Why should I franchise my business?

Franchising in South Africa has evolved from modest beginnings back in the mid-1960s into today’s preferred business expansion tool. Originally, franchising was linked to fast food operations but this is no longer the case. Over 600 franchises operate in more than 30 different industry sectors and new concepts emerge all the time. This article provides an overview of what franchising a business entails.

Who should consider franchising a business?

Essentially, franchising is a marketing tool but seen from the prospective franchisor’s viewpoint, it is also an expansion tool because it enables entrepreneurs to expand their established businesses at a much faster rate than would otherwise be the case. In my experience, the following are the most likely candidates for franchising:

  • SME ready to expand

Let’s assume that your company has a credible track record and business is booming. You have the urge to expand but lack the resources (management and money) to do so quickly. By offering franchises to others, you establish a growing network of highly motivated individuals who operate under your brand but carry the full business risk and are therefore highly motivated to succeed.

  • Under-performing branch network

Establishing branches requires a substantial investment up-front, plus the extensive initial and ongoing attention of senior management. Because branches are operated by managers, their true business potential is rarely fully exploited.

Experience has shown that by converting under-performing branches into franchises, poorly trading branches can be transformed into star performers very quickly. However, you cannot offload branches that cannot be rescued on unsuspecting franchisees.

  • Company wishing to implement a BEE programme

Companies are under pressure, to provide BEE certificates. This is no longer limited to government entities but increasingly includes corporate customers who want to improve their own BEE standing. Even landlords ask prospective tenants to provide BEE compliance certificates, for the same reason.

Franchising is the ideal vehicle for the implementation of sustainable BEE initiatives. It offers deserving members of staff or other qualifying individuals an opportunity to acquire businesses of their own. Because skills transfer, initial and ongoing support are integral parts of any franchise, these aspiring entrepreneurs stand a fair chance of success. Finance could be a problem but as we shall see, there are ways around that.

What does it entail to create a franchise?

Setting up a franchise is not a route to quick and easy riches. It can be highly profitable but requires a long-term approach.

Pre-conditions for successful franchising

  • Track record

Seen from the prospective franchisee’s viewpoint, a franchise is a blueprint to business success. The franchisor must have tried and tested the concept, and proven its commercial viability. The business must have a sound track record that extends over a minimum of one to two years. Moreover, the brand should enjoy the respect of its existing customers and suppliers. Agreement exists that to franchise an idea would border on fraud. (The right to an idea can be sold by granting a licence for others to develop it.)

  • Growing market

Setting up and operating a franchise is expensive. Unless the potential exists to grow the network into a size that allows economies of scale to kick in, rolling out a franchise will not be cost-effective.

  • Availability of sites

If the business is location-dependent, suitable sites must be available at affordable rentals, failing which the rollout of the franchise will soon stall. The same principle applies to the recruitment of staff, should they need specialised skills that are in rare supply.

  • Access to funding

I have already said that franchisees are responsible for funding their own businesses but this does not get the franchisor off the hook entirely. To set up the necessary franchisee recruitment and support infrastructure requires a substantial investment – see Development Costs below. Moreover, the franchisor should expect to operate the franchise division at a loss for the initial period, usually around two years. The reason for this is that while the basic franchisee support infrastructure needs to be in place from day 1, franchise fees will be a mere trickle at first because rolling out the franchise takes time and fee income from new franchisees will be low.

Financial issues

  • Development costs

Following the initial research phase during which the basics of the franchise concept are developed, the franchisor is responsible for the cost of having an operations manual, a franchise agreement and a disclosure document drawn up. Training and franchisee recruitment materials need to be developed as well.

With the exception of the legal documents, which must be drawn up by an attorney with experience in franchise matters, much of the work can be done in-house. However, in my experience, this doesn’t work too well. Presumably, everyone employed in the core business has a job to do. If they are asked to write operations manuals etc. ‘on the side’, it is reasonable to assume that either the core job suffers or the franchise material will never be completed.

  • Initial franchise fee

This is a lump sum the prospective franchisee pays the franchisor. It is payable once only, usually at the time the franchise agreement is signed. In terms of good franchise practice, the franchisor sets the initial franchise fee to recover the cost of developing the franchise, charged out on a pro rata basis. Depending on the number of franchisees that are signed up, it can take three to five years to recoup the initial set-up costs.

  • Ongoing franchise fees
  • Management services fee

In most instances, this fee is calculated as a percentage of the franchisee’s sales and becomes payable monthly. Percentages fall into a wide range (about 1 to 7%) and vary from one sector to another, and even among different franchises within the same sector. It boils down to the extent and quality of the support the franchisor offers.

  • Contribution to the marketing fund

Most networks operate a marketing or advertising fund earmarked for product promotions. All members of the network, including the franchisor’s own units, contribute. Contributions can either be in the form of a percentage of sales, or a fixed sum.

Access to funding

Banks know that a well-operated franchise substantially reduces business risks. They see a franchise as a win/win arrangement and are keen to provide funding, especially for prospective franchisees. They will require evidence that the franchise is set up along proven principles. They are especially concerned that the franchisor had the correct documentation drawn up and has the necessary infrastructure in place to provide superior franchisee support.

  • Prospective franchisor needs funding

A prospective franchisor can expect the bank to treat a request for funding in the same way as any other request for expansion funding. It is worthwhile noting that each one of the four major banks maintains a dedicated franchise division. Individuals with a good grasp of franchising staff these divisions. Drawing on their insights into the sector, they will be able to offer valuable advice long before they discuss funding options with you.

  • Prospective franchisee needs funding

As a rule, raising finance for the franchised unit is the responsibility of the prospective franchisee. The franchisor merely facilitates access to banks and assists with the compilation of the funding application.

  • BEE funding

Given South Africa’s not so distant past, it is not always possible for BEE candidates to come up with the necessary investment. Should such a candidate display outstanding qualities but cannot come up with the necessary investment, a joint venture arrangement under franchise may be the answer. It works as follows:

1. The franchisor establishes a joint venture (JV) company and grants it a franchise.

2. Initially, the franchisor holds the bulk of the shares while the incoming JV partner, who is trained and mentored to fill the role of the residential partner, receives a relatively small shareholding.

3. Over time, the residential partner has an opportunity to acquire additional shares at issue price until he/she owns 100% of the shares.

4. At this point, the mentoring component is withdrawn and the JV agreement reverts to a standard franchise agreement.

Legal issues

  • The franchise agreement

The franchise agreement regulates the franchise relationship. It is a complex document and can run into 70 or more pages but affords every franchisee the same grant. The Consumer Protection Act (CPA) specifies the minimum information it must contain.

  • The disclosure document

The disclosure document is a confidential document. It provides prospective franchisees with the information they and their professional advisors need to make an informed decision about the investment. The CPA prescribes the minimum information the disclosure document must contain and makes it compulsory for franchisors to provide qualified prospects with a copy at least two weeks before the franchise agreement is signed.

  • The operations manual

Strictly speaking, the operations manual is not a legal document. However, it is an extension of the franchise agreement. While the franchise agreement lays down the rights and obligations of both parties in legal terminology, the operations manual translates these into practical operating instructions.

Further information

This website, www.safranchisebrands.co.za, contains a growing number of articles that are of interest to prospective franchisors. In addition, once your new franchise venture is up and running, the site offers a platform for the promotion of your franchise opportunity.

The book How to franchise your business is published by the Franchise Association of South Africa (FASA) and written by Kurt Illetschko with expert contributions by legal and other topic specialists provides. It is currently in its sixth completely revised edition, explains the concept in detail and provides practical guidelines and checklists.

Kurt Illetschko

Acknowledgement: This article was contributed by Kurt Illetschko of ManualMakers CC. He writes disclosure documents and produces operations manuals. Contact: kurt@manualmakers.co.za.

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