745,290. That is the number of operational franchise businesses in America in 2017. When considering a business venture, there are many advantages that appeal to entrepreneurs and the growing number who join franchising is testament to this. Starting a business with a proven track record, recognizable brand and a winning business model greatly reduces the odds of failure. For many entrepreneurs, this is a lure that can prove hard to ignore.
But it is not easy setting up a franchise business if you do not have your own significant financial resources. Knowing how you will finance your franchise is critical to setting yourself up for better odds of success. Here are some ideal sources to consider for financing your franchise business.
Factors to Consider In Financing a Franchise
You have spotted an attractive franchise opportunity that you think makes a viable business case for you and the next step is to lock in the financing. But before you can start putting together sources for your startup capital you need to weigh a few factors to help you best determine what financing will best work for you.
- Understand Your Franchise of Choice
Deep research into the franchise you want to get into is essential in figuring out what financing structure will be most suitable. Understand the dynamics of the locations and product offering to ensure there is a viable product/market fit. Know your numbers if you plan to seek debt capital from lenders. Having a clear grasp of the franchise’s past financial performance and the reasons underpinning it will help you make a case for your loan.
- Have a Clear Business Plan
It goes without saying that a business plan is vital in helping you put the franchise opportunity into perspective to make realistic decisions. The information you need to develop a viable business plan will mostly come from the franchiser.
- Study the Franchise Disclosure Document
The Franchise Disclosure Document (FDD) is the plan that the franchisor offers you as you prepare to buy in. The FDD is a mission-critical master plan, and you need to go over it with a fine tooth comb with your lawyers. The FDD will come under scrutiny if you choose to raise external capital for the franchise.
- Understand Your Projected Cash flow
As you consider the approach, you need to take in raising capital the strength of your Cashflow will play an integral factor. Can the projected cashflow support the repayments if you decide to access debt capital? Clarity in the projected cashflow will help you avoid being over-leveraged and hence lower your risks of failure.
How to Capitalize a Franchise Business
1. Use Your Personal Savings
When it comes to starting new businesses, especially small ones, personal savings can be a low-risk avenue to get set up. Personal savings can be in the form of bonds, stocks, cash reserves or other assets that you can liquidate.
The reason why launching off with personal savings can be attractive to potential franchise owners is because you get to control your destiny in several ways. If you are your own financier, you are not under any outside party’s thumb. You have free operational reign to lead the business as you see fit.
When starting up with personal savings, you do not have to carry the burden of debt servicing upon startup. Keeping all your cashflow within the business at its point of origin can be a significant advantage.
If you already have a mortgage or other significant personal debt to service you will appreciate the wiggle room non-debt financing can avail you.
If your credit is less than stellar personal savings can also help you start a franchise without limiting your vision. In the event that the business does not take off as planned, you do not have the sword of Damocles hanging over you via monthly debt to pay off.
The downside to personal savings obviously is that you forfeit the future returns of the assets you will liquidate. Additionally, you also forgo the cushion savings can afford you in anticipating the unexpected. When considering savings as your franchise startup capital, your overall personal context will be a key determinant.
2. Tap Family and Friends Financing
A financing option that bears similarities with personal savings is the capital raised from friends and family members. It can be a source of the partial or full outlay that you need to start your franchise depending on your needs and the personal context in play.
Capital that you arose from personal relationships like these comes with certain spoken (and in some cases unspoken but still present) caveats. The main concern here is that the relationship in question can face rough winds or even be ruined altogether.
Family members or friends can easily lend you money without really thinking through the potential risks. While you get relatively accessible financing without any extreme repayment terms, you will constantly feel the pressure to repay it in good fashion.
If you decide to go this route in financing your franchise, consider drawing up an agreement stating the terms agreed to as a buffer should any unexpected eventualities occur.
3. Franchisor Financing
In an effort to get more franchisees through the door some franchisors offer debt financing to help you get started. Supporting franchisees who qualify is in alignment with the franchisor’s twin goals of growing the business and increasing its capitalization. The one-stop solution for new franchisees creates stickiness with the management providing a win-win all around.
For franchisor financing to work, you need to have a good credit record and meet the stipulated financial guidelines. Franchisors can opt to support you with full or partial capital which will almost always be in the form of debt.
The loans they advance are dictated by a set of guidelines they adhere to, and there is a variety of ways to structure this financing. You can choose a loan based on simple interest with a balloon payment five or 10 years down the line since you won’t be paying any principle on the loan. Or your franchisor can end up giving you a loan with no payment until after the beginning of the second year.
Some franchisors may decide to carve up their capital injection into portions spread across the entire startup cost. It can constitute covering the franchise fee, the equipment necessary to get the doors open or the projected operating costs.
In addition to supporting you with part of the startup capital, franchisors tend to also tee up equipment backing. Due to the clout they have with equipment leasing companies, they might be able to arrange a contract on your behalf with favorable terms.
Equipment costs can constitute anywhere between 25%-75% of your total capitalization. Getting favorable leasing provides a huge boost when starting up while freeing up some much-needed cashflow to cover operational costs.
4. Withdrawing From Your 401(k)
If you have a 401(k) it can be a potential source of startup capital for your franchise. Any 401(k) holder that withdraws their funds before they hit 59 and a half years old gets slapped with an early withdrawal fee that is 10% of the total amount saved. In addition to this charge, you will be liable for income tax on the amount you’ve withdrawn.
If you qualify for exemption from the early withdrawal charge a 401(k) provides you with a tax-free source of capital for your franchise. For those who do not qualify there is a workaround.
Form a new company and have it open a 401(k) of its own. Once you do this, transfer your existing personal 401(k) balance into the one controlled by the corporation. Since you control the way, the corporation’s plan can invest its money you can then deploy the funds in the franchise of your choosing. Note that this workaround can pose a degree of risk and you should always consult with your attorney and financial advisor.
A 401(k) doesn’t not require a lender’s oversight, and you’re free to deploy the capital in the franchise as you desire. The downside to this option, however, is that you risk losing your financial safety net. You will be betting the farm, and that requires a sober risk analysis. You also forfeit the future returns on your 401(k), and that opportunity cost is worth considering.
5. Getting a Small Business Administration Loan
A Small Business Administration (SBA) loan is a lifeline for potential franchisees who cannot qualify for a commercial lender’s loan. An SBA loan differs from a bank loan in that the government guarantees an SBA loan or it provides a subsidy. As a result clients with lesser credit scores or who miss other financial requirements become low risk and access funding they need through intermediary organizations.
While SBA loans are a useful facility, the qualification process can be quite protracted. On average an SBA loan can take anywhere from 60 days to several months to go through. Consider your odds of success before investing significant resources in pursuing this financing option.
SBA-backed loans can also have mandatory riders on how you run the business. Anticipate these potential restrictions and how they can impact your operational strategies to assess the suitability of this financing option for your franchise business.
Franchising is an attractive entry point into business without investing in laying the heavy groundwork necessary to prove a business model. While the approach helps increase one’s odds of success, it calls for significant initial capital outlay which can become a barrier to entry for many.
Consider the various financing options for a franchise business in light of your personal context and any existing debt obligations you may have. At the end of the day, the right answer is what will help you best achieve your objectives.