Franchise Financing Options

Franchise Financing Options

Avenues of Financing

There are several options available to obtain the amount of money obligated for the initial costs of their franchise. Many potential franchisees depend upon investors, lending institutions, family and friends, or their personal savings. Here’s a look at some of the most common.

Franchisor Funding

A number of franchisors offer financial assistance directly by way of debt financing, or through third parties. According to Joe Lindenmayer, President and Co-Owner of TSS Photography Inc., “franchise systems have adjusted to economic conditions”, by offering financial assistance or other incentive programs to prospective franchisees. Whether or not a franchise provides financing assistance is discussed under Item 10 of the FDD, or you can ask the franchisor directly if they offer any form of financial assistance. It is important to not bypass asking this question because some franchisors give better rates and assistance than most banks.

Here are three examples of franchises that provide financial assistance to potential franchisees.

Huddle House

Huddle House, a seafood/steak restaurant chain, offers an incentive program to assist potential franchisees buying a franchise. The program entails a reduced initial fee from $20,000 to $5,000, and no royalty payment for the first five months of operation of the franchise contract. According to Thomas Flaherty, Chief Development Officer of Huddle House, “Huddle House wants to attract experienced operators for new development in target markets. This program allows existing and new Huddle House franchisees the opportunity to develop with a lower cost of entry.” Flaherty also stated that, “the savings in paying no royalty for the first five months provides fuel for new restaurants to advertise more heavily during the initial stages.”

Johnny Rockets

Johnny Rockets, a classic Americana-themed restaurant chain, offers a different approach in an effort to assist franchisees that cannot afford the initial costs. The new initiative is “a new quick-service prototype.”  According to John Fuller, President and CEO of Johnny Rockets, “it allows [them] to operate in many non-traditional locations or in smaller spaces that are available, especially in some of those bigger cities where rent can be outrageous. It offers another way to get more points of distribution.” The target size of a Johnny Rockets restaurant is 1,300 to 1,800 square feet, but their restaurants can be as small as 900 sq. ft. and as large as 3,000 sq. ft. Most of their build-outs since around 2010 have cost around $500,000 to construct. Assuming there are no conversions from an existing restaurant, a smaller Johnny Rockets restaurant would cost nearly $400,000. And while there is no reduction in franchise fee for smaller footprints, smaller quick-service locations do offer a simplified menu and smaller-sized equipment.

In addition, Johnny Rockets’ parent company, Johnny Rockets Group Inc., has formed Tysons Franchise Finance LLC, to provide financial assistance to potential franchisees. Fuller says that “because financing has been difficult to obtain, our ownership group is stepping up to help current franchisees fulfill their development commitments and to help new potential franchisees.” The financing company plans on providing loans of up to between 50 and 70 percent of the initial investment without owning direct stake in any of its franchises.

Marco’s Pizza

In late July 2010, Marco’s Pizza secured $7.5 million to finance potential franchisees from an agreement it made with Main Street Bank of San Antonio, Texas. According to Ken Switzer, Chief Financial Officer for the company, the money will fund between 30 and 50 Marco’s Pizza units, citing the estimated $300,000 it costs to open one of the restaurants, including post-closing costs and working capital. If the potential franchisee meets the requirements of the agreement, they could be eligible to borrow up to 75 percent of the $300,000 initial investment. Marco’s Pizza also provides other financing programs where franchisees can use a line of credit to lease stores.

Financing from Family and/or Friends

Getting financial support from family and/or friends is another source of investment and a way to fund your franchise. Family and/or friends will often offer better terms than lenders, venture capitalists or outside investors. According to a London business study, investments from friends and family account for more than 70 percent of all venture dollars for start-ups. There are two types of funding options through friends and family: (1) a partner/investment, where they join into the business, or (2) a family member and/or friend offers a loan, which you pay back.

Before embarking on either of these options, create an agreement in writing detailing the terms and conditions. Agreements with family and friends should include:

• How much money was given, what it was used for, and the terms of paying it back.
• Whether that individual is putting money into the business, as an investment or a loan.
• If the loan is secured or unsecured. If the loan is secured, it needs to be broken down in detail of what the lender holds, as in title and property. If the loan is unsecured, specify what the interest rate is, payment due date and any other necessary information.

Drafting this agreement will protect both sides and assist in upholding your relationship. If you need help in creating an agreement there are companies out there that will help. Virgin Money USA is a company that assists and manages individuals’ money through friends and family, with specified loan terms and interest rates. The terms differ per individual and standing relationship with the borrower. Clear and mutual understanding of the legal responsibilities and the financial process relating to the business venture is a must. According to Virgin Money USA President and CEO Asheesh Advani, “make sure that if you do borrow, you document it properly.”

Home Equity Financing

Home equity financing is one of the cheapest and fastest sources for debt financing available. There are two kinds of home equity debt financing: home equity loans (sometimes called a HEL), and a home equity line of credit (also known as a HELOC). Both of these are considered as a second mortgage.

A home equity loan has a fixed rate and fixed monthly payments which has to be made until the total amount has been paid. The money is given in a lump sum; thus, once the borrowed money is paid off, you cannot get a home equity loan again. As for a HELOC, the money is not all given at once, and you are allowed to borrow funds in increments up to your credit limit. According to Heather McPherson, Senior Financial Advisor at FranFund, a consulting service that helps prospective franchisees find and compare loans, “the [borrower] would also need to be employed to justify a HELOC, have a favorable credit score, and a manageable debt to income ratio.”
The amount that you are able to receive for either option is based on the value of your home, which means your equity fluctuates over time. The amount of equity you have in your home can be calculated by taking the current market value of your home and subtracting any outstanding mortgages or liens. For example, if your home is worth $100,000 and you have $40,000 left to repay on your mortgage, your equity equals $60,000. However, financial experts suggest only borrowing a portion of the available equity and leaving some of your home’s value intact. Most lenders operate within a credit limit on a home equity line by taking a percentage (for example, 75%) of the home's appraised value and subtracting from that the balance owed on the existing mortgage. For the given example:

$100,000 (home value) x (multiplied by) 75% = $75,000 (maximum potential equity)

$75,000 (maximum potential equity) - $40,000 (balance of mortgage) = $35,000 (available equity)
The advantages of a home equity financing include a lower interest rate and access to larger loans. Plus, the interest that is paid on the home equity may be tax-deductible on a loan up to $100,000. See IRS Publication 936 for additional information regarding deductible interest on your tax return, and consult your financial advisor. The primary disadvantage to home equity financing is that if payments are missed it puts you at risk for foreclosure, as with a primary mortgage.

Retirement Funds

Another alternative is to tap into your Individual Retirement Accounts (IRA) or 401(k) funds. This can be done through the Entrepreneur Rollover Stock Ownership Plan (ERSOP), which takes the funds that have been locked into your retirement accounts and places them directly into a business, as an investment. This means that the money is withdrawn as an investment, and no penalty or tax charges will be applied. The money taken out can be used in numerous ways, such as to purchase a franchise, property, equipment, or working capital. The retirement funds taken out can be used in conjunction with other loans to meet your needs.

It works by the potential franchisee first creating a corporation for their franchise. After that, the newly-formed corporation turns into your new 401(k) profit sharing plan, which your current accounts will rollover into. Through the new 401 (k) plan, the funds will be used to pay for the stock in the business.
Another way to use retirement funds for the opening of a franchise is the Guidant 401(k) plan. The Guidant 401(k) plan allows potential franchisees the opportunity to make an investment into a business through their retirement plan by rolling their current funds into Guidant’s 401(k) plans. The Guidant plan provides a streamlined way to secure your funds as well as ensure the correct format is implemented to avoid any IRS implications.

There are four basic steps in the process of rolling over current retirement funds into the Guidant plan for your franchise:

• Form a Corporation
• The Corporation Sponsors a Guidant 401(k) plan
• Existing funds get rolled over into the new Guidant 401(k) plan
• The new Guidant 401(k) plan invests into the corporation (also referred to as stock)

To learn more about the Guidant 401(k) plan visit the Guidant Financial - Business Financing with Retirement Funds page on FranchiseDirect.com.

SBA Financing

The Small Business Administration (SBA) is a potential avenue of attaining the proper financing for your franchise through its specialized programs and focus on helping entrepreneurs accomplish their business goals. If the franchise agreement permits for independent operation, potential and existing franchisees can apply for a SBA loan with the SBA making the final decision on eligibility.

The SBA was established in 1953, and seeks to “to aid, counsel, assist and protect the interests of small business concerns, to preserve free competitive enterprise and to maintain and strengthen the overall economy of our nation.” The loans offered from the SBA through participating banks and lenders are designed for business owners who may have trouble qualifying for a traditional bank loan. They offer lower-interest rates, along with smaller down payments and longer repayment term options when compared to direct financing packages from banks and other lenders. In addition, the SBA offers participating lenders a guarantee of 80 to 85 percent of the balance on the loan, increasing the chance of a potential franchisee being granted one. For starting and expanding a business, the SBA offers three types of loans: the Basic 7(a) Loan Program, the Certified Development Company (CDC) 504 Loan Program, and the Microloan Program.

• The Basic 7(a) Loan Program gives assistance to businesses with specific purposes such as operating in a rural area, exporting to foreign countries, etc.
• The CDC/504 loan program is designed to encourage economic development within a community, and must be used on fixed assets such as the purchase of land and existing buildings; improvements like utilities, parking lots and landscaping; and the construction of new facilities, or renovating or converting existing facilities.
• Microloans are small, short-term loans that can be used in many ways, but not for the paying of existing debts or real estate purchases.

To learn about these loans in greater detail, including their requirements and terms, visit the Loans section of the SBA website.

SBA Franchise Registry

For a number of franchises, the SBA offers an expedited loan application process with its Franchise Registry. FranchiseRegistry.com is a website that allows franchisees to see which systems are participating in the program, SBA lenders to see details of the SBA approval, and franchisors to submit applications through a partnership between the SBA and FRANdata, an objective information company that researches and reports on franchising. The franchises listed on the registry have been vetted by the SBA to be small businesses, and that the loan funding will be used for a franchisee’s business in an appropriate manner. Eligibility is determined by going over the franchise agreement in great detail, looking for any language that would cast doubt on whether the borrower, or the buyer of the franchise, is not a small business but an unqualified larger entity. Once a franchise is approved, the franchise agreements for that business don’t have to be reviewed in-depth each time, streamlining the process for quicker approvals. According to SBA representative Michael Stamler, “the registry functions as a screen to ensure that a franchisee’s loan request is intended for his or her business.”

Lending Institutions (Commercial Banks)

Franchisees generally have an easier time securing a bank loan than independent business owners because of the established background of their franchisor. But that doesn’t mean that bank loans are simple to get. In fact, they can be quite difficult. According to Heather McPherson of FranFund, “these [loans] are even more difficult to obtain than an SBA loan. The risk to the lender is much greater in that it is not supported by the SBA at all. It will not just be based upon the overall financial health of the client as a borrower, but it will also weigh heavy on the business opportunity.”

Types of commercial loans include the following:

• Secured loans: supported, or backed, by collateral that can be sold by the lender if the borrower does not pay back the loaned money by the agreed upon time
• Unsecured loans: typically has a higher interest rate and is based on the borrower's credit standing
• Long term loans: typically run longer than three years and are used for expansion, refinancing, working capital and acquisitions
• Short term loans: used for smaller investments, and set up for terms of up to one year and given in comparatively smaller amounts ranging up to $100,000
• Equipment financing: used for the machinery and apparatus needed to run the business, if used the equipment purchased will serve as the collateral for a loan instead of personal property
• Line of credit (sometimes referred to as working capital): maximum amount of money that the borrower can withdraw from in increments as needed

The key to getting a commercial bank loan no matter the type is to be prepared with a sound business plan and all of the information required for the lender to make a decision. Resist the temptation to take the first loan offer you get. Shop around for the best loan package you can get as well, often banks will vary in not just how much money they’re willing to loan, but with the interest rate they quote as well.

Franchise Direct's Disclaimer