Erasibo Consulting

“It was noted that South African banks weathered the global financial crisis well, due to a strong regulatory environment and sound risk management practices.”
- Meeting between Minister of Finance and Bank CEO’s 31 May 2010

Small, medium and micro-enterprises (SMMEs) represent an important vehicle to address the challenges of job creation, economic growth and equity in South Africa. Around the world, one finds that SMMEs are playing a critical role in absorbing labour, penetrating new markets and expanding economies in creative and innovative ways.

The availability of finance is important for SMME business development. In South Africa the major banks have for years tried to limit their exposure to previously disadvantaged communities and SMME’s. The public relations spin, which is directed to us by the banks and their communications specialists, simply don’t live up to the spins promises. Banks say they are your “partners”; they are here to help with your “dreams” etc. to the point of nausea.

In my opinion, the apathy shown by the commercial banks towards the SMME sector is surprising, the banks talk a good talk about “development” and “empowerment” but have delivered very little in real terms to South Africans. Recently I interviewed a leading economic analyst to the government of South Africa, who pointed out to me the following perspective: “ there are two sides in South Africa; the banks and their interests and the rest of us”. Here is an excerpt from the Competitions Commission about the Banking Sector from their annual report 2008-2009:

Competition concerns in this sector arose from the fact that concentration was very high in almost all banking product categories with little evidence of rivalry between the four largest banks which accounted for 86% of total deposits and 99.7% of transactions through the payments system. Fees were also high and increasing rapidly with the incidence of costs falling particularly heavily on low-income customers and small businesses. There was also substantial public concern regarding the level of bank charges and other providers of payment services to consumers. The sector is of particular significance as more efficient and competitive financial services would reduce the cost of capital to SMME’s and all consumers. Lower bank charges and fees would also make banking services more affordable to low income earners

Read the National Treasuries: Facilitating the implementation of the Recommendations of the Banking Enquiry Panel report which is available at the National Treasury via this link http://bit.ly/9PQuz1

In researching this article it was very difficult to ascertain exactly what percentage of the major banks loan books are extended to SMME’s. Add to this the fact that the major banks coerce you as an SMME to enter into contracts which gives them all the protection whilst exposes you to all the risk and you start to see the banks for what they really are: profit at all costs.

A South African bank in 2010 is not your partner; it’s a line item for which you need to carefully budget every single month. The courts are filled with examples of what kind of partner’s banks are. You need to realize that when a bank evaluates your business idea what they are actually looking at is not the viability of the business, but whether or not your personal net worth will cover their loan, so that in the event of a recession, crime, malpractice on the part of the bank or even an act of God they will get their money back from you, even if it leaves your family destitute.

Here are some alternative sources of funding that you may want to try out first, before handing over your life to a major bank.

I find that the reason so many SMME’s don’t approach alternative funding partners is because:

• They don’t know what’s out there in the way of alternative funding
• They don’t know how to access and interact with these funds – this is more to do with the maturity of the individual applicant and less to do with the agencies procedures albeit that they are sometimes cumbersome; what did you think borrowing money was going to be easy?
• They prefer approaching the major banks because the marketing of the major outshines the alternative funders marketing and they find the major banks processes to be easier. In affect many people will take the riskier option of a commercial bank simply because the banks process faster by demanding higher risk burdens to be borne by the lender.
• They assume that these alternative funds are only for “blacks” – for the 2008/2009 period Khula Enterprise Finance allocated 52% of its funding to “black” business’s meaning the other 48% went to non black business. These alternate institutions don’t help their cause by not being clear on this message.
• Alternative funders don’t seem to have tailored the products as attractively as the commercial banks have i.e. where commercial banks will have specific products for franchising, financing of private schools, the funding limits are below the market value of viable business ventures such as franchises etc.

I prefer alternative funders to the banks because:

1. they take on more risk,
2. they don’t tie you as heavily to personal sureties (some in fact don’t ask for personal surety at all),
3. they do a an actual due diligence on the business you want to acquire, and
4. if you negotiate your contractual terms correctly you can get them on as backup should your deal go sour – and this is not be underestimated.

The organization listed below in my view are the best alternative funding options that a South African SMME / entrepreneur from a working class or previously disadvantage background has:

ID	Name	Website / Telephone	Details
	Small Enterprise Development Agency (seda)	http://www.seda.org.za Tel: 0860 103 703	Seda provides business development and support services for small enterprises through its national network in partnership with other role players in the small enterprise support. Seda also implements programmes targeted to business development in areas prioritised by the Government.
	The SA Micro-Finance Apex Fund (Samaf)	http://www.samaf.org.za 012 394 1796	SAMF is tasked to facilitate the provision of affordable access to finance by micro small and survivalist business for the purpose of growing their own income and asset base. The primary purpose of SAMF is to reduce poverty and unemployment and also to extend financial services to reach deeper and broader into the rural and peri-urban areas. Further to this, samaf wants to build a network of self-sufficient and sustainable micro-finance institutions.
	Khula Enterprise Finance	http://www.khula.org.za 08600 54852	The company is a wholesale finance institution which operates across the public and private sectors, through a network of channels to supply much-needed funding to small business. Khula’s channels include South Africa’s leading commercial banks, retail financial institutions, specialist funds and joint ventures. Its primary aim is to bridge the “funding gap” in the SME market not addressed by commercial financial institutions.
	Umsobomvu Youth Fund	http://www.uyf.org.za Tel: (011) 651 7000	The fund is aimed particularly at young people. The fund not only offers access to finance (at various scales) but also offers access to business consulting skills, education programmes and much more.
	National Empowerment Fund	http://www.nefcorp.co.za Tel:(011) 305 – 8000	The NEF’s role is to support BB-BEE.  The NEF anticipates future funding and investment requirements to help Black individuals, communities and businesses achieve each element of the Codes of Good Practice. These include a focus on preferential procurement, broadening the reach of Black equity ownership, transformation in management and staff and preventing the dilution of Black shareholding.
	Industrial Development Corporation	http://www.idc.org.za Tel: 011 269 3000	The IDC is a self financing national Development Finance Institution (DFI), whose primary objectives are to contribute to the generation of balanced, sustainable economic growth in Africa and to the economic empowerment of the South African population, thereby promotion the economic prosperity of all citizens. The IDC achieves this by promoting entrepreneurship through the building of competitive industries and enterprises based on sound business principles

How should you go about engaging with these potential funders? Potential funders are an essential element to your business network. Businesses cannot survive in isolation, especially SMME businesses.

Consider the following diagram, it illustrates where the commercial banks fit in servicing the South African market. Identify where you fit and begin an engagement process with the institutions that are targeting you.

There is no secret formula for successfully approaching a funder. There is not guarantee you will get the financing you require.  Your best chance of success with a funder is to firstly know your business and your environment; if you are a going concern you must have stable financial results and you should know how your potential funders would react to your business and its environment.

Your engagement process with funders should not start with the initial loan application. I would suggest following this elementary engagement process

Collate all your information: you will be asked by a funder to submit along with a business plan, financials and application forms, the following:

1. All company registration document
2. Place of residence and operation (typically a municipal account
3. Detailed CV’s on yourself and partners
4. Tax Clearance certificates if you are a going concern and are registered for tax with SARS
5. A detailed business plan with financials and projections – most funders have their own formats
6. Know your industry – collate as much information and interpret it about your industry, what are the drivers of your industry and where do you fit in your industry.

Pre-Application: Send out requests for information packs to the list of potential alternative funders. I would suggest learning as much as you can about the various funders and then selecting who to apply to:

• Ask for a complete profile on their products and services as well as application packs, and
• A detailed explanation  (most do not have these detailed) on the application process including what happens if you are successful and what prejudice will you face if you are rejected.
• Ask for a meeting with an account manager. You need to build personal relationships with these people. Funders receive thousands of requests a year, its best to try to differentiate you as best as possible; start with a handshake
• Enquire about whether or not the funder will take ownership in your business and what the pros and cons of this are.

Application: My best advice to you is to sit down with the funder (actually schedule time with someone) to walk you through the application process and the development of your business plan. This is one of the big differences between commercial banks and the alternate funding agencies; the agencies will assist you develop your business plan more than a commercial bank will.

Securing funding is no mystery. It’s just very difficult. If you speak frankly with knowledgeable account mangers in the lending game they will tell you, that ideally a SMME should start off with out any need for financing, financing can kill a good business idea. You really need to know what you need the money for and be disciplined to follow the application process and if you are lucky to secure the funding (by being pedantic about the detail) you need to be disciplined about how you spend that money, ensuring that you repay the funder.

Whether you are considering buying a business for a few thousand rand or for a few million rand or whether you are considering starting up a business, a due diligence exercise will prove most useful in providing you with a degree of peace of mind prior to putting pen to paper on the business agreement.

I want to stress that regardless of the size of the deal and regardless of who the parties to the deal are, make sure you undertake a due diligence. I will always advocate for the most thorough due diligence you can afford, this is money, time and effort you should spend in order to save you money, time and effort later. Also remember, you often get the value of service you pay for, so don’t cut corners.

In researching this article I have been staggered to see how little information is readily available on public platforms on the subject of due diligence. What is available is very pricey and usually only talks to high level issues. This is worrying considering how vital a due diligence exercise is, especially to the first time business owner.

What is Due Diligence?

For the purposes of this article, Due Diligence should be understood as an exercise to be undertaken as part of the purchase of a new business. Simply put, due diligence is an investigation into a business with the purpose of proving to the initiator of the due diligence (typically the buyer) whether the facts offered up by the other party to the deal (typically the seller) are in fact a true reflection of the business.

Who should do the Due Diligence?

In order to do a due diligence well you will need two key role players:

1. Professional Assistance: Due Diligence’s exercises are technical in nature and if you have the funds available make use of a professional firm that has done these types of exercises before. Apart from all the certificates and client references that you will get from the firm you hire, check to see if any of the people who will work on your due diligence have ever run businesses before – you cannot under estimate the value of experience.
2. You: Your personal involvement in the due diligence process is vital. The professionals you bring on board work for you, but will not always understand, amongst other issues, precisely what your vision is for the business, what your appetite is for risk is and how you would deal with problems that will be encountered.

I would encourage a more hands on, engagement with your team so that at the end of the day you are getting a due diligence report that will allow you to take an effective decision. You don’t just want a report that says, “Yes do it” or “No don’t do it”. A due diligence is not simply a synopsis on the business you want to acquire or startup. In fact your due diligence report (which will be a detailed report on all aspects of the investigation) can serve as a great tool for guiding your future business plans and strategies for the business should you acquire it.
Some finance houses and banks will offer to do a due diligence for you. Be wary of this service; be wary of any due diligence exercise where the companies doing the exercise for you will profit from your deal outside of the fee you pay for the due diligence.

A Due Diligence Model

Non-Disclosure Agreement

The due diligence exercises should always start with a Non Disclosure Agreement (NDA). Characteristics of the NDA that you should be aware of are:

• The NDA is to be signed between yourself and the seller.
• This agreement essentially protects both parties from the having their confidential business information made public.
• A confidentiality period must be specified. Please remember that the confidentially clause does not apply to illegal activity.
• The NDA should talk to you requiring a Due Diligence and it should specify the high level areas that the Due Diligence will cover. The seller must agree to this. If the seller does not agree to this, walk away.

Due Diligence Areas

A good due diligence exercise will cover the following nine areas1. In addition you (or your team) will need to acquire from the seller the following documents for your due diligence exercise. These documents should be made available to you quickly as the seller should already have these available. If the seller is unable or unwilling to provide this information this would be a cause for serious concern. The fundamentals of running a good business are record keeping.

: *please note the Due Diligence Item column is not exhaustive*

Due Diligence Area	Due Diligence Item	Documents Required
Financial Performance of business	Current years profit/loss? Previous years profit/loss? Current years revenue? Previous year revenue? Current year gross margin Previous year gross margin? 3-year revenue growth trend? Industry average growth trend? Profitability and margin comparison versus the industry? How does revenue growth compare to inflation? Does the company have pricing power? Why or why not?	Current annual business plan 5 years of audited financial statements 3 years tax returns (tax clearances for 3 years) 36 months of bank account history
Brand value	Can the brand be leveraged to enter new markets? Can the brand be leveraged to resist economic downturns? Is there a formal process, institution to product the brands value? Can the brand be marketed globally?	Patents Trademarks Copyrights Trade secrets
Business condition	What is the current cost of entry into the industry? Is this cost rising or falling, and why? Does the need for expensive fixed assets or other large capital expenditures limit our ability to compete? Are inventory and equipment a large part of value? If the business is service oriented, can it hold on to key talent? Why or why not? Is there a strong culture?	Articles of incorporation Amendments to articles Bylaws Office leases Other facilities leases Equipment leases Agreements with suppliers and vendors Selling agreements Special customer agreements
Prospects for the future	What is the industry outlook? Are the products or services differentiating enough? Will the products or services soon be outmoded? If applicable, is the research and development program adequately funded? Is international competition emerging, or is it a current factor within the industry? What is the company’s reliance on the overall economic conditions?
Competitive environment	How many direct and indirect competitors are there? What is the company’s relative standing against its direct competition? Are there specific costs, processes, or technologies that limit competitive entry into the market?	Available competitor information List of major customers List of major suppliers and vendors List of strategic partners and alliances
Human capital	Do the company’s products or services require special skills, education, or licensing? Is the work desirable within the job community? Are the environment and the culture considered suitable to the job community? How does the compensation rank versus industry averages? Is there a human resources strategy that promotes employee development? Are basic human resource compliance requirements met? If not, do the exceptions pose material legal risk?	Limited Liability Workers’ compensation Life insurance on key personnel Medical Aid Coverage – Documentation of recent claims Personal information about key employees to use for performing background or credit checks
Quality of assets	Real estate: Are the location and the facilities suitable for the business? Real estate: What is the underlying land value and quality of the title? Machinery and equipment: What is the degree of obsolescence? Machinery and equipment: What are the costs for repairs? What are the costs for deferred purchases?
Structure of purchase transaction	Will the purchase of the company be highly leveraged? What liabilities need to be assumed? Is the company safely capitalized in its current condition? How do cash flow ratios stack up against the industry and competitors?
Other risks	Is the labor unionized? Would critical staff remain if the company were sold? What is the general health of key personnel? Criminal Records of key staff. Are heavy government regulations prevalent in the industry, or is there potential for such regulation? Are customer accounts diversified, or are there a few large accounts upon which revenues are dependent? Are operations unusually susceptible to weather, political events, or other generally uncontrollable events? Is there any affiliation to organized crime? Can the business produce valid tax clearance certificates?

Due diligence is your safety belt, often you only realize that you need it, when the deal has gone sour and your business is in crisis. Do not make that mistake and overlook this process.

Our post “Why be the first franchisee” has been published in Your Business magazine (Volume 15 No.1).  Not a bad start to 2010.

This is the fourth article in our series on franchising (especially restaurant franchising). Best to familiarise yourself with our other articles which sets our tone.

Continuing on our series of articles on the franchise industry in South Africa, we want to look at the Consumer Protection act and what it’s impact is on the franchise industry?

The Consumer Protection Act is the second major development in favour of consumer protection in recent years. The first being the National credit Act which is designed to improve transparency; prohibit unfair contract terms and practices; and prohibit anti-competitive practices. The Consumer Protection Act is designed to protect consumers from exploitation and unfair practices by unscrupulous businesses, and to empower consumers to make wise purchasing decisions. Together these Acts entrench the protection of consumers as prescribed under the Constitution of the Republic of South Africa.

Rights of Consumers

Under the act, franchisees are regarded as “consumers” and franchisors as “suppliers.” Franchisees are given a number of consumer rights, including the right to equality, privacy, choice, information, disclosure, fair and responsible marketing, honest dealing, fair agreements, fair value, good quality, safety, and supplier accountability. Franchisees are also protected against undue influence or pressure; unfair tactics; and false, misleading, or deceptive representations concerning material facts. This would also apply to the contracting arrangements between franchisor and franchisee.

Franchise Agreements

Under the Act a franchise agreement is defined as an agreement where a franchisor grants to a franchisee for consideration a right to carry on business under a system or marketing plan substantially determined or controlled by the franchisor. In addition, the franchisee’s business is substantially or materially associated with advertising schemes or programs or with the trademarks of the franchisor, or any combination of these that are licensed to the franchises. The agreement must be in writing and signed by at least the franchisee. The Act allows for a cooling of period of 10 business days, wherein a franchisee may cancel a franchise agreement they have signed without incurring any cost

The right to full disclosure is entrenched in the Act. This is in recognition of the number of cases where franchisees had been devastated financially after investing their life savings into franchises that were sold to them on the premise that the franchises would be far more profitable than they ever actually would be. Under the act, franchisors will be required to disclose certain information to prospective franchisees, as provided in regulations to be promulgated by the Department of Trade and Industry.

Monopoly on the Supply of Goods

Currently, franchisees in South Africa have limited protection against unfair practices by franchisors under that country’s Competition Act, particularly in relation to the tying or bundling of unrelated products by a dominant franchisor or when it comes to exclusive dealing. Complaints stemming from these activities are, however, difficult to prove, and the franchisor in question has to be dominant or have market share.

The Act has taken the foregoing prohibitions in South Africa’s Competition Act and applied them regardless of whether the franchisor is dominant. The new law prohibits bundling or tying of products by a franchisor, unless the franchisor can show either (i) that the bundling results in economic benefits for consumers or (ii) that the convenience of bundling outweighs any restriction on consumer choice. Alternatively, the bundled goods or services must be offered separately and at individual prices.

The Act guards the right to consumer choice by generally providing that franchisors must not require, as a supply condition or as a condition of entering into an agreement, that the franchisee purchase goods or services from the franchisor or from any other designated supplier. It is a valid defense to show that products or services that the franchisee was required to purchase are reasonably related to the branded products or services that are the subject of the franchise agreement. It remains to be seen how closely linked to the brand “reasonably related” will need to be to excuse such a requirement by a franchisor. As a result, many franchisors will no longer be able to be the sole supplier of goods and services to a franchisee, unless it can be shown that the products and services are “reasonably related” to the brand.

Franchisors should take care to ensure that products and services essential to the protection of their brand are explicitly listed in their franchise agreements, to reduce any later issues regarding interpretation. In other words, the Act suggests that franchise agreements provide for core and non-core products. Core products or services would be the primary, unique products related to the brand.

With regard to transitional provisions, it appears that the Act will not apply to pre-existing franchise agreements (or transactions) entered into before the general effective date, expected to be October 2010. However it will apply to renewals of contracts. The Act highlights a number of factors relating to fair and honest dealings and unfair unreasonable and unjust contract terms. The Act allows for the cancellation of contracts, whole or part should it be deemed to have contravened these principles as detailed in the Act.

Closing

The Act will have huge implications for the franchise industry. For while it has boomed has also become a place for corrupt, fly by night operations.  The Franchise Association of South Africa has expressed concern with regard to the implication of the Act and the burden it will place on its members. This is a concerning position as the Act can only create credibility for the franchise industry by ensuring that it closes the gap for illegitimate franchisors to operate.

Surely this would be a benefit to FASA, to cleanse the industry of undesirable operators. Franchisors who lack the capacity for adequate, transparent contracting and operations shouldn’t be selling off franchises. Organisations like FASA shouldn’t be accepting these franchisors as members or providing a potential front for their operations.

This is the third article in our series on franchising (especially restaurant franchising). Best to familiarise yourself with our other articles which sets our tone.

Commercial banks are part of legitimate business. We trust them with our savings, we store our incomes in them, and we borrow money from them, all the time assuming that the transactions are legitimate and reasonable and regulated to some extent. We rely on them for every aspect of functioning of civilised life-homes, cars, business, school fees and personal events.  We also expect that they will exercise reason in their interactions with us because their survival depends on the patronage of their clients. So their responses to us are based on good credit lending praFFrctices and when banks make errors in planning, governments are hard pressed not to finance their recovery with taxpayer’s money, as in the case of the US recently. Banks are essential to the stability of our economy; citizens and the banks share a common investment in our economic future.

But have banks gotten too big for us. Do they represent something untouchable? So when they repossess homes and cars in a panic about the money that is being lost like a waterfall without following the specified due processes outlined in those contracts is this acceptable under the circumstances or is this just a case of bullying. And what really is their responsibility as the credit provider?

In responding to this question I will share with you our own insightful experience with the banking environment recently, which has been the cause of much debate within our own inner circle.

We took out a loan to finance a franchised restaurant. After the bank evaluated our application they informed us that we were not disadvantaged enough to qualify for any form of BEE preferences (the words used were “not black enough”). This opinion of the banks was nether policy nor constitutionally justifiable. However, we were in love with the business idea, so we didn’t make a scene. We put up 40% of the financing required for the franchised restaurant we wished to buy. The bank confirmed that it had done a due diligence on the restaurant and the franchisor and was extremely happy with the results and would finance the deal.

In fact the franchisor was so highly credible to the bank, that the bank offered them great deals on banking and transacting facilities for their franchisees and they offered the group an approved financing facility for all new franchise restaurant setups. Since we knew what the obligations placed on the bank were by law to thoroughly assess any new deal we felt extremely confident in all the new “benefits” the bank was offering the franchisor.

So when the figures provided to us and the bank by the franchisor turned out to be deliberately exaggerated and show that a fraud was committed by the franchisor so as to ensnare us in the business deal the issue of what exactly is the responsibility of banks in this circumstances was raised by us. The answer apparently is that the banks have no obligation. The bank completed a FICA assessment of the franchisor; their results didn’t cry out any kind of foul – it should have. There was evidence of their foul practice’s aplenty, which at the time was outside of our sphere of access.

Now that the bank is aware that there was a fraud committed by the franchisor does it discontinue giving out loans to new franchisees wishing to purchase restaurants in the same group or does it blacklist the group? No of course it does not.

Granted our matter hasn’t been to trial yet, but we can supply details (irrefutable forensic evidence) to the banks legal department and they can make a judgment about the caliber of clients they want to maintain or their obligation to new investors. If the bank continues to give out loans to unsuspecting buyers wishing to take up opportunities within the same group, would the new franchisees be able to sue the bank for facilitating a fraud since the bank has knowledge that the franchisor is suspected of fraudulent behaviour?

At the very least the bank should consider suspending any new deals pending our case going to trial and being decided on, because should we win our case the franchisor may not be able to operate anymore and new franchisees would be placed at risk of defaulting on their loans, which is a risk to the banks bottom line.

At the very minimum this franchisor has committed FICA fraud? Should the bank not have called in SARS immediately? The bank leverages their risk on personal sureties signed by borrowers – the franchisees, so whatever happens with the business, the bank will get its money one way or the other. But should they? The National Credit Act outlaws irresponsible lending and by this it means that the banks assessment of whether a borrower is suitable for credit has to do with an assessment of the borrower’s ability to pay. If the borrowers ability to pay has everything to do with the business’s capacity to generate a certain profit, and the business was in fact never able to do that as the figures provided were a fake. Is the bank not responsible for irresponsible credit provision?

I’m not suggesting that the banks share responsibility for your business decisions or mine. You go to the bank for financing not buying into your idea. But they do have a role to play in not perpetuating a fraud when they know about it and they do have a job to ensure that there facilitation is not being used for money laundering or other such activities. The new Consumer protection Act certainly talks to the issue of facilitating fraud and specifies the right to have contracts cancelled in this case. What does that mean for a bank that knowingly provides financing to fraudulent franchisors. Can those loans be cancelled and they held responsible for the transaction?

On the cross side asking the banks to take more responsibility will be ensuring that loan facilities become even harder to access and you will pay for this risk in the repayments.

If you are hoping to see your banker as a partner in your business, best check out the development bankers, such as the Industrial Development Corporation or National Empowerment Fund. Since they accept a high percentage of risk they are better at evaluating the risk with you. If the business collapses they lose their cash too. So if you have to go after a franchisor that has defrauded you have a big partner on your side and you are out a considerably less amount of cash.

This is the second article in our series on franchising (especially restaurant franchising). Best to familiarise yourself with our first article which sets our tone.

In this article we look at the rare instance of being the first franchisee. In our move into the franchise game we were approached to be the first franchisee of a new concept of stores for an established restaurant chain – the chain we are currently suing. We turned down that deal these are some of our thoughts on being the “ground breaker”

Starting a business is a tall order for most people and even a scary prospect especially for non-entrepreneurs hence the preference of starting with a proven model where the concept, business plan, and operating system are already put together in a franchise package.

However every franchise system has a first franchisee. The groundbreakers or icebreakers if we may call them, are the people who risk it all in pursuit of success and financial excellence.

And as important as success is to the first franchisee, it’s even more important to the franchise company. Their future growth will depend to a great extent on the validation and results of the first franchisee.

These are just some points to consider regarding getting involved with a startup franchise outfit, or an outfit that are expanding into new untested markets.

• Ground breaker: The first franchisee is comparable to being a first child. Being first means getting all the extra attention that normally comes with the position. The challenging thing is that the first child has to break the ice on every little thing. This makes it much easier for the children that come later, but it’s sometimes a real pain for the first child. They have to effectively train the parents to be reasonable and have realistic expectations, and this is often the same dynamic at play between the franchise company and the first franchisee.

• Acceptance of risk: As a first franchisee, you must be much more accepting of risk than a normal investor. Bold and brave, you should also be the type of person who’s willing to deal with a more fluid situation, where changing and adapting to unforeseen circumstances is a welcome part of business development. The first franchisee is usually a true entrepreneur and, much more so than later franchisees, is a partner with the franchise company in the development of the franchise system.

• Comfortable with uncertainty: It’s essential for both you and the franchise company to understand the unique role the first franchisee plays. The first franchisee is a person who’s comfortable with the uncertainty involved in being the groundbreaker for a system. The good news is that you’re undoubtedly going to receive a great deal of extra support from very senior staff of the franchise company. The bad news is that you’re going to represent a learning environment for the franchise, and you need to be accepting of that role.

• Learn by making some mistakes: Have realistic expectations. No matter how well the franchise prototype operations have performed, it’s going to be different running the first franchise unit. You aren’t going to intuitively understand everything about the business, and both you and the franchisor are going to learn by making some mistakes. There must be a fair amount of open and frank communication about what areas of the business are set in stone, and what areas will involve testing and learning as you build your business.

• Fair deal: The reality is that the franchisor is going to be using you as a learning tool. So both sides need to be reasonable about who should pay what in terms of “tuition” for this schooling. Though the support level given to the first franchisee is typically much more significant than for later franchisees, other value factors, such as the system documentation, are probably not going to be nearly as well defined or developed as they’ll be later. When negotiating the franchise agreement and other financial considerations, you should address these factors. Both you and the franchisor must feel the deal is fair and proper.

The following are the pros and cons of being the first franchisee:

Pros

• Availability of open territories: One advantage is the availability of open territories. The market has to be completely open.Today certain markets are closed and gaining entry into them is some what cumbersome however due diligence in research, realization and utilization of open markets can bring huge success to the franchisee. Give an example. I’m not exactly sure what you mean by an open market

• Financially sound franchisor: A financially sound franchisor committed to growing the franchise, and committed to the franchisees can be invaluable to the franchisee. The franchisor’s commitment has to be unquestionable as the first franchisee would rely on their support more so than later franchisees when systems are in place. (rephrase this- and the absence of such would be a tonic for disaster.  )

• Franchisor participation in risk sharing: Your success as a first franchisee is as crucial to you as to the franchisor because not only will you provide a bench mark of proven systems you will also provide a basis for a successful track record. To this regard the franchisors are likely to shoulder a larger risk in the business and operations than they would with later franchisees.

• Investor participation in risk sharing only a private investor would come on board with an unproven concept: Investors like the Industrial Development Corporation (IDC) who come on board as partners until the loan is repaid provide the much needed security for first franchisees considering the unproven systems and franchisor inexperience in dealing with franchisees and the business expansion itself.

Disadvantages

• No proven systems: You can receive a lot of glory and recognition for your part in advancing the franchise system, but there are certainly trade offs. You won’t have other franchisees to consult with that have already traveled the path before you. You’ll have lots of support and assistance, but the support won’t be tested and proven on others, so mistakes are going to be made. You’ll have to make your decision to get involved with the franchise without the benefit or assurance provided by an existing system with a number of successful franchisees, and that increases the risk of getting involved.

• Expandable concept: The biggest thing you want to look for is a concept that is expandable; your best bet today is really researching the franchise opportunity for uniqueness. Does the concept have a niche, or is it a blatant copy of another concept? Can you set yourself apart from your competitors? Unless the concept is expandable, franchisees are not able to extract value out of the transaction. However most people looking to buy into a franchise  don’t consider such a crucial factor hence they buy into already saturated lines of business like the fast food outlets.

• Chances of obtaining finance: The chances of obtaining finance from any institution on an unproven concept are slim if not next to nothing and the prevailing economic conditions have forced the crafting of more stringent criteria for obtaining finance. A business which has less than ten operating outlets is usually not considered a bankable franchise entity hence making it difficult for first franchises.

Perhaps the best approach for expanding the franchise model is to open up these initial franchises as partnerships between franchisor and franchisee. This protects both interests. From a franchisor perspective they get to protect their investment and further expansion of a new model and for a franchisee, you get the support and investment needed to set up and test a new business concept.

The sharing of risk is the safest and fairest approach to expanding a franchise concept model.

We have dedicated this blog to put up a number of thought pieces on the franchised restaurant industry in South Africa. We do this because the franchised restaurant industry has great personal interest for us as a result of our recent experience of having bought, run, cancelled the sales agreement and sued the franchisor.

As management consultants we have worked with researching, conceiving, redesigning, managing, marketing and evaluating all ranges of businesses- big and small. So when confronted with the challenge of buying a suitable franchised restaurant- it seemed like a “no brainer”!  After all we had evaluated and ran much bigger business investments, and restaurants have been an area we have researched extensively. In addition most franchisors we encountered were not the most sophisticated business people. In fact many were poorly educated but flamboyant characters. Plus we had resources to support our decisions- we had assistance from deal makers who put together billion rand investments and one of the oldest and largest law firms in the country (been around since the days of the gold rush). So we were ready to take on this industry and make it a success.

But still we got scammed.

Being scammed hurts your pride as hard as it does your pocket. But the experience of it has been priceless. We have interrogated all aspects of the business in detail. We have learn an incredible amount about the contracting, financing and operating a franchised business in South Africa We have also discovered a great interest in the prevention and investigation of fraud in businesses- which has become a new area of consulting for us. We have developed amazing contacts in forensics and with the specialised units of the police and security industry and banks.

There are unique aspects to South African businesses, from its closeness to organised crime to its labour issues. We (Garsen and myself) shall share with you some of the pointers and tricks to surviving a franchise investment in subsequent articles in the hope that you will benefit from our experience, research and learnings.

Lets fall in Love:

So we made a few mistakes. The first being that we found love. We found it in the business we wanted to buy- it was doing a great trade in a “recession proof” end of Johannesburg. We liked the franchisor they were young, daring and dynamic with a fast growing empire. We also liked the partnership approach they adopted to working with their franchisees and saw much potential for working together with them to build something better. This fit well with our needs. We did not originally come from a background in retail; in fact we have spent the last many years of our working career scoping, designing, marketing and rebuilding businesses of others. Broadly referred to as management consulting. Consulting is fabulous, intellectual, challenging and we had gotten really good at creating something from nothing. But we needed more ownership, more emotional investment. Food has always been my idea of sensuality-passionate love (sad I know!). So finding this fit of restaurant and franchisor felt like the coming together of a puzzle. That should have been the first warning sign. Anything too good to be true- usually is! But this was pure seduction and we were in love with the idea of the business. So this brings us to our first lesson we share with you, of loving the deal and not the business.

Whatever your motivating to get into franchising- whether you are looking for something low risk to start- working off a proven business concept, or have extra cash to put into an investment or been enticed by the advertised success rates or the business itself and the prospects thereof. Whatever the reasons, negotiating for the business has to be the prime focus and not the business itself.

How you negotiate for the purchase inevitably determines what happens thereafter in your business not sparing your leverage should you engage in legal battles with the franchisor. Unpleasant as this thought may be. A business doesn’t come with guarantees and no one is going to take care of your interests except you. So diligently cover all the areas of the contract and be more persistent than the franchisor is resistant, make sure you get what you want from a deal or you take your business elsewhere.

About the Contract:

The most important vetting exercise is really to find out how you can be in this business that you think you like without signing a franchise contract. If you can do that effectively, your return on investment over what would have been the franchise period will be at least double. And, no matter what they tell you, franchisees never have a better chance of success than independent, unaffiliated new business start-ups. The likelihood for success is exactly the same either way. Unless you are buying into a big brand concept, like a McDonalds or KFC which has a unique product that customers identify with. Being someone’s franchisee makes absolutely no difference whatsoever. There are usually many ways to obtain equivalent start-up and continuing support assistance without having to sign a franchise agreement. You just have to take the trouble to find out where they are. In most cases what you pay to set up a business or for the acquisition of an existing business is far in excess of the value of the business you are buying. Furthermore you continue to pay royalties for a name which in most cases has limited capital but comes with high restrictions that impact on your ability to survive in a changing economy. Also ensure that you know what comes along with your franchise contract. Franchise rules, license products, standard menus etc are all part of the package. These must enhance your business’s chance of survival and not just create another avenue of income for your franchisor- who is now able to force you to purchase new products which they have licensed that may be a lower quality, higher priced good that impacts on your business’s profitability. The Franchise contract must specify these products and the applicable quality standards. I have fond memories of returning deliveries of burnt coffee beans and putrid meats to the franchisor only to receive in return letters claiming breach of franchise agreement.

The representations about the wonderful support that you can expect to receive as a franchisee are always overstatements. ‘You are in business for yourself, but not by yourself’ is the mantra. Don’t believe everything you hear- read the contract to see what you are really being promised. The contract always says — in some form of legalistic sounding language — that you get whatever support the franchisor feels like providing from time to time. That’s it. There is never a contract covenant to provide competent and competitively effective support. But nobody ever figures this out before the franchise investment is made. It is always discovered after the fact, when it is too late and you have bought nothing but the right to sue, if you can afford to sue. Buying the right to sue is always a bad investment!

Consult a lawyer who specializes in franchising. Consider the time and money you put into hiring an expert as an investment in your future. A lawyer can tell you what your rights are in a specific situation and help you craft the right business plan to protect your business. As a business owner, you owe yourself nothing less. Consider the old saying” free advice is worth every cent that you have paid for it”.

One of the primary reasons that franchise scams still exist today is due to the individuals who do not do their homework and invest in these “opportunities”. They allow the bad opportunities to remain in business. Go on line and research news stories about the company and the industry. Visit their web site and get information about their consumer offering as well as their franchise offering. Learn what you can about their management and thoroughly research their background. When you first contact the company ask them about the process they use in selecting franchisees. If you get the sense that they don’t select franchisees but are in the business of selling franchises, that’s the first indication you should have that the franchise is risky. If the company is willing to “sell” you a franchise before you can perform a thorough evaluation of them and they can perform a thorough evaluation of you, that’s another indication of a poor franchise system. If on top of that the salesman you are talking with is not an employee but an outside sales broker that’s even a stronger indication. Remember, unless you buy, the franchise the brokers don’t earn any money. Never pay any monies or deposits upfront. Any franchisor who asks for money before you are happy to commit to an investment cannot be trusted- they are interested in making a sale and not the success of your business.

Conducting the Due Dilligence:

Start off with the disclosure document. Once you get the disclosure document be prepared to analyse it thoroughly. If this is an opportunity that still interests you after you read the company’s information, you should engage a qualified franchise attorney, consultant or accountant to help you in conducting your due diligence. The franchise salesperson or broker works for the franchisor and should not be a source of advice that you rely upon. Neither is your bank. Your bank’s only interest is whether you can pay back your loan- and it’s all the same to them if it’s from the proceeds of a successful business of the repossession of everything you own. So don’t rely on your banker’s advice with regard to the credibility of the franchisor. They will not take responsibility for this advice when the deal turns sour. Rely only on the qualified resources you hired to help you with the due diligence.

What is the financial condition of the company? Your investment is likely to be significant. In some franchises between debt and equity your investment may be more than seven figures. What about the franchisor, will you have more skin in the game then they do? Do they have a history of profitability? Are they earning their revenue from royalties and other continuing sources of revenue or are they relying on the sale of the next franchise to make payroll. Even new franchisors need to have financial resources to meet their commitments.

Whats the Franchisor’s Litigation History?

Franchisors must disclose relevant litigation. Sometimes litigation is good. Any franchisor that enforces system standards will occasionally need to sue its franchisees. If they are able to still maintain a good relationship with their other franchisees than that type of litigation is an indication of a strong and responsible franchisor. However, if there are pages upon pages of lawsuits from franchisees in the disclosure documents, that is not a good sign. You need to understand the basis for the lawsuits and make a decision based upon the facts. Your attorney can help you analyse the franchise litigation. These are just a few of the questions you will need to assess in determining whether the franchise is a scam. Your outside advisors will be able to help you put aside your entrepreneurial burn to get into the game and assist you in conducting a proper due diligence on the opportunity. Don’t get into a franchise unless you have the assistance of a qualified expert. The franchise salesman that has befriended has the advantage of having been through the selling process hundreds of times. This is likely to be your first experience.

No Current Franchises:

Treat a franchisor that has few or no current franchises with extreme caution. In the past, it has not been unheard of for companies that have never actually opened a single operating unit to aggressively sell franchises to unsuspecting franchisees. Naturally, the few franchisees that were eventually able to open for business failed because the company’s franchise business plan was ill-conceived and had never been tested. Minimally, the franchisor should be able to document the success of several existing franchises. They should also be willing to put you in touch with current franchisees so that you are able to confirm their success firsthand.

Inferior Selection Process:

Something else that should make you cringe is an inferior selection process. Quality franchisors run potential applicants through a fairly comprehensive selection process. This process screens applicants not only for their financial capacity to purchase a franchise, but also for their industry experience and their ability to manage a small business. If a franchisor doesn’t seem to be interested in any qualifications beyond your ability to buy into the franchise, bells and whistles should be going off. It’s quite likely that the success of the franchise isn’t a real concern for these franchisors. All they’re really looking for is a way to make a quick buck – at your expense.

Lack of Verifiable Financial Data:

Legitimate franchisors should also be able to produce verifiable financial data for the company as well as data for individual franchises. This information is vital in helping you assess the feasibility of owning a franchise should you decide to do so. You not only need to know the earnings of a typical franchise, but also whether or not the company’s financial position is sound enough to ensure its long-term survival. If a franchisor is hesitant or unable to produce financial data it’s usually because the numbers don’t paint a very rosy picture. Make sure that you get raw sales data as well as financial accounts. Financial accounts which are provided are only useful if they are audited statements and not internal management accounts. You must be able to get your auditors to do a verification of these figures from the raw data sources and an audit of equipment that is part of the sale. Remember the registration numbers of equipment on the audit must match that which you receive as part of the sale. Also compare the financials with what the franchisor says it is paying in tax- this gives you a good indication of income and/or the honesty of your franchisor. Avoid investing in a franchisor that is changing banks at the time of your deal. You may not know the reason for this decision, but it does break the “audit trail” and that prevents you from getting essential information.

Inadequate Disclosure Documents

Franchisors are required to provide franchisees with disclosure documents specifying the details of franchise ownership within their company. If the disclosure documents are overly vague and the franchisor is unwilling to fill in the blanks with details, run away from the opportunity as fast as you can. Otherwise, you risk becoming tied into a dead-end business with little (if any) legal protection for your interests. This disclosure must also include breech letters from landlords, financiers, health and other violations and summons and all licenses contained by the business.

Finally, make sure that the contract is everything it is supposed to be. If they promise that you will make a certain amount of money or that your expenditure is pitched at a certain level, you need to get it in writing in the contract, otherwise, you have no guarantee that they will follow through on that promise.  Also, it is strongly recommended that you get a lawyer to read through the contract before you sign anything, no matter how confident you are in your ability to understand it and the reputability of the company. Experience does count so bring in a specialist- much better to avoid the bitter personal experiences.

While some franchises do offer a good business concept, there are many scams out there and many businesses serve as fronts for organized crime and money laundering. Also many franchises are nothing more than a pyramid scheme the only beneficiaries being those first pioneers of the franchise. So beware in your dealings and look out for inconsistencies and hesitations- you could be dealing with a scam. Pay upfront for good advice its way cheaper than the forensic and legal costs that follow later if the business deal was not transparent and turns into a failure or a fraud. At the end of the day- all business is a risk. There are no guarantees against outright and clever fraud, as we had discovered in our own experience. But the above pointers protect you against the likelihood of you being a victim of a scam. Most importantly don’t begin any negotiations until you have worked out what you are looking for in deal. If the deal on the table is not the deal you want- simply walk away. There are many other options available to you. Do not compromise. Look for the deal you will love.