The Ultimate Guide to Franchise Financing
July 23, 2020 | Last Updated on: March 21, 2023
July 23, 2020 | Last Updated on: March 21, 2023
The lure of opening a franchise can be appealing for entrepreneurs. Newcomers to franchising see the well-established name with a ready-made market as an opportunity as a path to success. Experienced franchisees see the chance for growth and building on what they’ve already created.
Both cases, however, require capital. While financing a franchise has advantages over a financing a traditional start-up, franchises come with their own unique set of challenges. Restrictive franchise terms dictated by the parent company limit the amount of control that franchisees have in the operation of their business. These terms can limit cash flow, which can make growth and expansion more of an uphill battle than in a non-franchise business.
So how do you finance a franchise?
By definition, franchise financing is used to fund the purchase of a franchise or to provide working capital to an existing franchise. There are many franchise financing options designed to meet the many different needs of a franchisee. For instance, the needs of a new franchise are much different than those of an established franchise in need of working capital. The needs of established franchisees who are looking to add more locations within the same brand, or in a completely different organization, may also require unique solutions.
Just like a traditional business, it’s possible to get a business loan to open a franchise. The intricacies of how borrowing and repayment works vary according to loan type and terms. For example, Small Business Administration (SBA) loans for franchises have interest rates from 7.75 percent to 10.25 percent and loan terms of up to 10 years.
Parent companies – or franchisors – also can finance new franchises within their organizations. These franchise company loans are an ideal option for those who’d like to start a franchise, but don’t have money to invest.
The same is true for an option called rollover for business startups (ROBS). This plan allows franchisees to use funds from their retirement savings plans such as an individual retirement account (IRA), 401(k) and 403(b), for example, without paying early withdrawal penalties to fund your franchise. Funding opportunities also exist for entrepreneurs who’d like to use the equity in their home to fund their franchise.
Other potential sources of franchise franchising include short-term loans and lines of credit. There are also lenders that specifically focus on franchise businesses. These and other franchisee loan and franchisee funding options are detailed below.
No matter what route prospective franchisees may take to acquire financing, their net worth and credit rating are critical to their chances of being approved. A third important element is a sound business plan. Such a plan usually must be completed for financing to be acquired.
Read how this multiple franchise owner was able to save his businesses after getting a franchise loan from Biz2Credit.
A business plan must include a detailed study of the business being considered, projections and cost analyses, estimates of working capital, the franchisee’s management capabilities and several credit references.
There are thousands of franchise businesses available. Potential franchisees can research their options in the Small Business Administration’s SBA Finance Directory. This directory includes all franchises reviewed by the agency that are eligible for SBA financial assistance. In addition, the SBA Franchise Guide can be a great help when it comes to purchasing a franchise, offering valuable information to prospective franchisees.
The choice of franchise is highly personal, and should fit a franchisee’s interests, skills and lifestyle. But many of the top franchise chains don’t involve food. Working with perishable products can be challenging and expensive. But it can be also quite profitable.
According to Entrepreneur’s 2018 rankings, McDonald’s was the top franchise in America. In fact, six of the top 10 were fast-food restaurants. These rankings are based on costs (franchise fees, total investment, royalty fees); size and growth (number of stores, growth rates, closures), support (training, marketing and operational support), brand strength (social media presence, years in business) and the franchisor’s financial strength and stability).
While franchises are backed by the support and stability of large corporation, opening a franchise requires a large investment of capital. This investment can even be larger than opening a traditional, stand-alone business, given the size of franchise fees and ongoing royalties that can be required. In addition, franchise owners are typically responsible for their own advertising costs. Fortunately, numerous forms of franchise funding are available.
It’s not uncommon for corporations with franchise business models to offer customized financing for their franchisees. These franchise brand loans can be arranged either directly from the corporation or through partnerships with specific lenders. These lenders are familiar with the business model of the franchisors they partner. In that sense, they can be more valuable than the average lender because they can help finance everything that a new franchisee may need.
Franchisor Financing has many advantages for the franchisee in addition to providing the franchise fee. One of the most important benefits is that a lending agreement with a franchisor becomes a one-stop shop for everything the new franchisee may need. For instance, many of these programs can finance equipment and other resources that the new franchise requires.
Since the franchisor is an expert in its business, it can ensure that the new franchise is equipped with everything it needs to succeed before the business can open. The cost for all of these items are noted in the Franchise Disclosure Document. These costs are typically open to negotiation.
Of course, every franchisor financing agreement is different. These agreements may involve deferred payments in the early stages of the business. Repayment can also be structured on a sliding scale. But they can significantly ease the financial burden of starting a franchise. Some franchisor financing agreements can take on up to 75 percent of the debt burden from the new franchise owner. The potential variation in terms makes it critical that your attorney or accountant review both the franchise agreement and the financing agreement before you sign either one.
Most people think of traditional term loans from banks when of financing through a loan. The same applies to franchise financing. Traditional term loans from banks is another common method that franchisees fund the purchase of their business.
The formula is the same: a bank or alternative lender offers a lump sum of cash up front. That amount – plus interest – is repaid with interest in monthly installments over an agreed-upon period of time.
The lender, of course, will want to review your business plan and personal credit history once the loan application is filed. This is to assess the creditworthiness of the applicant. As with any loan, the lender want to determine how likely it is that the applicant can repay the loan for which it’s applying.
According to the SBA, new franchise owners have a greater tendency to borrow from commercial banks than traditional business owners.
It’s fair to assume that the stronger the credit history of franchisees, and the higher their credit score, the more likely they are to get their loan application approved. It also stands to reason that the terms of the loan will be more favorable.
The most desirable loan option for prospective franchisees is the SBA loan. These loans are partially backed by the Small Business Administration and funded by its lending partners.
As a result, these loans are constructed much like traditional business loans from banks or alternative lenders. The main difference is that SBA guarantees a portion of the loan in order to minimize the risk to lenders. This, in turn, results in lower interest rate being charged to the borrower. SBA loans also can offer the benefit of longer repayment terms.
Rates for SBA loans for franchise financing range from 7.75 percent to 10.25 percent. Franchisees will also be charged an origination fee that falls between .5 and 3.5 percent and a loan packaging fee from $2,000 to $4,000. There is also an SBA guarantee fee of two to 3.5 percent of the loan amount.
SBA loans for franchising financing can lend borrowers up to $5 million with repayment terms of up to 10 years. If the purchase of real estate is being funded with an SBA loan, the repayment terms can be extended for up to 25 years.
While the rates and loan terms can make SBA loans the most preferred option of a franchisee, the approval process to qualify for an SBA loan can be more difficult. Requirements can be tougher to meet, and the entire process can be lengthy. Loans may take 30 to 90 days to fund. In addition, funds from an SBA loan can’t be used to cover many startup costs, such as franchise fees. Franchisees should carefully and honestly assess their likelihood of being approved for an SBA loan before entering into the application process.
Alternative lenders (merchant cash advance companies, factors, and other non-bank lenders) have more flexible requirements and a shorter approval time than traditional lenders. As a result, these lenders can be an invaluable source for franchisees that quick funding, or who need more capital in addition to their commercial or SBA loan. They can also help with a number of different loan options such as financing equipment purchases and offering business lines of credit.
The downside of this quick access and flexibility is that it comes at a price. Alternative lenders typically offer charge higher interest rates than traditional lenders. They also offer shorter repayment terms and lower loan amounts.
Despite the extra cost, alternative lenders are the best option for some prospective franchisees. Business opportunities can disappear as quickly as they arise, and time can be of the essence when it comes to securing financing. In such cases, alternative lenders can be an important asset.
For established franchisees, these lenders may also offer small business lines of credit to help meet operating expenses. To qualify, borrowers typically need a credit score of at least 600, annual revenues of at least $100,000 and must have been in business for at least six months.
As the name suggests, this option is more suitable for first-time franchisees since it’s easier to qualify for than traditional financing. However, it’s also much more complicated.
ROBS allow borrowers to take retirement funds from an eligible retirement account, such as a 401(k), and use them to invest in a franchise. The key is that these funds can be withdrawn without having to pay taxes or an early withdrawal penalty. The funds can be used as a down payment on a larger financing agreement, such as an SBA loan. The money can also be used for other costs that traditional loans may not be allowed to cover, such as franchise fees.
The retirement account used must have a balance of at least $50,000 and cannot be from the borrower’s current employer. In addition, borrowers must be employees of their new business, and the new business must offer an employee retirement account. The new business also must adhere to all IRS and U.S. Department of Labor requirements.
ROBS-financed franchises can save more of their income from the start of their operation. That’s because a ROBS isn’t a loan, so there’s no debt or interest to pay back. The main cost with a ROBS is monthly administration fees. But these fees are more than 10 times less expensive compared to the fees associated with a loan.
This option is designed for franchisees who are already in business. A fast online working capital loan can used to fund any business activity, such as equipment purchases or to make payroll. While the costs for online working capital loans can be higher than those of a long-term loan – and the qualifications tougher – online working capital loans can get franchisees the funds they need much faster.
Interest rates for online working capital loans can vary wildly, ranging from nine percent to 80 percent APR. But borrowers typically receive rates ranging from 30 percent to 50 percent. The APR includes loan origination fees of up to five percent of the loan amount. Online working capital loans may come with penalties for early repayment.
To qualify for an online working capital loan, borrowers normally need a credit score of at least 600. They also need to have been in business for at least one year with annual revenues of at least $50,000.
If a franchisee can’t obtain financing through the franchisor, banks, the SBA or an alternative lender, it’s time to get creative. In such instances, crowdfunding can be a clever option to try.
Crowdfunding has become a popular source of financing over the past decade for wide variety of personal and professional projects, including small business financing. It’s not uncommon for entrepreneurs to establish their own personal crowdfunding page. Of course, effective promotion of the page is critical. There are also dedicated organizations that crowdfund for businesses and franchises.
In addition, there are websites that crowdfund for specific industries and types of businesses. The mission of these sites is to lend those funds to prospective business owners who need financing. Prospective borrowers have to qualify for a crowdfunded loan should they choose to go through a crowdfunding financing company.
The general requirements for a crowdfunded loan are a credit score of at least 660, personal net worth at least equal to the loan amount, a minimum down payment of 20 percent and six profitable months in business.
Interest rates on crowdfunded loans range from 7.75 to 12 percent with an origination fee of up to 4.5 percent. Loan amounts can range from $100,000 to $2 million. Loan terms can range from five to seven years with a monthly repayment schedule. While the interest rates on crowdfunded loans are not unreasonable, the monthly repayment may be problematic. Franchisees that prefer longer repayment terms may want to look into SBA loans.
Franchisees who own a home and have 20 percent to 30 percent equity in it may be able to get a Home Equity Line of Credit (HELOC) with a low interest rate. These funds can be used to cover any startup fees, including franchise fees. HELOCs give borrowers immediate access to a lump sum to draw against as needed. As is the case with a normal business line of credit, borrowers only pay interest of what they use.
The risk is that the residence of the borrower is used as collateral. This means that failure to make payments means that the borrower could lose their home. The benefit of a HELOC is access to low-interest rate funds as needed. HELOCs allow borrowers to access up to 80 percent of their home equity based on the appraised value of the home. Interest rates on a HELOC or Home Equity Loan (HEL) commonly range from three to six percent.
Closing costs for a HELOC for franchise funding are typically between two to five percent of the loan amount. Included in the closing costs are items such as the application fee, appraisal fee and any real estate recording fees.
A HELOC requires a credit score of at least 680. For a HEL, a credit score of at least 620 is necessary. For both vehicles, borrowers need at least 20 percent equity in their home to qualify. But lenders prefer the minimum amount of equity to be between 30 and 40 percent.
Borrowing from friends and family is one of the most common ways through which franchises are financed today. Such arrangements have a high level of flexibility and can be constructed in several ways. For instance, a formal loan agreement can be created, or friend or family member can be brought into the franchise as a business partner.
Regardless of what method is chose, a contract should be written and notarized that spells out the terms of the loan or partnership. This will help eliminate any potential disagreements or ill feelings later on. In the case of a loan, such a contract should cover repayment terms and other expectations. If a partnership is being created, the contract needs to specify the percentage of the business that the lender owns and the responsibilities of each partner.
As laymen, franchisees and their associates may not know what terms are appropriate for a friends and family loan. Friends and family might not even want to receive interest on their loan. But it’s important for franchisees to pay interest on the amount they borrow. If not, the IRS might consider the money a taxable gift.
As of mid-2019, the required minimum annual interest rates were 1.8 percent for short-term loans (less than three years) and 2.09 percent for long-term loans (up to nine years). These rates come from the IRS Index of Applicable Federal Rates (AFR). The AFR index provides the minimum interest rates the IRS expects to be paid on all loans.
In order to avoid any unnecessary paperwork or tax implications, it’s advisable that franchisees use an administrative service to manage friends and family loans. This adds a level of professionalism to this type of loan and can increase the comfort level on both the borrower and lender.
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