The Risk of Underestimating Working Capital in Franchising

One problem that I see with potential franchisees looking to invest in a franchise is that they look at their lending options, and only consider borrowing enough for the buildout/initial investment, and then for the first three months of working capital to get their project off the ground. This is not a sound game plan, and I’ll tell you why.?

Why Three Months Isn’t Enough

Although the three months of working capital on hand is typically the industry standard in franchising (or at least for brick and mortar businesses) and its also what we see in typical franchise disclosure documents across multiple brands, it is not always advisable to have so little cash on hand when starting out your business. In my mind, three months of working capital is just scratching the surface of what you might need to get your business up and running, because as we know, there are some things that are not going to go totally to plan.??

When in the process of launching a franchise, things in the build out or set up process can sometimes be delayed. And when I say sometimes, I mean often! For example, you're training your staff and you don't get a license approval from the municipal government so you can't open your doors for business on the grand opening day you anticipated. Everyone's in a holding pattern, and you need to continue to pay your staff before you open your doors so that you don’t lose them. Did you factor that up for a contingency plan? Probably not.?

Commodity Prices and Profit Margins

Another reason to have more liquidity/working capital on hand is to factor in the headwinds that come from inflation and the fluctuation of commodity prices in the market that are out of your control. What is the cost of commodities? If you're in the food business, and let's say chicken prices soar, you haven't really factored that into your profit and loss statement, so that could also leave you high and dry and needing more working capital just to keep the business afloat while you look to bring prices up.

?You really want to make sure that you have strong liquidity, so that you're ready for any type of scenario that comes across your business. Let's think about covid. None of us saw that coming. How long could you hang on if covid really came into the picture again??

That is why we talk about cash flow and liquidity. The conversation around ideal liquidity when starting a franchise venture really needs to start with your lender partner. Leverage their expertise to help guide you in developing a business plan of a few scenarios (best case, forecasted, worst case). Developing a business plan and profit & loss (P&L) exercise to see what type of cash reserves you need to be saving for a rainy day is critical.