A financial institution looks at the expected cash flow generated by a franchise and determines the amount of debt that the franchise can sustain. The purchaser must provide the difference between this amount and the cost of the newly acquired franchise – this is known as unencumbered funds. According to Alan Greenspan, former US Federal Reserve chairman, “Any informed borrower is simply less vulnerable to fraud and abuse.”
Entrepreneur asked Anita du Toit, franchise specialist at FNB why unencumbered funds are so important in the franchise sector.
Why are unencumbered funds necessary to buy a franchise?
If the franchisee borrows 100% of the funds, albeit from a bank or other sources, the business will be over-geared. The franchisee will have to make huge repayments every month and it’s unlikely that a young business will be able to afford this.
Putting cash into the business avoids the over-gearing scenario. Secondly, banks want to see the intent of the franchisee to take some risk by also investing in the business.
Related: DTI Funding Guide
What percentage of unencumbered cash is required upfront to buy a franchise? Is there a set amount?
Most franchisors and banks require the franchisee to invest 50% of their own funds in cash into the business. In some instances, such as petrol stations and retailers, this amount can drop to 30%.
Are alternatives available for entrepreneurs who have some unencumbered funds but not enough to meet the franchisor’s requirements?
The alternatives include getting a partner on board to contribute to the business or saving some more discretionary funds like bonuses towards the own contribution. Some government institutions have special programmes for BEE franchisees where they accept a lower own contribution.
What are the advantages of unencumbered funds for the bank?
It mitigates the risk of the bank by reducing the amount the franchisee will have to repay towards debt. It ensures that there is enough free cash flow to pay the bank and other debtors, thereby ensuring the ongoing success of the business and reducing risk for the bank.
What disadvantages face the franchisee?
Obviously, the franchisee will have less cash available to use personally or in the business. However, taking a bank loan has advantages including the fact that the interest repayments reduce the taxable income of the business. Franchisees can also apply for an overdraft to ensure that there is a buffer in case of a cash flow problem.
Is there any small print that should be of concern to a franchisee in terms of unencumbered funds?
The unencumbered funds should really be cash available in liquid form and not obtained from a bond or other loan which would increase the debt level of the franchisee in his/her personal capacity. Banks also look at the personal balance sheet of a franchisee when assessing affordability.
Any useful advice or tips that I can use regarding unencumbered funds?
Don’t over-extend yourself by putting your last available cash into the business. You should still have an emergency fund to draw on in case business conditions worsen or in case of personal emergency.
Just like a salaried employee, a franchisee should aim to have enough cash to cover his/her living expenses for at least three to six months.
Even if you have unencumbered funds what if banks refuse finance?
A bank can finance the balance if the applicant meets the required criteria. In addition to a franchisee’s own contribution, the franchisee also needs to offer some form of collateral. If no assets are available to offer as security, the applicant can apply to Khula Enterprise Finance here.
Khula is dedicated to the development and sustainability of small businesses in South Africa. They have been assisting entrepreneurs for more than 13 years. However, they are a wholesale lender and the franchisee would need to approach a commercial bank, such as FNB or any of their non-bank retail financial intermediaries to apply.
For more information contact FNB Franchising +27 11 632 0390