Advice on family funding for your franchise

Ensure you have a comprehensive written agreement in place if you're thinking of using family funding to finance your franchise, says Carl Reader

Many prospective franchisees turn to family members to help them fund their new venture. The terms are often flexible and the application process is shorter than a bank’s. So is this the right way to start your franchise?

There are several reasons why a new business owner would ask relatives to help finance their venture.The business proposition might have been turned down for bank funding, they might be intimidated by the formality of the application process or it could be that the individual has a poor credit record. Whatever the reason, it is important both parties enter into any agreement with a full understanding of the potential issues that might arise.

Positive light
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Before considering family funding, it is worth investigating whether the banks are willing to lend. Despite the negative press, banks have to lend to stay in business and franchising is looked upon in a positive light due to the increased chances of success when compared to most non-franchised start-ups. Provided that the franchise is a proven model and the business plan stacks up, bank funding remains the main option for most new franchises.

If a family loan is considered to be preferable, both sides should decide on the following terms:

* Amount of loan. Both parties should agree how much is going to be funded and when the money will be available.

* Repayment terms and interest. The length of the loan, repayment terms and interest rate should all be clearly set out. It is also important to cover how the interest is calculated, so that any early settlement can be calculated accurately

* Risk of default. Not every business is going to be successful. As there is a risk of default, both parties should consider what happens if the business is unable to meet the agreed repayments.

Ideally these terms will be included in a written agreement, which will help prevent any future misunderstandings or disputes over money.

It is also important that the transaction is approached in the same way that bank funding would be. Even though it might be the case that family members are willing to lend money without a detailed business plan, I believe that both sides have a moral duty to ensure they are comfortable with the proposed business.

As a result, a business plan should be prepared with the same detailed financial and operational projections as a bank would expect to see. Not only will this demonstrate the viability of the business, but it will also give the prospective franchisee the chance to fully appraise the opportunity, its suitability to the local area and their skill set.

Equity share
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One area that families need to consider is whether the funder takes an equity share in the business. I have seen cases where the money is provided based on a share of the business being allocated to the funder. If this happens, both sides need to discuss a reasonable percentage.

This method of funding can cause difficulties in respect of payments to the business owner, however. In a corporate business a shareholder who is also an employee would expect to receive payment for work performed as a salary and a return on investment as a dividend. In a smaller business, payment for work performed and investment return is often blurred. This is reinforced by the current tax legislation, which tends to favour dividend payments to shareholders of small businesses.

This complication is not a problem for most small businesses. However, if there is a silent partner in the business you need to decide whether they should be entitled to a share of all the profits or just a certain amount. A workable solution is to allocate different classes of shares to each party, so that different levels of dividends can be paid. It can then be agreed between the parties how much should be paid to the franchisee for work performed and any profit over and above this amount can be distributed as dividends.

If this approach is taken, it is essential that a shareholders’ agreement is prepared. Although loan and shareholder agreements may seem excessive for a family transaction, I have seen many disputes occur after a deal has been agreed. The formalisation of the process will help ensure that both parties know exactly how the deal is structured and each other’s obligations.