RAISING CAPITAL FOR THE GROWING FRANCHISOR
By Andrew J. Sherman, Esq.

One of the most difficult tasks faced by the management team of a growing franchisor is the development and maintenance of an optimal capital structure for the organization. Access to affordable debt and equity capital continues to be a problem for the growing franchisor despite the fact that franchising has matured as a viable method of business growth.

Only recently have the investment banking and commercial lending communities given franchising the attention it deserves. There are finally enough franchisors whose balance sheets have become more respectable, who have participated in successful public offerings, who have played (and won) in the merger and acquisition game and who have demonstrated consistent financial appreciation and profitability. These developments have played a role in providing young franchisors access to affordable capital in recent years. Nevertheless, a growing franchisor must be prepared to educate the source of capital as to the unique aspects of financing a franchise company. And there are differences. Franchisors have different balance sheets (heavily laden with intangible assets), different allocations of capital (directed as expenditures for "soft costs"), different management teams, different sources of revenues, and different strategies for growth.

This presentation will provide an overview of the various methods of raising capital which are available to franchisors of all sizes and types, with a special emphasis on early-stage and emerging growth companies. Naturally, the amount of capital potentially available, as well as the sources willing to consider financing a given transaction, will be largely dependent on the franchisor's current and projected financial strength, as well as the experience of its management team and a host of other factors which will be discussed in more detail later in this chapter.

The Initial and Ongoing Costs of Franchising

Before turning to the key elements of business planning and an examination of capital formation strategies, it is important to understand the specific nature of the capital requirements of the early-stage and emerging franchisor. Although franchising is less capital intensive than internal expansion, franchisors still require a solid capital structure. Grossly undercapitalized franchisors are on a path to disaster because they will be unable to develop effective marketing programs, attract qualified staff or provide the level of quality of ongoing support and assistance which franchisees need to grow and prosper.

Bootstrap franchising has been tried by many companies, but very few have been successful. In a bootstrap franchising program, the franchisor uses the initial franchise fees paid by the franchisee as its capital for growth and expansion. There is a bit of a "Catch-22," however, if the franchisor has not properly developed its operations and training program and materials prior to the offer and sale of a franchise. Such a strategy could subject the franchisor to claims of fraud and misrepresentation, since the franchisee has good reason to expect that the business format franchise is complete, and not still "under construction." A second legal problem with under capitalization is that many examiners in the registration states will either completely bar a franchisor from offer and sales in their jurisdiction until the financial condition improves, or impose restrictive bonding and escrow provisions in order to protect the fees paid by the franchisee. A third possible legal problem is that if the franchisor is using the franchise offering circular to raise growth capital, then the entire scheme could be viewed as a securities offering, which triggers compliance with federal and state securities laws.

The start-up franchisor must initially develop a budget for the developmental costs of building the franchise system. This budget should be incorporated into the business plan, the key elements of which are discussed below. The start-up costs will include the development of operations manuals, training programs, sales and marketing materials, personnel recruitment, accounting and legal fees, research and development, testing and operation of the prototype unit, outside consulting fees, and travel costs for trade shows and sales presentations. Naturally, there are a number of variables which will influence the amount which must be budgeted for development costs, including:

• the extent to which outside consultants be required to develop operations and training materials;
• the franchisor's location and geographic proximity to targeted franchisees;
• the complexity of the franchise program and trends within the franchisor's industry;
• the quality, experience and fee structure of the legal and accounting firms selected to prepare the offering documents and agreements;
• the extent to which products or equipment will be sold directly to franchisees, which may require warehousing and shipping capabilities;
• the extent to which personnel placement firms will be used to recruit the franchisor's management team;
• the use of a celebrity or industry expert to "endorse" the franchisor's products, services and franchise program;
• the difficulty encountered at the United States Patent and Trademark Office in registering the franchisor's trademarks;
• the extent to which direct financing will be offered to the franchisees for initial opening and/or expansion;
• the compensation structure for the franchisor's sales staff;
• the difficulty encountered by franchise counsel in the registration states;
• the extent to which the franchisor gets embroiled in legal disputes with the franchisees at an early stage;
• the quality of the franchisor's marketing materials;
• the type of media and marketing strategy selected to reach targeted franchisees;
• the number of company-owned units which the franchisor plans to develop;
• the length and complexity of the franchisor's training program; and
• the rate at which the franchisor will be in a position to repay the capital (or provide a return on investment), which will influence the cost of the capital.