When you dive into the FDD of a franchise brand, you will see a section titled “Item 7 Estimated Initial Investment”. Within this section, you will typically see towards the bottom of the investment chart a line item for “Additional Funds.” Many times, it states a time period of 3 months. However, some franchisors will allocate four or more. In reviewing the details of this line item across multiple franchise industries, it is often referred to as “expenses for the first X months of operation”, “working capital”, or “operating expenses.”
On the surface, it appears to prospective and newly awarded franchise owners to be positive. The thought is that a number is allocated to operating expenses/working capital already for you. However, solely putting faith in this number range is the first turn toward the boulevard of broken dreams.
Additional Funds: Possible Outcomes
As a franchisee, one expects to meet or exceed the average benchmarks established within the franchise system. In my career within franchising, I have seen many franchisee outcomes:
Some franchisees are under-capitalized from the start.
The leading cause on the franchisor side is inaccurate numbers from an emerging franchise brand based on projected expenses a franchisee may incur. This is often because the sample size is too small or isolated to a distinct market. Think of construction costs in California compared to Iowa. The leading cause on the franchisee side is over-inflating their financial position or not being conservative within their projections for the projects.
Overruns occur, eating away at working capital.
The franchise owner is fully transparent in their current financial position; they allocate for a construction contingency of 10%. In addition, they set aside 4X the anticipated 3-months operating expense, and they follow the franchise system (operations and marketing plan). Sometimes, this scenario can still lead to the boulevard of broken dreams.
Perhaps zoning was needed for the use (think childcare or petcare facilities), and these professional expenses were twice than anticipated. Perhaps construction encounters some major change orders eating away all the construction contingency. The franchisee is in deep with having spent over 50% of the loan value. They tap into the 4X “additional funds” cushion to get the project complete and open. They are on a seasaw directly balanced in the middle, if everything goes as planned they are successful. If one thing goes wrong, there may not be more funds to tap into.
Franchisees start out slow, but momentum compounds.
One franchisee I had the pleasure of meeting from a petcare brand had a slower-than-average start and did not reach cash-flow break even (CFBE) until 8 months later than expected. However, once that tipping point was reached, this franchisee eventually grew to be within the top 10% of performers within the franchise system.
Franchisee hits the sweet spot.
They open the doors or launch their service within a territory, and for a compounding of reasons, the location performs as projected or exceeds projections. I’ve seen franchisees open, and they double top-line sales of other first-year units within the system, with some exceeding 600K in EBITDA by their third year of operations. This does not imply a second or third unit will do the same. However, a great operator plays a key role in repeated success.
What are “Additional Funds” Used For, and What are the Variables
The answer is that it depends on the concept. Franchisors will typically represent expenses from the below categories:
- Initial payroll and payroll taxes
- Marketing and advertising expenses
- Gasoline and general auto maintenance (for example, home services franchises)
- Repairs and maintenance
- Internet, phone
- Utilities
- Software
- Office Supplies
- Recruiting expenses
- Technology fee
- Rent
- Legal and Accounting
- Outside Services
- and any other general business expenses
Diving into some of these expenses is where you begin to see a significant difference in the additional funds needed. It’s essential to understand what data fueled the assumptions for the range within Item 7 of the FDD you are reviewing.
Payroll Within Additional Funds
The federal minimum wage is $7.25 per hour. In California, effective January 1st, 2025 the minimum wage is $16.50 per hour for all employers. To provide a glimpse into the impact; assume you are looking within a franchise category that has an average of five full-time employees. Each employee works 40 hours per week, and that 12 weeks covers the “3-month additional funds” time period. States that follow the federal minimum wage will have $17,400 in payroll over this period. This does not including payroll tax expenses, medical, dental, vision, or other potential perks. In California, this would equate to $39,600. Again, this does not include payroll tax expenses, MDV, or other potential perks.
The difference in this example is $22,200. If the average number of full-time employees is ten, then this number is $44,400, and that trend continues. The more employees a franchise concept has, the bigger the potential for discrepancy in the additional funds needed.
Rent Within Additional Funds
If you are exploring a brick-and-mortar franchise that requires leasing a space, it’s important to consider the price per square foot (SQFT). There are areas of the United States where commercial rents could be $25 SQFT (Gross). While other areas of the country, such as Los Angeles, New York, Boston, and Miami, where these rates could exceed $75 SQFT (Gross). If one were to look at a franchise brand that requires 1,500 SQFT, the range on the low end would be $9,375 versus $28,125 for 3 months. This assumes the first month’s rent deposit is not allocated for somewhere else. Once again, the larger the space, the bigger the potential for unaccounted-for additional funds needed.
Within this section, we looked at just two accounts that make up “additional funds.” As you stack the differences from market to market, you can see a broad range emerge.
There is usually a legalese statement to the effect that the amount of working capital you need will depend on several factors. These factors include the area you are located in, how well the operator follows the systems & operations manual, your management skills and business acumen. In addition, it includes economic conditions on a local level, the prevailing wage rate, and the presence of competition. In many ways, this is prompt for a potential franchise owner to evaluate their working capital needs specific to their market.
These variables are potholes you can see and map out ahead to avoid them. By having the right funding plan, the most accurate and realistic projections, and a diverse picture of your local landscape, you create a map that steers you away from the boulevard of broken dreams. Or at least less likely to encounter it.
Your Runway: Time to Cash Flow Break Even
Different consultants, brands, and franchise team members throw around a lot of meanings for cash flow break even. For simplicity of this article, we define cash flow break-even as “the point where your operating cash inflows match your operating cash outflows.” When calculating a cashflow break-even point, debt service (including interest payments and principal repayments) should be included as part of the total expenses, meaning it is factored into the calculation to determine the minimum revenue needed to cover all operating costs and debt obligations.
We will touch on debt service in the next section; however, for now, let’s focus on time. If you take one thing from this article, this is what provides the most value.
The runway depicted within your average FDD is too short.
Tim Katsch
Cash Runway
Cash runway refers to how long a business can sustain its operations with the current cash reserves before running out of money. It is calculated by dividing the company’s cash balance by its net monthly burn rate. The monthly burn rate is the amount of cash spent each month minus incoming cash from operations. A healthy cash runway is crucial for businesses, particularly startups or companies in growth phases. This runway determines how long a franchise owner has to achieve profitability or secure additional funding. Businesses with a short cash runway often face increased pressure to cut costs, boost revenues, or seek outside investment to avoid running out of funds. This often leads to the Franchise Death Loop (discussed in a future article).
A line of credit can significantly impact a company’s cash runway by providing a financial cushion that extends the time the business can operate without additional revenue. However, this is not always an option and should be planned out before it’s needed.
Unlike cash reserves, which are finite, a line of credit offers access to additional funds as needed. This helps cover temporary cash flow gaps or unexpected expenses. The additional liquidity can alleviate financial strain, enabling a company to invest in growth opportunities or weather downturns without immediately resorting to drastic cost-cutting measures. However, it’s essential to use a line of credit judiciously. Borrowing increases liabilities and incurs interest costs, which can increase the burn rate over time if not appropriately managed.
When planning to open your franchise business, build a longer runway by allocating enough working capital to your project. It gives you the best odds for the business to take flight.
The Unseen Dangers Are The Most Dangerous
If variable data and expenses are the potholes, then unplanned expenses are the ice patches that will quickly send you off the cliff. Many franchise disclosure documents state that owner salary or draw, interest costs & debt service amounts, and royalty & brand fund payments are not included in the additional funds’ number.
Paying Yourself During Ramp
Evaluate what your plan is for operating the business. Will you be at the location or in the market all week long? If so, will you be taking a market salary for such a position? Some franchise owners have savings or other investments that they will live off as the business ramps. While others are in situations where there is a need to draw a salary, even if minimum, after a certain period of time. If you fall into this bucket, conversations should be had with your lender, accountant, and franchisor regarding the best path forward in allocating for this. It is not typically covered within the “Additional Funds.”
Manager
Some franchise concepts and, thus, FDDs are written to assume the business will be owner-operated. Before signing a franchise agreement, it’s best to understand the model fully and what financial assumptions go into it. For example, if an FDD is written to assume you will be the General Manager of a location, then a salary for this role may not be allocated. Should you decide to hire a General Manager for $65,000, this number would have to be calculated in the Payroll category of Additional Funds.
What is Your Total Debt Service
Debt services are typically not included in Additional Funds. If you take out an SBA 7(a) loan to fund the start of the business, you will have a monthly debt payment. Depending on the current prime rate and assuming a 10-year term, this might be as little as $1,250 monthly for a home-based business and beyond $20,000 per month for a large brick-and-mortar business.
The bigger the loan value, the more the unseen dangers become more dangerous. On the low end, 3 months of debt service is $3,750; planning for a 12-month runway is $15,000. Regarding the sample high-end debt service, that is $60,000 and $240,000, respectively. The moral of this section is to evaluate the debt service in your working capital projections, ask for feedback, get guidance. Plan for the runway you might need, not the amount of runway tarmac you hope to take off on.
Royalty
While we have not reviewed every FDD out there, many Franchise Disclosure Documents do not include royalty or brand funds under “Additional Funds.” The royalty amount will vary greatly, with standard numbers being 6%, 8%, or 10% of gross sales. All, of course, depending on the type of concept and structure. Some will be lower, some higher, and others will collect a “royalty” via product or service fees instead of a percentage of sales.
For the sake of this article, let’s assume the royalty is 8%. Looking at the projections you prepared or will prepare for your location or territory, you may plan on $50,000 in sales over the first 3 months as the business grows. Alternatively, it could be $250,000 in the first 3 months of operations. This equates to $4,000 to $20,000 in additional working capital that may not be accounted for attributed to Royalty expense. Ask the questions, get the answers, and plan accordingly; your future self will thank you.
Additional Funds Conclusion
Smokey the Bears’ original catchphrase was “Smokey Says – Care Will Prevent 9 out of 10 Forest Fires.” In 1947, it became “Remember… Only YOU Can Prevent Forest Fires.” The same rings true in franchising. Care will help prevent you from taking a trip down the Boulevard of Broken Dreams. At the end of the day, only YOU can prevent it from happening. “YOU” does not mean you have to go alone. You means it’s your business that is independently owned and operated, you are the leader, in that leadership role call in all the resources you need to get it right before you open. From the franchisor support team to lenders, from other franchisees in the system to personal coaches, have a team to evaluate all aspects of what Additional Funds should cover within your loan application or personal funds planning.
