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Alicia Miller

As the saying goes, “franchising is simple, as long as franchisees are making money.” However, in some systems, it may seem easier to sell franchises than to actually get them open and profitable—and then to keep them profitable. That’s a recipe either for excessive “sold not open” numbers or the stall-out scenario I wrote about in October’s FT.

If you’re a franchise recruiter, you may think, “I found a great new franchisee, now operations (or training or real estate) needs to take it from here.” That’s shortsighted. Sales should stay in the loop regarding any downstream franchisee problems, i.e. units at risk, or UAR.

I’m going to dip briefly into finance and operations management tactics for a moment. I promise to tie it back to your franchise development success.

Starting liquidity

Prior to the COVID-19 crisis, most franchisors focused on franchisee liquidity only during the application process: 1. Are opening funds sufficient? 2. Can funds last until the franchisee hits initial breakeven?

But franchisors can and should monitor ongoing franchisee liquidity, just like lenders watch their loan portfolio. Banks routinely impose loan covenants and periodic reporting requirements, and request financial statements from borrowers in their SBA portfolios. Typically, lenders collect tax returns, prepared financial statements and updated personal financial statements of all guarantors with at least a 20 percent ownership. Since franchisees with loans already submit their information to banks, franchisors can ask for copies—and should.

Watch the burn

Monitoring franchise system health usually falls to operations or finance. Outright failure to monitor, misdirected methods or errors based on poor data are surprisingly common, even for large systems. Monitoring is often too focused on compliance or subjective performance measures (aka not in good standing or NGS units) instead of financial risk.

Franchisors attempting to understand franchisee financial health will often track unit EBITDA, also known as gross income. However, EBITDA doesn’t address cash flow, franchisee debt, the cost of assets (or replacing assets) or needed cash to fund working capital.

Cash is king. The best advance warnings about pending financial failure are: available liquidity, combined with monthly cash burn, which then signals remaining time available to prevent closure.

The pandemic notwithstanding, remember that sometimes liquidity problems are a symptom of poor capital planning or lack of financing access; it’s not always a signal of a bad operator. Upfront training should include capital planning so that franchisees can secure adequate lines of credit and establish contingency plans.

Update your agreement

If your franchise agreement doesn’t explicitly address periodic liquidity reporting, consider adding this provision as a standard requirement. (And seek advice of counsel.) At a minimum, collect the following information from franchisees: SBA personal financial statement (SBA form 413); documents verifying liquidity of franchisees and operating entities; and documents verifying ability to borrow.

Many franchise agreements already have similar language, but often the franchisor doesn’t collect the information.

Liquidity should be examined monthly along with other operational performance indicators. For franchise concepts that require significant debt commitments to get open, keeping an eye on system debt service commitments and available liquidity is especially critical. Don’t forget to examine total portfolio risk in the case of multi-unit operators, as recent bankruptcies of large franchisee ownership groups have demonstrated. Even sophisticated, multi-unit franchisees can end up over-leveraged due to expansion, acquisitions, upgrades, unforeseen events and re-imagining efforts. Market shocks can then undo marginal business models or operators, or over-leveraged franchisees.

Once you have a true sense of unit viability and the timelines for acute situations, the corporate team can employ a range of tactics to assist based on where units fall on the risk spectrum. The key is to stay in front of potential problems and have enough time to try to either remediate operational issues or hopefully coordinate a transfer to a more capable—and better capitalized—owner.

Third-party specialists can often assist. Offering franchisees access to independent advice can reduce risk of tortious interference or other claims. Again, involve counsel to create and execute a solid assistance plan.

Franchisees helping franchisees

The best franchisors also embrace franchise advisory councils to provide ongoing assistance, coaching, mentoring and best practice sharing to both new and struggling franchisees. Creating an established communications channel and making sure franchisees stay profitable is essential to a strong franchisor-franchisee relationship. FACs can be an effective bridge and valuable resource in this effort.

Development impact

Back to franchise sales. It’s important to keep your sales team in the loop regarding units at risk. Knowing what’s not working can help prevent future recruiting mistakes. Re-examine recruiting and approval processes. Required investment thresholds might need to be increased. Real estate approvals might need a second look if franchisees are over-spending compared to business model assumptions. Keeping sales in the loop also means potential resales can get earlier attention and assistance.

Many franchisors set franchisee expectations for a “halo of support” during the purchase process. They may say, “Our team is here for you,” or, “We’re only successful if you’re successful.” When you say these things, also set the expectation that you will ask (ongoing) for their financial information so you know how they’re doing. Because your interest in, and commitment to, their long-term success isn’t just a sales pitch.

Alicia Miller is a managing director at Catalyst Insight Group. Her Development Savvy column covers smart ways to market and grow a franchise. Reach her at amiller@catalystinsightgroup.com. Don Tyson contributed to this column, dtyson@catalystinsightgroup.com.

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