If you want to open a franchise of an established brand but don’t have the cash, you may be able…
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 startup costs.
Options for franchise financing include Small Business Administration and conventional loans, plus many alternatives. Read on to learn about ways to finance a franchise, what to expect when you apply for financing, and how to choose the right franchise loan.
[Read: Best Small Business Loans.]
What Are the Best Sources of Franchise Financing?
Start with the franchisor, which may be able to recommend partner lenders if you need money to purchase a franchise.
“Franchisors, in many instances, have preferred lender lists and resources that know the brand,” says Ron Feldman, chief development officer at ApplePie Capital, a financial solutions provider for franchises.
Consider your options for franchise financing:
The SBA has three primary business loan programs: 7(a), 504 and microloans. SBA-certified lenders issue these loans that, except for microloans, feature federal backing. This guarantee reduces risk for lenders, helping them approve loans for businesses that may not otherwise qualify for funding.
Here’s more about SBA loans to finance a franchise:
— 7(a) loans. The most common type of SBA loan is available in amounts of up to $5 million. These loans have many uses, ranging 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 fixed assets, such as equipment and real estate, or for improvements to facilities. You can’t use a 504 loan for working capital or inventory, but you can combine it with a 7(a) loan or others to help you meet these needs.
— Microloans. 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 usually exceed the loan limit, says Dianna Seaborn, director of the SBA’s Office of Financial Assistance.
Conventional business loans are typically provided by banks, credit unions and other financial institutions. They do not have an SBA guarantee, which means these loans are riskier for lenders to make. Startup franchises may not be able to obtain conventional loans.
Rollovers as Business Startups
ROBS financing allows you to use retirement funds free of taxes or penalties to support startup costs. ROBS can be complex and must follow specific steps to avoid prohibited transactions.
Although you are not borrowing and paying interest as with a loan, you are putting your retirement on the line and passing up 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, let you tap your home equity for cash and use your property as collateral. A home equity loan provides a lump sum upfront, and a HELOC offers a revolving line of credit that you can access as needed, like a credit card. You can use this money to finance a franchise, but your home is at risk of foreclosure if you fall behind on loan payments.
Securities-Backed Lines of Credit
A securities-backed line of credit can help you finance a franchise by harnessing the value of your investments without selling them.
This product resembles a HELOC, but you’re borrowing against your investments rather than your home. You will make monthly interest-only payments, repay some or all of the principal, and then borrow again later.
Franchises that rely on costly equipment can use equipment leasing to fund part of that operating expense. Restaurant franchisees may use equipment leasing, for example, because buying equipment upfront can be expensive. You’ll pay a monthly fee to use the equipment and may have the option to upgrade, purchase, continue renting or return it at the end of the lease.
Some franchisors offer franchisees financing in part or in whole. Just keep in mind that a franchise financing program isn’t your only option, and you should compare the franchisor’s offer with other funding sources.
What to Expect When You Apply for Franchise Financing
When you apply for a loan for your franchise, the rules will be similar to other business loans. You’ll need to show that you can afford to repay the loan, and lenders may decide based on your business or personal credit.
If you opt for an SBA loan, ultimately the lender decides whether to approve the loan. You must meet the SBA’s minimum requirements and the lender’s approval requirements.
Prospective borrowers also need to prepare a satisfactory loan package, or application, to receive SBA money. This package provides several items for lenders to determine the risk of your loan. Your loan package must include:
A statement of purpose. This critical component of the loan package may be labeled “executive summary” and attached to your business plan or contained in a letter to the lender. Include the loan amount you have requested, loan purpose, term and collateral, as well as a brief description of the business and how the loan will help it.
Your business plan. A business plan describes your company, includes an organizational chart, explains your products or services, details your marketing strategy, and includes financial projections. Your financial projections should estimate earnings and expenses for the lender, including whether the business will generate enough cash flow to service the debt. Help with business plans is available from the nonprofit Score Association, an SBA partner offering free templates and other resources.
Business and personal financial statements. Your loan package should have 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 statements, if available. Startups can supply 12-month income 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 collateral. Business loans often require collateral, including business and sometimes personal assets, such as your home.
Generally, income is more important to loan approval than credit score, Feldman says. If you won’t have the earnings or reserves to cover expenses once you get started, your loan isn’t likely to get approved.
Still, lenders may consider your business and personal credit scores for a loan to expand or upgrade your franchise and review your personal credit for startup financing.
[Read: Best Unsecured Business Loans.]
Getting Support From the Franchisor
The Federal Trade Commission requires the franchisor to supply to prospective franchisees the franchise disclosure document with information on the risks and rewards of an investment. Aside from this document, support from franchisors varies widely.
Financial support from franchisors can include waived or reduced franchise fees or royalties for qualified franchisees, plus some franchise brands offer their own financing programs. Franchisors may also provide franchisees lender recommendations and help with business plans.
How to Compare Your Options for Franchise Financing
Franchise financing isn’t one size fits all. The right franchise loan will depend on your needs and finances and not those of hundreds of nearly identical businesses.
Consider these factors as you compare your franchise financing options:
What you need to finance and how much. Lenders set different limits on what you can borrow as well as 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 other equipment. SBA microloan limits of $50,000 are typically too small for franchisees, and you may need more than one type of loan to meet your franchise financing needs.
What you can qualify for. Even with support from a proven franchise system and excellent credit, you aren’t guaranteed approval for a conventional business loan. SBA loans, however, are designed for small businesses that don’t fit traditional financing requirements.
Your risk tolerance. A franchise loan that requires a personal guarantee can tap your assets, such as your home and money in your bank accounts, if you default. ROBS financing bets your retirement funds on your startup, and a home equity loan jeopardizes your home if you can’t keep up with payments.
Your loan terms. Once you have a few loan offers, compare the terms and consider how they work for your priorities. Some banks are looser 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 along with the prime rate, he says.
Your franchisor and your local SBA office can assist as you choose a lender. For example, they’ll know which lenders specialize in your type of franchise and whether those lenders work with startups.
Consult with a third party before you sign on the dotted line. Ask an accountant, attorney, business consultant or all three to walk you through your franchisee responsibilities and help you select your best franchise financing option, Seaborn says.
The SBA can include the cost of professional consulting services in your loan.
“Make a decision from an informed place,” Seaborn says. “There’s time and effort in reviewing these documents, and it’s critical to understanding franchisor requirements.”
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