Best Ways to Finance a Franchise
If you want to open a franchise of an established brand but don’t have the cash, you may be able to finance all or part of the purchase. Franchise financing is a common method of paying thousands of dollars in start-up costs.
Franchise financing options include small business administration and conventional loans, as well as many alternatives. Read on to learn more about ways to finance a franchise, what to expect when applying for financing, and how to choose the right franchise loan.
What are the best sources of franchise financing?
Start with the franchisor, who may be able to recommend partner lenders if you need money to buy a franchise.
“Franchisors, in many cases, preferred lists of lenders and resources that know the brand,” says Ron Feldman, director of development at ApplePie Capital, a provider of franchise finance solutions.
Consider your franchise financing options:
The SBA has three main business loan programs: 7(a), 504, and microloans. SBA-certified lenders provide these loans which, with the exception of microloans, are federally backed. This guarantee reduces risk for lenders, helping them approve loans for businesses that might otherwise not qualify for financing.
Learn more about SBA loans to finance a franchise:
- 7(a) loans. The most common type of SBA loan is available for amounts up to $5 million. These loans have many uses, from real estate and equipment to working capital and franchise fees, but require a personal guarantee if you own 20% or more of a business.
- 504 loans. This loan program provides long-term, fixed-rate financing of up to $5 million for major capital expenditures, such as equipment and real estate, or for facility improvements. You cannot use a 504 loan for working capital or inventory, but you can combine it with a 7(a) loan or others to help meet these needs.
- Microcredits. The SBA microloan program provides up to $50,000 in financing for working capital, inventory or supplies, furniture or fixtures, and machinery or equipment. Microloans are available to franchisees, but franchise costs typically exceed the loan limit, says Dianna Seaborn, director of the SBA’s Financial Aid Office.
Conventional business loans are usually granted by banks, credit unions and other financial institutions. They don’t have an SBA guarantee, which means these loans are riskier for lenders. Start-up franchises may not be able to obtain conventional loans.
Rollovers as startups
ROBS financing allows you to use retirement funds free of taxes or penalties to support start-up costs. ROBS can be complex and must follow specific steps to avoid prohibited transactions.
Although you don’t borrow and pay interest like with a loan, you put your retirement on the line and miss out on potential investment gains with ROBS. Essentially, you’re betting that your franchise business is a better investment for your retirement funds than any other option.
Home Equity Loans
Home equity loans and home equity lines of credit, or HELOCs, allow you to leverage the equity in your home to get cash and use your property as collateral. A home equity loan provides a lump sum up front, and a HELOC provides a revolving line of credit that you can access as needed, like a credit card. You can use that money to fund a franchise, but your home is at risk of foreclosure if you fall behind on your loan payments.
Securities-backed lines of credit
An equity-backed line of credit can help fund a franchise by leveraging the value of your investments without selling them.
This product is similar to a HELOC, but you borrow against your investments rather than your home. You’ll only make monthly interest payments, repay some or all of the principal, and then borrow again later.
Franchises that rely on expensive equipment can use equipment rentals to fund some of these operating expenses. Restaurant franchisees can use equipment rentals, for example, because purchasing equipment up front can be expensive. You will pay a monthly fee to use the equipment and may have the option to upgrade it, buy it, continue to lease it, or return it at the end of the lease.
Some franchisors offer franchisees partial or full financing. Remember that a franchise financing program is not your only option and you should compare the franchisor’s offer with other financing sources.
What to expect when applying for franchise financing
When applying for a loan for your franchise, the rules will be similar to other business loans. You’ll need to show you can afford to repay the loan, and lenders can decide based on your business or personal credit.
If you opt for an SBA loan, it is ultimately the lender who decides whether or not to approve the loan. You must meet minimum SBA requirements and lender approval requirements.
Prospective borrowers must also prepare a satisfactory loan record, or application, to receive money from the SBA. This package provides several elements for lenders to determine the risk of your loan. Your loan file must include:
A statement of intent. This essential part of the loan file can be labeled “executive summary” and attached to your business plan or contained in a letter to the lender. Include the loan amount you requested, the purpose of the loan, the term and collateral, and a brief description of the business and how the loan will help them.
Your business plan. A business plan describes your business, includes an organizational chart, explains your products or services, details your marketing strategy, and includes financial projections. Your financial projections should estimate the lender’s income and expenses, including whether the business will generate enough cash flow to repay debt. Help with business plans is available from the nonprofit Score Association, an SBA partner offering free templates and other resources.
Professional and personal financial statements. Your loan file should contain cash flow, income, balance sheet and personal financial statements. Include a 12-month cash flow statement and realistic six-month cash flow projections.
Established businesses must provide three years of income and balance sheets, if available. Startups can provide 12-month revenue projections and a balance sheet representing assets and liabilities for the planned opening date and 12 months later.
The lender will also want a personal financial statement to measure the borrower’s net worth and the value of the collateral. Business loans often require collateral, including business and sometimes personal assets, like your home.
In general, income is more important for loan approval than credit score, Feldman says. If you don’t have the income or reserves to cover the expenses once you start, your loan will likely not be approved.
Nonetheless, lenders may consider your business and personal credit scores for a loan to expand or upgrade your franchise and review your personal credit for start-up financing.
The SBA does not have specific credit score requirements, unlike private lenders. A personal credit score below 650 can be a barrier to approval, Feldman says.
Obtain support from the franchisor
The Federal Trade Commission requires the franchisor to provide prospective franchisees with the Franchise Disclosure Document containing information about the risks and rewards of an investment. Apart from this document, the support of franchisors is very variable.
Financial support from franchisors may include waiving or reducing franchise fees or royalties for qualifying franchisees, and some franchise brands offer their own funding programs. Franchisors can also provide franchisees with lender referrals and help them develop business plans.
How to Compare Your Franchise Financing Options
Franchise financing is not unique. The right franchise loan will be based on your needs and finances, not those of hundreds of nearly identical businesses.
Consider these factors when comparing financing options for your franchise:
What you need to finance and how much. Lenders set different limits on what you can borrow and how you can use the money. Examples: 504 loans are used for real estate and long-term assets, microloans for inventory and supplies, and equipment leasing to rent rather than buy machinery, vehicles, or equipment. other equipment. SBA microloan limits of $50,000 are generally too small for franchisees, and you may need more than one type of loan to meet your franchise financing needs.
What you can claim. Even with the backing of a proven franchise system and excellent credit, you are not guaranteed to get approved for a conventional business loan. SBA loans, however, are designed for small businesses that don’t meet traditional financing requirements.
Your risk tolerance. A franchise loan that requires a personal guarantee can leverage your assets, such as your home and money in your bank accounts, in the event of default. ROBS financing bets your retirement funds on your startup, and a home equity loan puts your home at risk if you can’t keep up with the payments.
Your loan terms. Once you have a few loan offers, compare the terms and think about how they work for your priorities. Some banks are softer on the down payment percentage but higher on the interest rate and vice versa, Feldman says. Consider whether the interest rate is fixed or variable, meaning it can change over time with the prime rate, he says.
Your franchisor and your local SBA office can help you choose a lender. For example, they will know which lenders specialize in your type of franchise and whether those lenders work with startups.
Consult a third party before signing on the dotted line. Ask an accountant, lawyer, business consultant, or all three to guide you through your franchisee responsibilities and help you choose your best franchise financing option, Seaborn says.
The SBA may include the cost of professional counseling services in your loan.
“Making a decision from an informed place,” Seaborn says. “Reviewing these documents takes time and effort, and understanding the requirements of the franchisor is critical.”