Seven Crucial Considerations for Franchise Financing

How your initial financing decisions can impact the future of your business.

By Tom Pretty, TD Bank

Starting or buying a franchise offers the opportunity to achieve the entrepreneurship dream while capitalizing on the structure of a franchise system. As this dream takes shape, it's important to determine how a small business owner (SBO) can finance their franchise, since many variables affect their ability to secure credit. It's important for entrepreneurs to understand the available financing options and be aware of how "fine print" such as fees, collateral, loan terms and more can impact the total cost of credit. When seeking a loan or line of credit, savvy franchise owners will weigh the pros and cons of finance options including U.S. Small Business Administration (SBA) loans, conventional loans, Rollovers for Business Startups and inclusion of equity investors. With these options, which type of financing may be the best fit for achieving business success as a new franchise owner?

1. SBA Loans

One option SBOs may consider are SBA 7(a) and 504 loan products, since these loans can provide cash savings, lower down payments and longer terms than conventional loans. The SBA guarantees a portion of these loans for banks, meaning that these lenders are usually more willing to approve these loans for SBOs who may not have the credit score or history needed for a conventional loan. 

2. 7(a) Loans

SBA 7(a) loans help business owners obtain financing for general business purposes, including working capital; buying equipment or furniture; buying or renovating buildings and refinancing debt. 7(a) loans of up to $5 million are issued with terms of up to 10 years for working capital and 25 years for fixed assets, compared to conventional loans that typically carry 15- to 20-year terms. Lower equity injection requirements, typically 10 percent, and a longer term (or payback period) create lower monthly payments, allowing SBOs to preserve their cash so they can invest excess funds into their businesses. However, 7(a) loans are typically more expensive upfront, always require a personal guarantee and if not fully secured, SBOs must provide a lien on other personal assets, including their home.

3. 504 Loans

Like 7(a) loans, SBA 504 loans require less money down and have longer terms, but can only be used as long-term, fixed-rate financing for purchasing major assets like real estate and long-term machinery or to renovate facilities. This means that any startup cost (including franchise fees) would come out of the franchisee's pocket or be covered through another funding source. The maximum 504 loan amount is also $5 million. Although 504 loans don't require a personal guarantee, they typically have higher fees than a traditional bank loan. Furthermore, 504 loans require the involvement of three parties, so every month franchisees must pay two different institutions, which can be challenging. TD Bank and many other lenders try to minimize this pain point, but it is still an obstacle associated with this lending type. 

4. Conventional Bank Loans and Lines of Credit

Conventional bank loans offer cheaper cost of capital with low origination costs and interest rates since they don't require the fees associated with SBA loans. Conventional loans may also appeal to SBOs because there is a perception that SBA loans take longer to close, although banks with SBA Preferred Lender status, like TD, can help fast track this process. Furthermore, conventional bank loans can be challenging for startups to secure until they have a proven business financial track record. As a result, banks typically require business owners to put more money into the loan. Like SBA 7(a) and 504 loans, conventional loans do not require SBOs to relinquish business equity to an investor; however, conventional bank loans and lines of credit typically have shorter terms than SBA loans, resulting in more expensive payments. 

5. Rollover as Business Startups (ROBS) Account

This lesser-known financial product allows individuals to roll funds in a 401(k) into a ROBS account to finance a business venture. There are no early withdrawal fees, penalties or income taxes on this loan since the money is left in a tax-free vehicle. ROBS offer a low cost of capital since SBOs don't pay fees and instead distribute some investments into the company. This should be done with caution and with the advice of a certified financial planner to ensure IRS rules are adhered to, and SBOs must keep in mind there is a risk that a significant portion of retirement savings will be lost if the franchise fails to generate profit and doesn't succeed. 

6. Equity Investors 

Another option is to seek an equity investor, who does not require large upfront costs and can serve as a valuable partner on growing and operating the business. The downside is that the equity investor requires a share of the business and profit because of his or her financial involvement in the business for years or even the life of the business. Although there is typically no interest rate associated with equity investor financing, they can be the most expensive source of capital due to the percentage paid to the investor, unlike bank loans, which usually have a fixed, low rate and defined payment schedule. Another risk to bringing in an investor is that if the partnership doesn't work out, there can be significant break up costs.

7. Cash

SBOs can consider using cash to fund their startups if they are financially able to do so. This allows for full control of the business without the involvement of an investor. However, as many SBOs know, cash is king, so preserving cash for a rainy day is prudent.

As SBOs build out their businesses, it's important to consider all these options to determine which may be the best fit. No matter which type of financing is selected, SBOs can increase their chances of securing funding by creating a structured business plan, working to develop a track record of accomplishments, and ensuring they understand the benefits and limitations of the financial solutions they choose and how they align with the company's growth strategy. 7 

Tom Pretty is the Head of SBA Lending at TD Bank, America's Most Convenient Bank®, where he leads a team of Small Business Administration experts who originate and manage the Bank's SBA portfolio, including SBA Express, 7(a) and 504 loans. Find out more about TD Bank here.