Advice & Tips Ask an Expert May/June 2019 Resource Articles

Q: What are the benefits of debt, and what are the key considerations when evaluating my options?

When franchisees are looking to start, grow, or expand a franchise business, one of the first questions they need to consider is: “Where will the capital come from to open this location?” At the heart of the ques­tion is whether raising capital to purchase the franchise, build, and grow it is the right option for you and your business objective. In order to effectively answer this question, let’s take a quick look at some of the financing options that are available to prospective franchisees.

Raising capital through financing falls into two main buckets: debt and equity, which can both be used to grow a business. Debt is borrowing money with the obligation to repay. This most commonly takes the forms of term debt (either long-term committed facilities – between one to five years or short-term facilities – demand facili­ties less than 12 months) and overdraft or line of credit facilities. Typically, debt is repaid with interest over a specified period of time, and has implications on your business’ cash flow, which need to be taken into consid­eration when evaluating a specific growth opportunity. Financial institutions such as banks readily provide vari­ous forms of debt. Equity, on the other hand, is usually provided in exchange for ownership in the business and a share of the profits. Equity can be provided by you, the franchisee, or from other investors and/or partners. Equity typically does not have scheduled repayments during the term of the investment, though specifics can vary. While some portion of franchisee equity capital on a new project is necessary, this article will focus on the debt considerations for your franchise investment.

Taking on debt to grow your business should only be considered if there is a tangible benefit provided from the use of that capital, either in the short or long-term. Simply put: How will you benefit from taking on debt?

A net benefit in cash flow (new cash inflow less debt repayments) should be the first consideration when considering taking on debt. You must asked yourself if you can grow your revenues through either a renova­tion, expansion, or building a new facility. If taking on debt allows you to satisfy any of these questions, then it is time to evaluate the second main consideration: How much additional cash flow will I generate? And is that amount of net cash flow enough to make the effort worthwhile. Additionally, it is also important to under­stand the long-term implications of your growth. What will be the benefits of this project when the debt is fully repaid? How much additional cash flow will I generate that I otherwise would not be generating? How much is the business worth if I look to sell it? Debt often allows franchisees to achieve higher levels of free cash flow and greater overall business values in less time than if expansion were delayed. The ability to achieve these states faster through use of debt is the largest benefit that it provides.

Once the decision to take on debt is made, there are several key factors to consider. Total debt amount, price, amortization, and Security are the first primary factors that come to mind for most franchisees as they have the greatest impact on annual repayments and yearly cash flow. They provide the basics to make an informed deci­sion. It is important to understand the impact that these factors may have on your proposed facility. For example, an amortization of 10 years versus five years will lower your annual debt repayments by 43 per cent (all else being equal). While this example may be drastic, such changes can mean the difference between a project that is viable, and one that is not.

But while any of these factors may provide a differentiation between various financial institutions, they should not be the only factors used to evaluate the ben­efit of a financial lender. As mentioned earlier, total debt amount, price, amortization, and security are important factors, and are most easily used to compare financial institutions. But there are several other considerations that are just as important which should be discussed and explored, including:

  • Fees: What is the initial application fee? What are the ongoing annual fees? What is the annual review fees? What are the fees for banking services? Often these can offset any perceived rate benefits offered by one financial institution versus another.
  • Financial Covenants: Will my cash flow allow me to meet my covenants easily? How much room do I have if revenues slow down? Is my pro forma realistic, or will there be cash flow issues? How frequently are covenants being tested?
  • Appetite for Growth: Does your financial institu­tion have a desire to continue financing your future development? Can you get a pre-approval for future growth? Are they evaluating your business holisti­cally, or on a unit by unit basis?

These are just a few of the additional items that should be discussed with your financial institution when evaluating your debt options. A financial lender should be able to walk you through various lending options and scenarios, present the implications (both favourable and adverse) on your business, and be there to answer any of your questions. A financial lender should be a partner to your business, so never hesitate to ask them about any of the above.

Tom de Larzac
Head of Franchise Banking
HSBC Bank Canada