Evaluating & Buying a Franchise

A Crash Course in Financing a Franchise Business

What Are the Costs of Franchising?

Following the Green

You've decided to open a franchise - you're sold on the company, confident in your market and have the perfect location selected. The only thing keeping you from opening your doors for business is that green stuff called capital. When you first got the itch to become your own boss you had a big task in front of you. Countless hours were spent analyzing franchise opportunities and researching franchisors. Even after you've chosen a franchise you have more work to do. Before you can consider approaching a lending institution for a loan, you must write your business plan and net worth balance sheets.

"Your business plan will show you how much money, if any, you will need to raise or borrow to acquire and start your franchise of choice," said John P. Hayes, Ph.D., author of the Franchise Pre-Investment Checklist and contributor to Fred DeLuca's Start Small Finish Big: Fifteen Key Lessons to Start-and Run-Your Own Successful Business.

"You must come up with a specific figure; ball park numbers don't work," advised David Caplan, author of How to Start a Business for Free: The Ultimate Guide to Building Something Profitable from Nothing. "Investors want to know exactly how you arrived at the numbers you've come up with."

Securing the necessary funds for your business is not as cut-and-dry as going into a bank and asking for money. Your least likely bet is applying for a small business loan from your neighborhood bank and trust, although no option should be ruled out completely right off the bat. You may, however, have better luck going after commercial banks and non-bank lenders. "There are a lot of directions to go," said George Knauf, franchise advisor for FranChoice, a consulting agency that offers free advice to potential franchisees. "Most people first think about getting an SBA loan. But the SBA does not lend money, they guarantee loans." SBA funds are accessed through an approved lender. Your franchisor may offer suggestions for lenders with which they have previously worked, which can expedite the loan process. SBA guaranteed loans offer more flexible terms than traditional, commercial loans, including lower down payment requirements, longer repayment terms and no balloon payments due at the end of the loan period. Keep in mind that accepting a SBA guarantee brings another partner to the deal.

"The market is very interesting right now," said Knauf. "With mortgage interest rates the way they are, most franchise funds are coming from home equity loans." Many of Knauf's clients opt for home equity financing, as the interest rates are lower and you only pay for what you use. Securing an SBA loan is an arduous process, and business loans are not as secure as a mortgage. "Lenders want 100-200 percent of what you are asking for in collateral," said Knauf. If you have equity in your home, or even a 401K, it may be an easier road to securing funds for your franchise. "Under a corporation, borrowing from your 401K allows you to lend money to yourself without penalty." If this latter option appeals to you, consult a financial advisor before proceeding.

There are numerous funding options, various types of capital, and several loan programs and financing sources. So, where do you begin? "An understanding of each is crucial for one practical reason," said Caplan. "In order to obtain financing, you must know the nature of what you seek."

Equity Capital

According to the Small Business Administration (SBA), equity capital is money raised by a business in exchange for a share of ownership in the company. This form of financing permits a business to obtain money without incurring debt or without having to repay a specific amount at a particular time. Two main sources of equity capital are angel investors and venture capitalists.

"Equity capital commonly represents the original investment in the business plus retained earnings," Caplan said. "So, a banker who asks you 'What do you have in the business?' wants to know about your equity capital," Caplan said. Banks generally do not loan equity capital. Additional sources of equity for a business come from non-professional investors such as friends, relatives, employees and customers.

"A lot of people fear leaving their jobs to start their own business," Knauf said, "but will throw some money at a business venture." With every upside there also is a downside. In the case of bringing personal acquaintances, friends and relatives into the mix you are relinquishing some control over your business, as investors will often weigh in on the decision making process.

Working Capital

Working capital is defined as the excess of current assets over current liabilities. In laymen's terms, your current assets are the most easily convertible to cash, as they are the most liquid. Your business's current liabilities are the obligations due within one year. Working capital, therefore, measures what funds are available to pay a company's current debts. In addition, working capital represents a margin of protection a company can give short-term creditors.

"The need for working capital arises from the ongoing activities of business," Caplan explained. "As sales increase, so do accounts receivable - that is, money owed to you and the business by customers but not yet received."

Growth Capital

If you plan to grow your business, make improvements to facilities and equipment, and develop and market new products and services, you will need growth capital. "Growth capital differs from working capital," said Caplan, "because the need for it does not spring from the cyclical nature of the business. If you don't make it clear that you need either working or growth capital, the bank may explain that the loans it makes are temporary and that it can't lock its money into a business."

"Every business needs all three types of capital if it succeeds," Caplan continued, "equity capital for permanent needs, working capital for seasonal needs and growth capital for expansion."

There are several loan programs to meet various financing needs. The following loans are common among franchisees.

Small Business Loan Programs

7 (a) loans

The most common SBA loan program, funds are guaranteed by the SBA for up to $750,000 through approved lenders. Personal guaranteed also are required; personal assets also may be required for security.

LowDoc

This is a general purpose loan guarantee program that was created to aid in expediting the loan process of up to $100,000. The application is one page and focuses on the applicant's character and personal credit.

FASTRAC

This also is a general purpose loan guarantee program that offers a more efficient loan process because a preferred lender performs the credit check and approves the loan under preferred lender guidelines established by the SBA.

Microloan

These loans are offered directly through approved local economic development agencies and max out at $25,000. The interest rates on these loans are generally much higher than SBA guaranteed loans and other lenders.

504 loans

These loans also are offered directly through approved local economic development agencies. Funding is based on assets and job creation. The financing agency is limited to 40 percent of the project but not to exceed $1,000,000.

Prequalification programs

These private sector programs are open to women and minorities. Local agencies act as liaisons to aid minority and women-owned businesses prepare loan applications, review credit, conduct analyses, and submit a prequalification application to the SBA, who in turn issues a loan guarantee commitment letter to a prospective borrower, who then brings the letter to a commercial lender to apply for a guaranteed loan up to $250,000.

Home equity loans

These loans are secured by a primary residence or second home to the extent of the excess of fair market value over the debt incurred in the purchase.

Don't give up hope

So what if you've done your homework, drawn up the business plan and balance sheet and you fall short of the minimum requirements for borrowing enough capital to start your dream business? Don't give up hope, but don't be unrealistic - if you have negative net worth and no equity capital, you may want to apply your aspirations to saving money for a future enterprise. However, there are success stories and you could be one of them. "Actually, I think most people would be quite surprised by the number of businesspeople who start on a shoestring and their array of improbably beginnings," said Fred DeLuca, cofounder of Subway ®. "You don't even have to scour the country to find them. For a real eye-opener, survey ten local businesspeople in your own community to learn how they got started and how much money they started with. My bet is that at least two of them, and perhaps as many as five of them, will tell you an interesting story of the tiny business they started long ago with less than $10,000."