Franchise Financing Report
Franchise Financing Options
There are several options to obtain funding for initial franchise costs. Many potential franchisees depend upon investors, lending institutions, family and friends, or their personal savings. In this section of the report, we will take a look at the following:
- Home Equity Financing
- Retirement Funds
- Franchisor Funding
- Financing from Family and Friends
- Online Matchmaking
- SBA Financing
- Bank Loans
Home Equity Financing
There are two kinds of home equity financing: home equity loans (HEL), and a home equity line of credit (HELOC). Both of these are considered second mortgages.
A home equity loan has a fixed rate and monthly payments until the total amount has been paid. The loan is provided as a lump sum and once received cannot be expanded for additional borrowing.
As for an HELOC, the loan is provided incrementally and borrowers can obtain additional funds up to the credit limit under an adjustable interest rate. 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 loan 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. 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 percent) 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 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. Those considering home equity financing should be aware that if payments are missed, the risk of foreclosure is the same as a primary mortgage.
Another alternative financing source is your Individual Retirement Account (IRA) or 401(k) funds. One way to transfer funds into a business is through the Entrepreneur Rollover Stock Ownership Plan (ERSOP). The ERSOP takes the funds that have been locked into your retirement accounts and places them directly into a business as an investment.
The first step is to create a corporation for the upcoming franchise business, and that newly-formed corporation turns into a 401(k) profit sharing plan, which your current accounts can be rolled into. The funds in the new 401(k) plan can then be used to pay for the stock in the business.
This funding tactic allows money to be withdrawn as an investment without incurring penalties or tax charges. Withdrawn funds can be used to purchase a franchise, property, equipment, or working capital. Likewise, the retirement funds from the IRA or 401k can be used in conjunction with other loans to meet your needs.
The Guidant 401(k) plan is another way to use retirement funds to open a franchise. This plan allows potential franchisees 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 potential challenges with the Internal Revenue Service (IRS).
There are four basic steps in the process of rolling over current retirement funds into the Guidant plan for your franchise:
1. Form a Corporation
2. The Corporation Sponsors a Guidant 401(k) plan
3. Existing retirement funds are rolled over into the new Guidant 401(k) plan
4. The new Guidant 401(k) plan invests in 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.
Some franchisors have adapted to the current lending environment by taking matters into their own hands, including offering financial assistance directly or through third parties. Whether or not a franchise provides financing assistance is discussed under Item 10 of the FDD, or you can inquire with the franchisor. A number of franchisors can offer franchisees better financial packages than some banks, so direct financing through the franchisor is often advantageous.
Another adjustment made by some franchisors to better accommodate their franchisees is altering their franchise models. Smaller and full-size franchises now more readily allow prospective franchisees to choose the investment level, with lower investments made possible.
Financing from Family and Friends
Two primary funding options through family and friends includes: (1) a family member or friend invests in the franchise as a partner, where they join you in the running of the business, or (2) a family member or friend offers a loan, which you agree to pay back.
Before embarking on either of these options, create an agreement in writing that details the terms and conditions. Consider reaching out for professional assistance when drafting the agreement if necessary to protect all involved parties.
Agreements with family and friends should include:
- Whether allocated funds come in the form of a business investment or a loan
- Amount of loan, what it is to be used for, and terms of repayment
- Whether loan is secured or unsecured; if secured, a written detail of lender collateral such as in title and property, and if unsecured, specify interest rate, repayment plan, and any other necessary information
Beyond traditional funding channels, franchisees can now connect with lenders online based on compatibilities. BoeFly, a site strikingly similar to online dating sites, allows prospective franchisees and other small business funding seekers to create a membership account for a fee where they can submit a loan request for potential lenders to view.
Once the loan request is complete, BoeFly matches the request with “compatible lenders” who review received requests and then contact suitable loan seekers. The method has been embraced by over 1,500 lenders hosted on the site, including popular franchisors Dunkin’ Donuts, Arby’s, Baskin-Robbins, Hardee’s, Planet Beach, Matco Tools, and Great Clips among others.
The Small Business Administration (SBA) is a popular avenue for franchisees seeking financing. The SBA offers many specialized programs to help entrepreneurs accomplish their business goals.
Loans offered through the SBA with 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 approval for potential franchisee loan applicants. 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.
- Basic 7(a) Loan Program assists businesses with specific purposes such as operating in a rural area, exporting to foreign countries, etc.
- CDC/504 Loan Program encourages economic development within communities, 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 offer minimal short-term lending options, not to be used for 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 database of FRANdata, an independent, objective source of franchise industry information and analysis. The registry lists participating franchise systems for potential franchisees seeking expedited loan approval options through the SBA. Franchise eligibility is determined by detailed analysis of the franchise agreement to ensure that the borrower, or the buyer of the franchise, is a small business and not an unqualified larger entity. All franchises listed on the registry have been vetted by the SBA to guarantee that the loan funding will be used for a franchisee’s business in an appropriate manner.
Once a franchise is approved for listing in the registry, the franchise agreements no longer have to be reviewed in-depth each time an application is submitted, which streamlines 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.”
Though acquiring bank loans can still involve challenges, franchisees generally have an easier time securing a bank loan than independent business owners because of the established background of their franchisor. 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:
- Secured Loans: supported by collateral that can be sold by the lender if the borrower does not pay the loan on time
- Unsecured Loans: typically have a higher interest rate 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 up to $100,000 for terms of up to one year
- Equipment Financing: used for needed machinery and apparatus, which after purchase can also serve as collateral for a loan instead of personal property
- Line of Credit (or working capital): maximum amount of money that the borrower can incrementally withdraw from as needed
The key to commercial bank loan approval is preparation with a sound business plan and detailed information that supports the lender’s decision. Resist the temptation to accept the first loan offer you receive. Shop around for the loan package that best suits your specific needs and situation. Loan offers and interest rates often vary from bank to bank.