Business Advice

The Pros and Cons of Borrowing from Family to Buy a Franchise

Although bank interest rates are at record lows in Australia, many potential franchisees still can’t raise the finance to acquire a franchise and are increasingly turning to non-bank lenders, particularly their parents and family members.

The Franchise Advisory Centre estimates around 10% of new franchisees are now funded or underwritten by family finance, which it terms the Bank of Mum and Dad (BOMAD).

BOMAD financing is very different from traditional bank lending. Banks will methodically and unemotionally evaluate a loan application, and will ultimately price their risk based on the security offered by the borrower, and their capacity to service the loan.

The security requirement will normally boil down to bricks-and-mortar real estate (usually the borrower’s home), and the servicing requirement will be assessed on the business’ capacity to generate enough cash to repay the loan and meet all its other obligations (as well as pay a reasonable rate of return to the operator).

BOMAD financing on the other hand, is often based on emotional, rather than purely financial considerations.

If the Bank of Mum and Dad underwrites a loan provided by a bank by giving personal guarantees, or putting their house up for security, they bear secondary risk if the franchise goes bad and the loan is not repaid.

However, if the Bank of Mum and Dad is the loan provider themselves, they bear the primary risk if the loan goes bad, which can have a flow-on effect to the relationship between the family members involved.

There are a number of advantages and disadvantages of BOMAD financing for franchisors and franchisees. Here are a few:

Advantages for franchisors:

Access to younger, potentially more talented candidates

With Baby Boomers approaching retirement age, more and more franchisees are coming from the ranks of Generation X and Generation Y. Generation X are often mortgaged to the hilt due to the rising property market, so have some real estate equity for security, but often not enough to buy a business. On the other hand, Generation Y can’t afford to enter the property market, so rarely have any real estate equity to offer.

However both of these generations bring youth and vigour to franchising and are desirable candidates for franchisors. BOMAD financing may be the only way they can afford to get into business for themselves.

Disadvantages for franchisors:

The loan is not treated as seriously as bank finance

A franchisee risks all manner of adverse consequences if they miss repayments or default on a bank loan. These consequences are often absent for a BOMAD loan, which may not even be documented with a loan agreement between the parties.

Therefore if the cost of failure to a franchisee is low, their drive to succeed may also be low. This is not a strong recipe for success and if the franchisee loses money, they may simply treat it as an advance on their inheritance, which might upset the family dynamics for a bit, but is often nowhere near as severe as what will happen if a bank doesn’t get repaid.

Mum and Dad might end up running the business

If the business underperforms badly, the franchisee’s parents may become so concerned about their investment that they step in to influence the operation of the business, or are forced to take control altogether.

This form of reverse inheritance (ie. the kids passing something to their parents) is a nightmare for franchisors, and even though it might be a breach of the franchise agreement, may be tolerated in preference to shutting down the outlet altogether. The parents who end up running the business might never have attended franchise training, or fully understand the operations and culture of the business. Often for the franchisor, this makes a bad situation worse.

Advantages for franchisees:

Potentially easier access to finance on more favourable terms

Borrowing from the Bank of Mum and Dad may not require any securitisation, and may involve other more favourable terms (such as a lower rate of interest) compared to a bank loan.

This can make life a lot easier for the franchisee, so long as they treat the loan seriously, which means at the very least they should still prepare a business plan and agree to minimum repayments over a set timeframe just the same as they would need to for a bank.

Plus, Mum and Dad as proud (and invested parents) will always be more supportive and interested in the franchisee’s success than a bank.

Disadvantages for franchisees:

Interfering parents

Just as Mum and Dad are proud of their child’s achievements in business (with their money), so too will they offer unsolicited advice, guidance and other assistance that may be counter to the franchisee’s training or intuition, and be far less helpful than intended.

Often this unsolicited support will be an unhelpful distraction to the smooth operation of the business, and at other times, it will be extremely useful. The key for the franchisee is to take the rough with the smooth, filter appropriately, and understand that all help offered by parents is generally made with the best of intentions.

Lack of proper documentation

BOMAD loans are often undocumented, meaning they are not written down but are loosely based on a handshake or mutual understanding. If they are written down anywhere, they are rarely anywhere near the standard required for a bank loan.

To eliminate the opportunity for future family arguments over money, BOMAD loans need to be documented via a formal loan agreement between the borrower and lender, indicating the principal to be lent, the term of the loan, the rate of interest to apply, and the consequences of default.

Additionally, the parents should amend their wills to acknowledge the loan as an asset of their estate, and outline whether the loan should be offset against any other inheritance due to the child in the event of their passing.  This helps reduce the potential for ugly disputes between siblings when dealing with their parents’ estate, or the risk of an executor calling-in the loan to settle the affairs of the estate.

A franchisor would be wise to ensure that any BOMAD-financed franchisee has a proper loan agreement. It may even make it a condition of granting the franchise that it be provided with a copy of the loan agreement to ensure that the franchisee is committed to repaying the loan and that the conditions of the loan are consistent with those of the franchise.

The bottom line

This is not an exhaustive list of the pros and cons of BOMAD financing, however it does highlight some key considerations for both franchisees and franchisors.

BOMAD financing is expected to grow in future and those franchisors who learn how to embrace it whilst managing its associated risks wiill potentially accelerate their growth compared to those who don’t.

Jason Gehrke is the director of the Franchise Advisory Centre and has been involved in franchising for more than 25 years at franchisee, franchisor and advisor level.