Planning to open a franchise and looking for ways to get financing for it? We have a guide to help you understand the types of business financing you can secure for your franchise and also prepare for the challenges in securing it. The below guide will help you analyze and calculate the major risks involved in choosing an established franchise with a premium cost on it vis-à-vis settling for a franchise of a lesser-known brand and paying less for it. Finally, the detailed information on the sources of financing available to franchisees can be a useful resource for those franchisee owners in need of funds either to manage an existing franchise or those looking to open one.
Setting up a franchise can be a smart business decision for an aspiring entrepreneur who looks forward to owning a business independently but at the same time wish to be associated with an established brand. However, as is with any new business, the upfront costs of opening a franchise can be quite high. Ways to get financing for your franchise is one of the most relevant questions that concern most entrepreneurs. Find out effective ways to meet the initial set up costs and also how to regularly infuse capital into it without burdening yourself and making it function optimally. Read below to understand the relevant factors that might help you in your decision to enter a franchise.
Making the right choice of franchise brand
While exploring the franchise opportunities, make sure that you weigh the pros and cons of franchising. Decide on the industry and also the brand with which you would like yourself to associate and succeed in the franchising business. Opting for a well-established franchise of big and successful brands will reduce your risk of business failure. The franchise of an established company has a proven business model and the products & services offered by this company already enjoy a good market share. Hence you would not have to worry about making a name for yourself. Using the trademark of a recognized brand will also let you enjoy the benefits of promotional activities carried out by the franchisor. The pool of support received from the franchisor – be it for training, setting up, or advertising or other operational matters- will let a small business owner compete with big businesses with ease, which otherwise may seem quite challenging. Although the cost of taking the franchisee for a brand name may be quite exorbitant, securing bank financing can be easier as big brands come with a strong reputation.
Nevertheless, if costs of associating with a high premium charging franchisor are discouraging you to go with a brand name then you might as well go with a low-cost, lesser-known brand. Remember that the initial costs of buying the franchise may be low but there would be other continuing management costs and expenses that you would have to bear as long as you run its franchisee. A lesser-known brand name may also not be able to provide you with adequate franchisor support needed in the initial phases. The cost advantage of settling for a less famous brand name may be high but it might pose risks in making adequate profits. In some cases, franchisors require a large percentage of the sales and revenues to be shared by the franchise buyer. If such is the case, make sure that even if you settle for an obscure brand, its products and services are strong enough to carve a niche and can enjoy a greater pie of profit in the market place. Check out the exit strategy of both famous and less-known franchisors to ensure that you may not face complexities at the time of renewal of franchise agreement or in times of disposing of the franchisee when you decide to do so in the later stages.
How does franchise financing work?
Once you have decided on the brand of franchisee you wish to buy, ensure that you understand the financial implications and funding needs. Franchise financing can be used either to purchase franchise rights of an already established brand or funds can also be used to facilitate working capital requirements of an existing franchise. A business owner needs a strong business plan and healthy cash flow to get adequate funds needed to maintain the existing franchise or operate a new one. There are various sources from whom franchise financing can be obtained and the exact process of how funding application is processed, borrowing and loan repayment works varies depending on the type of loan taken out. The type of franchise funding that will work best for your business depends on your specific requirements. The business needs of a franchisor that needs a loan to purchase the new franchise and make it functional will differ significantly from those with needs to acquire working capital financing for an already established franchise.
Types of Franchise Financing
One can approach the Small Business Administration (SBA) for a franchise business loan, seek a bank loan or one can also utilize one’s retirement savings or fall back on the crowd funding method- there are various ways to fund a franchise. Seeking funds from family and friends is also a preferred method of many franchisors. Below we look at the financing options available to franchisees, the costs associated with their funding, application process and also the qualifications required to be fulfilled to secure franchisor funds.
1. Franchisor Financing- Business owners looking to open a franchise can seek financing help at favorable terms from their franchisor. The process of obtaining a loan from a franchisor is often easier than securing business loans from traditional sources such as banks and SBA loans. The financing programs of franchisors are less complex and mostly less-time consuming, thereby proving to be a good funding method to secure capital for a potential franchise owner. Many franchisors have their financing programs and even if your franchisor does not have loan programs, initiating discussions with them for funding is always a smart idea. Some franchisors offer financing help considering their vested interest in supporting a borrower to become financially capable to buy its franchise.
One prominent way of securing financing assistance from the franchisor is through the negotiation of the startup costs and operational expenses. While buying a franchise, one has to spend a lot of money to procure things needed for the franchisee. Expenses of all such items need for opening the franchise can be listed in the Franchise Disclosure Document. Upon negotiations, the costs of some items in the list can be discounted or paid by the franchisor such as the franchise fee.
Seeking lending from preferred lenders of the franchisor can also help. Consider taking out loans from lending partners that have been referred by franchisors. You may also lease out essential equipment from leasing companies sharing good relations with the franchisor. Lending from the franchisor can potentially save you from paying exorbitant interest rates and also help you take off the ground without wasting time searching for another lender.
2. SBA Loan – SBA is one of the most important sources of franchisor financing for small businesses. The association provides long-term SBA loans or short-term loans and also lines of credit. Business owners with strong credit history and in favor of lower interest rates and longer loan repayment terms for up to 10 years can go for SBA-backed funding. An SBA loan can be used for purchasing equipment, buying commercial property and meeting other working capital requirements. SBA policy’s goal to promote the growth of small businesses make franchisee a great fit for taking out small business loans.
However, SBA loans can take a lot of time to get processed and reach the franchisee as opposed to loans provided by commercial banks. Moreover, funds from the SBA loans cannot be utilized for meeting a few of the startup costs, including the franchise fee being paid to the franchisor. An SBA loan interest rate may range from 7.75% to 10.25%. Apart from this, the borrower also needs to pay the loan origination fee of around 0.5% to 3.5%, a hefty loan packaging fee and also a substantial loan guarantee fee. Nonetheless, costs of the SBA loan are lower than other franchisee financing forms as they are guaranteed by the federal government. A borrower can take a loan amount up to $5 million, although taking smaller amounts is easier to secure. The repayment terms on the loan can last for up to 10 years and extended for up to 25 years if the loan is used for the purchase of the commercial real estate.
A significant percentage of SBA loans are provided to franchisees whose loan performance data can be accessed and their ability to repay the loan can also be predicted by the lender. Only businesses with good credit scores and strong franchising plans can proceed with an SBA loan application to funding their franchise.
3. ROBS – Small business owners in need of financing help for franchisees can also use their retirement funds. This is known as Rollover for Business Startups that lets you take out funds from the retirement savings account to invest them in your franchise without paying taxes or bearing an early withdrawal penalty. Financing from ROBS can be used as a down payment and also for paying franchise fees and other costs involved in taking out larger traditional loans. The best part about this financing is there are no debts or interest to pay back and hence franchisees using this financing can save more in the long run. It sets this financing method as quite a favorable one for those with lower monthly fees on funding franchisees.
Using the ROBS financing method lets an owner sponsor a retirement plan under its franchise. The personal retirement fund becomes the company fund that can also be used to buy shares of stock for the franchisee business. With the sale of stock, adequate capital can be secured to buy a new franchisee and strengthen an already existing one. One needs an eligible retirement account for benefiting from ROBS. It requires a borrower to have a retirement account with at least $50,000 in it.
Roth IRAs plan is not eligible for securing this type of financing help. However, doing ROBS entails the big risk to a lender of losing out its retirement funds if the franchise fails to succeed. There is only an initial cost of setting up ROB and administering the plan to ensure compliance with all rules and regulations. Additionally, there is also a maintenance fee required to be paid.
4. Fast Online Working Capital Loan for Franchise Financing – An existing franchise in need of working capital will have many funding options available than those who venture into new business. Since franchise businesses are based upon proven business models that have already attained a certain degree of success in some other locations, the risk of financing posed to the lender is less as compared to the risk involved in lending to a new business.
Securing funds through this method can be used to make payroll payments to the franchisee employees and also for other business activities such as for leasing machinery or equipment purchases. Although this method of financing does not have stringent qualification requirements like an SBA loan and the financing approval may also take less time than traditional bank loans but the costs are quite higher.
Different lenders have varying qualification requirements for the fast online working capital loans but borrowers looking to secure this financing need to have a minimum credit score of at least 600. Moreover, the borrowers are required to have at least one year of experience in managing business operations and annual business revenue of $50,000 or greater.
5. Crowdfunding – Business owners buying reputed franchises can opt for Crowdfunding wherein the financing companies raise money from both credit unions and individuals. This method of franchise financing facilitates loans that can bridge the gap between traditional business loans like SBA loans and alternative lending methods that come with much higher costs.
Franchisee buyers using crowdfunding have to pay interest rates ranging from 7.75% to 12% and a substantial loan origination fee. The loan terms can be for 5 to 7 years.
Maintaining a good credit score of 660 and above is essential for qualifying for the crowd funding franchise method. Ensure that you have a net worth greater than the loan amount you are seeking or at least equal to it.
6. Home Equity Line of Credit – Homeowners with 20% to 30% equity in it are eligible to secure franchise funding with a low-interest rate. Funds can be used to pay the franchise fees and meet other costs. This method financing allows you to draw out funds immediately and you need to pay interest on the amount you are using.
The home equity line of credit is extended against the collateral of the home of the borrower. Failure to make franchise loan repayment can lead to the loss of ownership over the home by the borrower. A borrower can receive up to 80-90% of their home equity with lower interest rates. Also, there are early closing costs associated with this method of financing.
7. Friends & Family Loan – You might also seek financial support from people you know well. Borrowing money to fund a part of the expenses involved with franchise opening or management can be a good idea as the loan amount & repayment terms can be negotiated and kept flexible. Moreover, this kind of financing does not require much paperwork or have tax implications.
Challenges Facing Franchisees in Securing Financing
Investing in a franchise requires one to invest a lot of money and also time. Unlike in a startup where entrepreneurs can take off the ground on a shoestring budget, owning a franchisee entails huge investments and securing the funds for its successful operation comes with its share of challenges. Here are a few factors to take care of to overcome franchise funding challenges.
- One of the first things to do before approaching a lender to secure funds for the franchisee is to list out both the assets and liabilities to provide a proper estimate of one’s total net worth. Most franchises require the prospective franchisee buyer to have a good net worth. Hence, if you are looking at potential franchise opening opportunities, make sure that you fulfill the financial standing required to be qualified as a preferred franchise buyer.
- After you have completed working at the balance sheet, analyze the credit rating. Almost all lenders would weigh the credit scores based on the income, stability and debt & credit card payment track record of your past financial transactions.
- Maintain a good track record of payments before you approach a lender. Clear your debts and pay your monthly bills on time to attain a good personal credit score. The credit bureaus also maintain a file about your credit history and lenders are most likely to check the records before deciding on lending requests made by you. Hence, make sure that you have no record of delinquent payments and you rectify any incorrect information updated in the bureau.
- After finalizing the net worth, draft a solid business plan that can create a good impression upon the lender and help your application for franchise financing get approved quickly. With a solid plan to get financing help for your franchise, you would not have to worry about the initial investment costs and also its ongoing expenses.
- You might witness the costs of opening a franchise and supporting it often exceeding the royalty and franchise fees at least in the initial stages of its foundation. Also, brace to bear the costs of bank loans and financing help secured from financial institutions.
- Apart from huge startup costs to enter the franchisee business, a prospective franchise buyer needs to prove their dedication to stick to the franchise rules and regulations without bringing on random changes to the basic operational structure. So franchise is only for those who can accept the business system as laid out by the franchisor and run as per the rules.
Before you sign on the dotted line of the agreement with the franchisor, ensure that you fulfill the eligibility criteria for being the right fit to buy a particular franchisee. It is imperative to understand how to secure financing support required to adequately manage its operations and funding its inventory & working capital requirements. Also, ensure that you understand all the above aspects involved in the process of purchasing a franchisee and the challenges that come at every step before diving into the franchise system.