based on geography and demographic factors, a good result cannot be guaranteed in all cases. I remember one instance from my experience in which a group of us invested in a QSR franchise. We selected and developed a new market. We felt confident in our investment since the market we chose was within 100 miles of a highly profitable market owned by the franchisor. Unfortunately, our results were not good and we opened the lowest volume stores in the entire chain.

Franchising can be a mutually profitable endeavor for both the franchisee and franchisor when the franchisee selects the appropriate franchise system, has the capital to sustain the business, and the management skills and aptitude to be successful.

Gene Baldwin is a partner in CRG Partners Group, LLC, a national turnaround consultancy that brings new life to distressed companies through operational and financial restructuring.  Gene can be reached at 316-371-2908 or at gene.baldwin@crgpartners.com

 

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