Franchise start-up costs: how do I finance them?
Don’t be surprised if a franchise executive wants to know three things about you when considering you as a franchisee. Franchisors want to know how much cash you can put toward the purchase, how much you are willing or able to borrow, and your net worth (all of your assets minus all of your liabilities).
The cash you’re willing or able to put toward the purchase, how much you’ll need to pay during critical startup months, your ability to borrow, and potential partners are just a few of the ingredients that will go into your unique financing mix. of purchasing your franchise.
Just because you have cash, for example, doesn’t mean you should spend it all on a franchise purchase. Like it or not, very few franchises are instantly profitable, which is why many new franchisees need to plan specifically to have adequate operating capital to be able to pay themselves a salary for several months or even years. This decision alone could cause you to borrow more and use less cash. Dave Ramsey advocates will likely want to wait to buy a franchise until they can pay 100% cash. In short, how you finance your franchise opportunity has more to do with your personal needs than the franchise you are buying.
One option is to use funds from an existing 401k plan instead of borrowing money. The nuances of this call for a much longer article than this, but here are the basics. Money from an existing 401k plan can be rolled over into a special type of 401k that will allow you to buy stock in your own company. This often requires that your business be organized as a C Corporation rather than an LLC or other type of business entity. Many companies, such as Fran-Fund and Benetrends, specialize in helping franchisees make this work. If done correctly, this approach can be handled with ease, but it should never be undertaken without the advice of experienced professionals and your attorney. It can create some interesting and potentially beneficial financial options, but again should be carefully considered. Some would consider using existing retirement dollars on debt as a conservative approach, while others might consider it quite risky. Consult your business advisors if this is a decision you are considering. One final note, using your funds in this way will incur a fairly significant one-time fee that often includes establishing and registering your corporation. Despite this, it’s often a great option for careful investors, but it’s worth noting that if the amount you’re going to use is less than $30,000, you might consider simply withdrawing your 401k funds, paying the IRS penalty, and possibly end up spending less to get the financing. This decision, like any financing issue that has tax consequences, should only be considered with the involvement of your CPA, your attorney, or both.
Many franchises can be operated with little or no investment in real estate, but for those that require commercial space, part of your financial considerations will need to be related to leasing or purchasing real estate. Purchased real estate can often be self-guaranteed, meaning that the property will secure the note against them. Unless you can build the space from scratch and get a construction loan, you will likely have to find a way to pay for or finance the improvements required by the franchise for the tenant.
Similarly, some franchises require major equipment purchases, while others do not. If your chosen franchise requires equipment, you will need to find a way to finance the equipment. Under many conditions, lenders may provide equipment loans or equipment lease options to lenders who do not qualify for standard business loans.
Some franchise systems have internal financing available for qualified buyers, others do not. In-house financing is attractive in many cases, but can often include interest rates that are not as attractive as what a buyer might get from other sources. Franchisees that offer in-house financing are much more likely to spend time and energy evaluating your business experience, motivation, sales skills, etc. as a means of pre-qualifying you as a buyer.
The US Small Business Administration can help new franchisees with loans. This is a topic that deserves a full article, however here are some limited basics. SBA loans often come from local banks and other regular lenders, not from the SBA. Instead, they are backed by the SBA. There are several types of SBA-related loans available, but lenders generally want to lend more than $150,000 rather than smaller amounts, and these loans will almost always require collateral similar to any other business loan. In some cases, the equity in your existing home may meet this need. SBA loans often require more documentation, but you might consider locating a Small Business Development Center in your area to help you evaluate your options and complete your paperwork. In some cases, your selected franchise will assist you with drafting the necessary business plans and documentation required for SBA loans.
When starting a new business there is always the option of seeking investment capital. In other words, you can sell a percentage of your new company to investors in exchange for the money to start. While this is a fairly common approach to financing a new business, it is less common among new franchisees. This may be due to the fact that many new franchisees quit their jobs and become franchise owners as a means of gaining more control over their own destiny, and perceive even minority investors as a potential threat to that goal. Similarly, the use of investment capital requires careful planning, the involvement of attorneys, and an understanding of C corporations, LLCs, and similar complex business structures. Venture capital substantially complicates a business deal, and new franchisees often choose to purchase a franchise rather than start from scratch as a way to reduce complexity.
As a franchise consultant, I always encourage potential franchisees to ask the selected franchisee to help them consider financing options. The best franchises will almost always be willing to provide you with information on financing options. Likewise, I advise clients to seek the advice of their CPA and attorney.