Why you need franchise financing
You spotted a franchise business for sale and you're fired up with the excitement of running your own business with the support of a franchisor. But whether it's a bar, restaurant, gas station, or fitness center franchise (or any other franchise startup) you will still need franchise funding to get your business off the ground. Here is all you need to know about financing the purchase of a franchise.
What does it cost to buy a franchise?
First, here's a quick run-down of the costs involved in buying a franchise:
- Franchise startup costs: This is the upfront fee you'll pay the franchise company to open your branch of the company. It could be anything from $15,000 for a Subway franchise up to $75,000 for a Hilton brand hotel
- Ongoing franchise royalty fees: This is a percentage of your revenue that you have to pay to the franchise company, usually every month. Royalty fees average around 4-6% of your gross sales revenue, but they can be under 1% or as high as 50%.
- Advertising fees: Most franchises also require franchise holders to pay shared costs of advertising. This can be a fixed fee or a percentage of gross revenues.
- Costs for raw materials: Some franchises, especially if it's a restaurant franchise, require franchise holders to buy raw materials from specified vendors or from the parent company at a high markup.
On top of this, you'll need to fund equipment, employee salaries, and other initial and ongoing costs.
How to get money for a franchise
Fund a franchise startup yourself
It's possible, although unlikely, that you might be able to pay the costs of buying a franchise business in cash from your own savings. While this might seem like a dream approach because you'll be starting your franchise debt-free, it's not advised; it's best to save your cash for emergencies and for funding future growth. Tip: part of the allure of owning a franchise brand is that the concept is pre-packaged, making scaling up far easier when compared to starting a business from scratch. Rapid growth will require cash and equity, so keep that in the forefront of your mind. Franchise costs are controlled by economies of scale. Essentially, supplies ordered through the franchisor or the franchisor's suppliers are far less expensive when you order for 10 locations, as opposed to just one.
Ask friends and family for franchise funding
Another option when purchasing a franchise is to approach friends and family to see if they'll give you a loan or join you as a silent partner in your investment. This sounds attractive, because you'll probably get good rates and fewer difficult questions than from a franchise lender, but if the business goes sour, your relationship could never recover.
Buy a franchise with a partner
Typically, those who start franchises are partnerships that combine the individual strengths of the partners. One partner may have the industry experience, while another partner might have a background in real estate or marketing.
If you choose to solve your franchise finance issue by taking a partner (or more than one), there are two main issues to bear in mind. The first is: who will make the decisions? Although you might intend to run a 50-50 partnership, this is highly impractical in terms of the day to day running of the franchise. Your franchisor won't accept a franchise run by committee, so one of you has to be named as the designated operator. It's very difficult to change this person in the future, so make the decision carefully.
The other big concern is that your silent franchise partner might want to limit their exposure to just investment. However, this isn't possible with most franchises. Your franchisor will usually insist that all the franchisees make a personal guarantee against the franchise agreement (and your landlord will probably require it too). If the investor isn't on board with this, your partnership will be over before it begins. These aren't the only issues to consider when starting a franchise partnership, so if you want to go this route we recommend that you consult a franchise lawyer before you sign anything.
Turn to crowdfunding for franchise funding
People use crowdfunding for all kinds of things today, from paying for a wedding to finding a cure for cancer, so why not use it to fund your new franchise idea? It's an attractive proposition, especially since it opens up your franchise funding options to people who are not accredited investors. But there are a lot of obstacles to raising money through crowdfunding. Crowdfunding regulations require franchisees to prepare compliance documents that can include audited financial statements and filing Form C with the U.S. Securities and Exchange Commission, which contains important background information about your franchise's business plan, directors, principal shareholders and plans for using crowdsourced funds. You'll also need permission from your franchisor and could have to hire a broker-dealer to oversee the process. Consulting a franchise lawyer before deciding on crowdfunding is also recommended - and another expense. Added to all this, you're only permitted to raise a maximum of $1 million over 12 months which might not be enough to make it worth the time and expense of going through the process.
Use home equity to fund your franchise
If you have plenty of equity sitting in your home and you need working capital to fund your franchise, using a home equity loan or HELOC for franchise funding is very tempting. After all, the rates for home equity and HELOC loans are very low. A home equity loan and a HELOC are not quite the same - a home equity loan brings you a single lump sum, usually with a fixed rate of interest. A HELOC is more like a credit card, in that you'll be given a maximum credit limit and can borrow and repay and borrow again up until that limit. HELOC rates are often variable.
While this is an easy and attractive option, home equity loans are generally not a good path to choose to fund your franchise. Most franchise lawyers will tell you that if you need to use your home equity to fund the franchise, you're not in a secure enough economic position to take it on.
Some other considerations to bear in mind before borrowing against your home equity include:
- If your loan rate is not fixed, it could rise to more than you can afford to repay if interest rates increase.
- Unlike some other loans, the interest you'll pay on your home equity loan is not tax deductible unless you're using it to buy or renovate a property.
- Will the value of your home continue to increase? Remember that if your home value drops, so does the amount of equity you can access.
- What will you do if you need emergency cash in the future? Generally your home equity should be your last resort for emergency financing.
It's important to remember that a home equity loan is a personal loan. This means that it is counted as part of your personal debt burden even though you are using the loan amount for business purposes. If you've already got a lot of other personal debt, taking out a home equity loan could push your loan to income ratio over the scale and damage your credit standing for a long time to come.
Most importantly, if you take out a home equity loan or HELOC then your own home is on the line if your business fails. Before taking out a HELOC or home equity loan, consider carefully how you would make payments on the loan if your franchise doesn't succeed. If you don't have a solid backup plan, then you could lose your business and your house at the same time.
Get a business loan
The final option, which we recommend when buying a franchise business, is to get a business loan. There are many financing options which offer good rates, with franchise lenders who are familiar with the specific needs and circumstances of franchisees. There are even government-backed loans available.
Why getting a loan is best for purchasing a franchise startup
The best source for franchise funding is a business loan. Franchises are traditionally seen as safe subjects for a business loan, especially if you are opening up a franchise with a reputable brand, like a restaurant franchise with Burger King. Many banks have dedicated loan packages which are tailored to the needs of new franchisees. A business loan also means that you won't have any personal liability for the loan if your franchise business fails. In general, business loans offer the best rates with the lowest risks, although you need to choose the best business loan product to suit your circumstances.
Where to go for franchise loans
Traditional bank business loans
Many traditional commercial banks offer business loans to all types of businesses, including franchises. In fact, because franchise startups have the backing of an established brand, banks are usually more likely to agree to the loan. Franchise holders are estimated to be more likely than other small business owners to get a business loan from a commercial bank.
While some banks have specific franchise loan options, most include franchise lending under their regular short term secured or unsecured business loans. Some business loan products you could use for franchise funding include working capital loans and equipment leasing loans. Commercial banks tend to offer very good interest rates, but their requirements for eligibility are usually very high. You'll need to show a solid net worth, a high credit score and usually put up some form of collateral or down payment in order to get approval.
SBA loans are provided by banks and alternative lenders, but they are backed by the government's Small Business Administration (SBA). The SBA 7(a) loan is guaranteed by the government for up to 90% of the loan total, meaning that even if you default on the loan, the lender won't be left to suffer the consequences. This makes it much easier to qualify. If your franchise company is on the SBA's Franchise Registry of approved franchise businesses, it's a lot more likely that your application will be approved. In fact, franchises are among the most popular recipients of SBA loans. More than 10% of all SBA loans are given to franchises. SBA loans also offer extremely flexible loan amounts, from $250,000 all the way up to $2 million.
SBA loans have lower interest rates and longer repayment terms, frequently making them the most favorable loan option for buying a franchise. An SBA 7(a) loan is for working capital, equipment leasing, or commercial real estate, with a typical repayment period of 5-6 years. You can use an SBA 504 loan for fixed equipment and commercial real estate. Real estate SBA loans can have a repayment period of up to 20 years.
One drawback is that it takes a long time to get approval for the loan - up to 90 days - and you'll need to have a high credit rating of over 680 and a down payment of 10-20% of the loan total. Although SBA loans are a good choice for franchise funding, you should also bear in mind that the interest rates are usually variable. Although the government ties SBA loans to a maximum interest rate which is connected to the prime rate, you can find that you're paying more than you expected initially so do budget for a rise in interest rates.
Other government-backed franchise funding options
There are also other government-backed loans that you could be eligible for as a source of franchise funding. While the SBA's famous Patriot Express loan for veterans starting a small business was withdrawn in 2014, there are government-backed alternatives for veterans buying a franchise.
SBA Express is the closest replacement to the Patriot Express and should be the first stop for veterans looking for franchise finance. It's a faster version of the standard SBA 7(a) loans and is open to all applicants, not just to veterans, but veterans won't have to pay the upfront guarantee fee that is charged on SBA loans. It deserves the name 'express' because it actually takes only 3 days to get approval for the loan. You can borrow up to $350,000 at rates that will be set by the direct lender you approach, but like with the regular SBA loans, the government pegs the maximum interest rates for a SBA Express loan at 6.5% above Prime for loans below $50,000 and at 4.5% above Prime for loans of more than $50,000.
The SBA Veterans Advantage Guaranteed loans is also a good port of call for vets who are purchasing a franchise using the regular SBA loan. It offers to pay 50% of the guarantee fee for loans over $150,000 up until $350,000
Women, minorities, and franchise holders with disabilities might also be able to access specific government-backed loans for their demographic.
Ask the franchisor
Some franchisors are willing to help out their franchise holders by extending some form of internal funding. There are a few ways that this could be structured. Some franchisors set up partnerships with local banks to make it easier for new franchise holders to access lending. Others might offer a structured loan through their own finance partner, for anything from 15% to 75% of the total franchise fee. The loan could be a simple balloon loan where you pay only the interest until the end of the loan term, or it could be a traditional loan with payments waived until after the first year of business.
Another scenario is that the franchisor agrees to defer the upfront franchise fee, or offer a financing plan for some or all of your franchise equipment, operational costs, or other costs. Borrowing from the franchisor has the advantage that the franchise company understands your circumstances and is likely to be more sympathetic and helpful than a traditional bank. You're also probably not going to have to put up collateral. On the other hand, interest rates tend to be much higher than other franchise financing options so it's best to compare all the alternatives first.
Alternative business lenders
If you're unsuccessful with traditional lenders and your franchise company doesn't offer funding, you can turn to alternative lenders. The rise of FinTech in the last few years has seen an explosion of online lending platforms that offer working capital loans, secured short and long term business loans, commercial real estate loans, equipment leasing loans, and many other business loan options. While rates are generally higher than through a bank, approval times are faster and eligibility requirements can be more relaxed.
Rollover business startups (ROBS) using retirement funds
Many people looking for loans for a franchise startup decide to pull on their retirement funds using a Rollover for Business Startups (ROBS). The ROBS scheme permits people to draw money from their 401(k), IRA, or other retirement account without paying taxes or early withdrawal penalties to invest them in purchasing a franchise. The advantage is that you don't have any debt to repay or interest charges to deal with, and there are no restrictions on what you can use the money for. However, you do run the risk of losing all your retirement savings if your franchise doesn't succeed.
All of the above
Purchasing a franchise can be an expensive business move. Many new franchisee owners find that they need to use a combination of funding sources in order to cover all of their initial costs. This could mean using ROBS to gather enough down payment to qualify for an SBA or traditional bank loan, or trying crowdfunding to get together the funds for the upfront franchise fee.
How to get a loan for a franchise
Before you start looking for business loans for your franchise startup you need to get all your financial affairs in order. This means preparing a personal financial statement (PFS) that lists your net worth from all your assets, including your:
- Checking and savings accounts
- Investments, stocks, and real estate holdings
- Cash in hand
- Expensive items like cars and antiques
- Any other assets
You'll also need to list your liabilities, which include:
- Any current debt such as credit card debt
- Existing business or personal loans, including home mortgage and auto loans
- Current bills
- Any other financial obligations
Your credit rating is also extremely important for determining your eligibility. It's a good idea to check up on your credit score by requesting a report from each of the three main credit agencies before you apply for a loan. You might be able to take simple steps to improve your credit rating before applying for franchise loans so that you're more likely to be approved.
Banks, credit unions, and SBA lenders will also check your track record of living within your income before they decide whether or not to approve lending you money. Your income statement shows your income sources. If you can reassure lenders that you can live within your income, they will be more likely to conclude that you are a good risk for a franchise loan too.
Many franchise lending providers will require you to put up some kind of collateral before they agree to give you a franchise loan. This could be in the form of a lien on your home, your vehicles, or using some other valuable item as a guarantee on your loan amount. Sometimes you'll be asked to make a down payment of up to 30% of the total loan amount before the lender will agree to release the rest of the funds.
The final important article when applying for franchise funding is to present a professional business plan. Just like when opening any other business, your business plan needs to include a study of the field of business you're entering, revenue projections, working capital estimates, cost analyses, and a stable marketing plan. Credit references and an indication of your personal skills should be included as well.
As well as your net worth, credit score, financial track record, and a business plan, to get approval for an SBA loan you'll have to meet the SBA's eligibility requirements. This includes having a credit rating of 680 or more, a down payment of at least 10% of the loan total, and a financial history that is free of delinquencies or defaults on government debts (which includes student loans). The SBA also looks for some form of personal or business collateral and two or more years of experience in business. The SBA usually requires you to have used some alternative financial resources such as your personal assets before you turn to them for a loan, so it's a good idea to try other lines of franchise funding before an SBA loan.
In many ways it's much easier to be eligible for ROBS financing. You're drawing on your own funds so there isn't a rigorous set of eligibility requirements to meet. However, it can be a lot more complicated and it's a good idea to use an experienced ROBS expert to set up your ROBS funding.
Assuming that you have an eligible retirement fund with at least $50,000 in it, you'll need to also follow all the IRS and DOL requirements, offer an employee retirement savings plan at your new franchise, and not be drawing on an account from your current employer. Most tax-deferred retirement plans are eligible, including a 401(k) and IRA plan, but Roth IRAs are not accepted.
How to get franchise finance for franchise equipment
When it comes to financing the equipment you need to run your franchise, you have a number of options. Many of the franchise financing options that we've already discussed are suitable for funding franchise equipment. One good example is the SBA loan, which can have a repayment term of up to 20 years and low rates, making it a good choice for equipment financing.
Another very popular option for financing franchise equipment is to find a good equipment leasing program. Equipment leasing can carry about the same costs as using an SBA loan to buy the equipment, but without having to wait the several weeks it takes for an SBA loan to be approved. Additionally, an SBA loan requires you to put up something as collateral, while an equipment leasing arrangement uses the equipment itself as collateral for the loan.
One last option for financing your franchise equipment is to see if your franchisor has any equipment leasing programs in place. Many franchises offer a better equipment financing deal to their franchisees than you could get elsewhere.
Choosing a working capital loan for expanding or buying a franchise
If you're buying a franchise or want to expand an existing franchise, you need good cash flow. While business term loans are useful for providing upfront capital to purchase a franchise, sometimes you need a more flexible loan option to deal with short term cash flow issues or to enable you to seize a sudden opportunity to expand.
A working capital loan is a type of business loan that is ideal for cash-flow and expansion, since it is a small but fast loan that is paid off incrementally over a shorter repayment term. The advantages of using a working capital loan for franchise funding are:
- Fast approval time with approval usually taking around 48 hours and funds coming through within a few days
- No restrictions to the purpose of the loan
- Shorter and easier application that doesn't involve a hard credit pull
- Shorter loan term with weekly or daily repayments that are easier to manage than larger monthly ones
You can get a working capital loan from many sources - your bank, the SBA, or an online lender.
Are merchant cash advances good franchise financing options?
A Merchant Cash Advance (MCA) is another form of short-term, flexible working capital loan but it carries more risks than a standard working capital loan. With a MCA, instead of borrowing a lump sum or against a flexible line of credit which you have to repay with interest, you're borrowing your own future earnings.
Your lender doesn't technically lend you any money. Instead, he "buys" your future credit card sales for a lump sum which you repay every day as a percentage of that day's sales. This means that there's no set repayment term - you'll make payments every day out of your takings until you've paid off the total. The advantages are that there are no variable interest rates, funding comes through in a few days, and you could pay off the loan faster if you make more sales.
The risk is that your sales will drop and you'll never make enough money to invest in your business in order to push sales back up, because you already spent all your income in advance. An MCA has a very high interest rates when viewed across the life of the loan - the equivalent of around 80-120%, in contrast to bank business loan rates of 7-60%. You can usually borrow up to around $500,000, or 50% of your estimated future credit card sales. Generally, using an MCA for franchise funding is not recommended because of the risks of borrowing more than you'll earn in credit card sales.
Can I get a business loan for a franchise with poor credit?
It's possible, but it's going to be tough. SBA loans and traditional bank franchise loans require good credit scores of at least 680. If your credit rating is just a short way below this level, it could be worth checking your credit report for fast ways to improve it and taking steps to raise your credit score before you apply.
If your credit score can't be easily rehabilitated or you have a bankruptcy in your history, you still have options for ways you can get a business loan for a franchise. A ROBS could be the innovative rescue it was designed for, since it doesn't involve any reference to your credit rating. Another option is to take a general business loan out from an alternative, reputable online lender who will lower credit score requirements in exchange for higher interest rates. Finally, this might be a good time to approach friends and family to see if they'll serve as co-signees to a franchise loan or pay some of the franchise fee themselves.
Whether you take out a business loan to buy a franchise, turn to an SBA loan, or find some other source of franchise finance, there are plenty of franchise funding options out there. Do your research and seize the opportunity!