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In Need of Expansion Capital? Consider Other People’s Money

“In Need of Expansion Capital? Consider Other People’s Money”

The biggest barrier to expansion faced by today’s small businesses is capital. Entrepreneurs using traditional forms of capital acquisition have only two options: debt or equity. However, they would be wise to consider franchising because it allows them to expand without the risk and lack of availability of debt or the cost of equity. This article from Entrepreneurial Edge magazine looks at franchising as an alternative form of capital acquisition.

The biggest barrier to expansion faced by today’s small businesses is capital. Entrepreneurs using traditional forms of capital acquisition have only two options: debt or equity. However, they would be wise to consider franchising because is it allows them to expand without the risk and lack of availability of debt or the cost of equity.Anyone who has been to a bank recently knows the first problem all too well. Unlike the “go-go” days of the 1980s when banks would often lend a company several times its net worth, banks today are often reluctant to lend even in situations in which they are fully secured. And while this situation is changing now that interest rates are once again on the rise, it is unlikely that most entrepreneurs can readily obtain the amount of expansion capital from a bank that they need.

Even if they were to obtain this capital, however, the real problem that they would face is risk. One needs only to look over the leveraged-buyout graveyard dug in the 1980s to fully understand the impact of this risk. Many companies are buried there that were profitable, but could not withstand the debt load they were carrying in a down market.

As an alternative, expansion-minded businesses can look to the equity markets for growth capital. But after they have exhausted the most obvious sources of equity capital — friends, relatives and suppliers — they are forced to turn to the investment community.

Again, the first problem they are likely to face is that of availability. Venture capitalists, for example, will fund approximately one business plan out of every 100 submitted. The issues of cost and control are important to consider, as well. While venture capitalists will generally not collect interest, they usually value your company in such a way that provides them a minimum of 35 percent annualized return on investment! And while most venture capitalists want you to run the company, they will not allow you to continue leadership if you are not making your projections.

Franchising, as an alternative form of capital acquisition, offers some significant advantages. Since the franchisee provides the initial investment at the unit level, it allows for expansion with minimal capital. Moreover, since the franchisee — not the franchisor — signs the leases and commits to various service contracts, franchising also allows for this expansion with virtually no contingent liability, thus greatly reducing the risk of the franchisor.

Therefore, as a franchisor, not only do you need far less capital to expand, but your risk is largely limited to the capital you invest in the development of your franchise company — an amount that is often less than the cost of opening one additional company-owned location.

Finding the Motivated Manager

Another barrier to expansion facing many of today’s entrepreneurs is finding and retaining good unit managers. All too often, a business owner spends months looking for and training a new manager, only to see that manager leave or, worse yet, hired away by a competitor.

Franchising allows the business owner to overcome many of these problems by substituting a motivated franchisee for the unit manager. Interestingly enough, since the franchisee has both an investment in the unit and a stake in the profits, unit performance will often increase.

In fact, a recent study conducted by Francorp and DePaul University found that franchised units typically outperformed company-owned operations, often by more than 20 percent. Even franchise veteran McDonald’s has recognized this trend, confirming in its most recent annual report that franchisees outperform managers by 11 percent in same unit sales.

From a managerial point of view, franchising provides other advantages, as well. By eliminating the need for day-to-day, unit-level responsibility, franchising allows management to direct its efforts toward improving the “big picture.” Moreover, since a franchisor’s income is based on franchisee’s gross sales and not profitability, monitoring unit level expenses becomes significantly less cumbersome.

The Innovator’s Worst Enemy: Time

Every entrepreneur I have ever met who has developed something truly innovative has the same recurring nightmare: someone else beats them to the market with their own concept. These entrepreneurs realize that even if they had all the capital they needed to expand, they would probably be unable to do so as fast as they needed in order to lock out competitors.

The problem is that opening a unit takes time. You need to hunt for appropriate sites, then negotiate leases, arrange for the design and build-out, secure financing, hire and train staff, and purchase equipment and inventory. The end result is that the number of units you can open in any given period of time is limited.

For these entrepreneurs, franchising may be the only way to ensure that they capture the market share to which they feel entitled, because it is typically the franchisee who performs most of these tasks. The franchisor provides the guidance, of course, and the franchisee does the legwork.

Franchising allows these companies to saturate markets before competition can gain a significant foothold. Moreover, franchising allows the franchisor to grow a leaner organization. Large advertising, human resources and accounting departments can be avoided because most of these functions are assumed by the franchisee. Thus, franchising not only allows the franchisor financial leverage, but it allows him to leverage his resources as well.

Because companies can grow much faster in this situation, they can take advantage of numerous economies of scale much sooner. The most obvious example of this, of course, is the savings achieved through the collective buying power. But the advantages go much further. With more units in place, more dollars can be generated for national and local advertising, thus increasing sales. Greater overall income can provide for additional research and development, allowing both the franchisee and the franchisor to stay on top of industry developments.

The Great Equalizer

Franchising isn’t for every entrepreneur. But it does offer enough advantages worth investigation by many entrepreneurial companies, especially those hoping to achieve dynamic growth. It levels the playing field between the entrepreneurial companies and the lumbering corporate giants. It allows entrepreneurs the advantage of speed, capital and motivated management that they could not otherwise access.

Franchising alone will not make your company the next Boston Market, but without the advantages it offers, few entrepreneurial companies can compete effectively with their larger and better-capitalized competitors.

About the Writer: Mark C. Siebert is CEO of the iFranchise Group, a leading franchise consulting firm that offers the skills of the nation’s top professionals in franchise strategic planning, operations training and documentation, franchise marketing and sales, advertising fund management, franchise recruitment, and development of Internet-based applications for emerging and established franchise companies worldwide.�He can be reached at (708) 957-2300.

This article first appeared in ENTREPRENEURIAL EDGE MAGAZINE — Fall 1996 (ISSN 1086-8399). Copyright 1996 by the Edward Lowe Foundation. All rights reserved. Entrepreneurial Edge is a trademark of the Edward Lowe Foundation.