Analyzing Financing and Funding Options for Franchisees

January 09, 2017

The key to finding the perfect financing solution is understanding franchisees’ options based on their credit, personal financial statement and resources for capital.

By Candice Caruso

By now, potential franchisees have realized one glaring reality of the franchise sector — it’s a highly detailed form of business ownership.

They’ve most likely done hours of research, read pages of legal documents, scoured the internet looking for the perfect franchise match and made a commitment to sign. Now comes the big question: “How will I pay for this business venture?”

Like the franchise industry itself, funding can be a complex area to understand. There are US Small Business Administration loans, conventional bank loans, crowdfunding, a variety of credit lines and a number of other ways to generate the capital needed to fund a franchise. How can new business owners possibly know which one is right for them?

SBA loans

For many in the franchise industry, franchisors and franchisees alike, the expansion and development of the SBA has been a significant driver in the changing financial landscape.

The SBA 7(a) loan program is the most commonly used for franchise funding, with about 10 percent of loans going to franchisees. It is also one of the few programs available to new franchisees that select their franchise from the Franchise Registry. 7(a) loans are issued by a bank or other qualified lender, most commonly between $250,000 and $500,000, and are partially guaranteed against default by the government.

This is a major advantage for franchisees by incenting lenders to extend loans to startups and small businesses that would otherwise not meet their underwriting requirements. Typically, an SBA loan provides approximately 70 percent to 85 percent of the business capital needed, with the remainder being met through the franchisee’s equity investment. The proceeds from an SBA loan can be used for startup expenses, working capital, inventory, supplies, equipment and more. Franchisees who are considering an SBA loan should be comfortable with extending a personal guarantee and collateralizing the loan.

Conventional bank loans

Many traditional banks and financial institutions have embraced franchise lending, in part because of the reputation franchise companies offer. That’s especially the case for well-known and highly established systems. The more well known a franchise is, the better chance the franchisee will be offered favorable lending options.

Conventional bank loans are most commonly available to existing franchise locations related to resales or growth capital. A strong history of profitability is important. In general, the lender will need to review three years of financials and tax returns for an existing franchise location. Strong credit scores will also greatly increase the chance for gaining capital through traditional lending channels.

With bank loans, franchisees are typically required to provide collateral, even with good personal credit. This can include anything from equity in a home or another large personal asset.

Crowdfunding

Since the US Securities and Exchange Commission finalized rules related to crowdsourcing funds for franchise businesses, many hopeful business owners, investors and community members have quickly realized the benefits.

While it’s still fairly difficult to use crowdfunding as a sole source of business funding, it enables small businesses to be donation-based or investor-based, reducing debt and subsequently allowing franchisees to be more connected to their business partners and communities.

Traditional private investing continues to be more popular than crowdfunding, a big reason being the amount of money these startup and franchise companies need immediately. Investors must be convinced that the market is in-line to support the business, that it has a clearly developed business plan, there is opportunity for growth, a unique but interesting service or product to sell, and the confidence that the franchisee can generate enough capital to actually get the business up and running. Most investors are seeking a profit and with a franchise, may have quicker success than investing in a non-franchise startup business.

Additionally, there are some crowdfunding platforms that provide loans as an alternative to bank lending options. These options are limited to proven franchise brands with high track records of success. They will also have unique underwriting requirements for the lender. The franchisee may also have to be prepared for higher interest rates based on the lender’s risk.

Rollovers as business startups

Another common franchise funding method for entrepreneurs, which has gained popularity in the last several years, is Rollovers as Business Startups.

ROBS, by definition, is a qualified plan in which a current or prospective business owner rolls over his 401(k), IRA or other eligible retirement funds and invests these dollars into his business. Once invested in the business, the funds can be used to pay startup costs, business acquisition costs or to recapitalize an existing business. The company stock becomes an asset of the retirement plan, keeping the retirement dollars tax-deferred and penalty free.

These funding methods are specifically common in the franchise sector, in part because franchise systems are thought to be a lesser risk than traditional startup companies. As more information emerges and financial providers educate their clients about the use of ROBS, the funding method is growing more accepted in traditional business startup.

One of the biggest advantages entrepreneurs find in using ROBS to fund their business is being able to invest their own money, which eliminates or minimizes their need for debt financing. This typically means starting out with more capital to spend on advertising, equipment and hiring expenses.

As with any funding method, there are risks involved with using retirement funds to invest in a business, but many of these risks can be significantly reduced if franchisees work with a financial firm that is knowledgeable and experienced in ROBS structures.

All of these funding methods are commonplace in the franchising sector, but what works best for one entrepreneur doesn’t necessarily mean it will work for another. The key in finding the perfect financing solution is understanding the franchisees’ options based on their credit, personal financial statement and resources for capital.

Candice Caruso is President of Pango Financial, with nearly 20 years of experience in the financial services industry and 10 years as an innovative business funding expert.