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Options for financing the purchase of a franchise are as varied as the franchise opportunities themselves. Your timeline, risk tolerance, credit history, and other factors will determine the best option for you. Let’s take a look at a few common sources of franchise financing.
Small business / franchise financing options
Franchise financing sources include:
- Home equity line of credit
- Bank loan
- SBA loan
- Equity financing
- Retirement accounts
- Franchisor financing
- Credit cards
Saving and using cash
Do you have sufficient liquid or semi-liquid assets (e.g., cash, stocks, home equity, etc.) to run your business until you break even? If so, consider self-financing the purchase. Make sure to compare the “opportunity cost” of tying up your capital with the “hard cost” of accessing another type of financing instead.
If you don’t have adequate funding but hope to have it in the future, start preparing today. Maximize your savings and build your net worth and asset base. Set up a “business ownership” account at your bank. Then commit yourself to depositing a fixed amount of at least $500 into this account from each monthly paycheck. You can even set up a direct deposit to ensure consistency and remove the temptation to skip a deposit now and then. Most important, don’t touch any of these funds until you’re ready to invest in a business of your own.
You’ll be surprised at how quickly the money will grow. And your commitment will show potential funding sources that you’re serious about owning a franchise. After as little as six months to one year of following this savings plan, you will have a nice nest egg. Then you can check with franchisors directly or contact a FranChoice consultant to explore your financing options.
Bank and Small Business Administration (SBA) loans
The easiest way to borrow money is to establish a line of credit at a bank. You’ll need to have sufficient personal collateral, usually equity in your home, to secure a loan for the purchase of a business. Collateral enables the bank to recoup their loss if you default on the loan. Putting your personal collateral on the line also shows the bank that you’ll work hard to protect your own investment and theirs.
Banks, savings and loans, and commercial finance companies are all potential lending sources. Loans from these sources are called debt equity. The U.S. Small Business Administration (SBA) also provides funding options. Its website provides information as well as advice on how to write a loan proposal. If you decide to borrow money, keep in mind that the lender will require you to pay cash for a part of your business start-up costs (usually 25-50%).
The Small Business Investment Company Program (SBIC) is one of many financial assistance programs available through the SBA. “SBICs” are privately owned and managed investment funds, licensed and regulated by the SBA. SBICs use their own capital plus funds borrowed with an SBA guarantee to make equity and debt investments in qualifying small businesses.
Equity financing involves selling an ownership interest in your business in exchange for capital. Investors may be friends, relatives, or employees. Or, you can pursue what’s known as “venture capital” from a professional investor. Attracting venture capital for the purchase of a franchise may be challenging, however. Venture capitalists tend to favor companies that have earning potential exceeding that of a typical franchise unit.
You may be able to access funds from your IRA, 401k, or other retirement savings account to invest in a business. Known as a “Rollover as Business Startups,” or ROBS, this funding structure is similar to buying stock in a public company, except you’re investing in your own privately held company. Your retirement account invests directly in your new franchise and takes ownership by purchasing stock in the corporation. There are no early withdrawal penalties or upfront taxes. And the percentage of profits corresponding to your retirement account’s ownership can be redeposited. This franchise financing method is very specialized, so it’s important to consult an experienced professional.
One of the great advantages of franchised businesses is their track record. In many cases, the franchisor leverages this track record to set up financing programs for new franchisees. They can be leases or loans and are awarded primarily due to the success of the franchise system rather than the creditworthiness of the individual borrower. If you’re interested in this option, gather information from the franchisor during your research and investigation.
Partners, friends, and relatives
Friends and relatives who have confidence in your entrepreneurial abilities may be willing to loan you money as you begin your business venture. You may also want to look for a partner to help you finance and run the business, especially if you lack business skills or experience. We’ve seen great results when partners complement each other, for example, when one is a dynamic cold caller and the other excels at handling the employee and customer service aspects.
Determining franchise financing is one of the most critical choices you’ll have as a new owner. It’s wise to throughly investigate your options and consult with appropriate professionals. Don’t forget that your franchisor is a great resource for information.
What can you learn from a Franchise Disclosure Document (FDD)?
History of the FDD
Until the 1960s, there was little franchising momentum in the United States. But after the success of McDonald’s, the franchise industry expanded rapidly. In 1979, the Federal Trade Commission’s Franchise Rule became effective. It required franchisors to provide potential franchisees with a document then referred to as the Uniform Franchise Offering Circular. In 2008, it was renamed the Franchise Disclosure Document or FDD. Its purpose is to enable prospective franchisees to make an educated and informed decision about whether to purchase a franchise.
The amended Rule requires franchisors to furnish the FDD to prospective franchisees at least 14 days before the prospective franchisee signs a binding agreement or makes any payment in connection with the proposed franchise sale. The signing of any agreement or receipt of payment can take place on the 15th day after delivery of the disclosure document. This ensures that prospective franchisees have at least two weeks to review the disclosures.
The FDD’s content
History and Experience. The FDD must include a history of the franchisor’s past activities. This information must address activities of the officers and directors as well as the corporate entity. Examples include business experience and any fairly recent litigation or bankruptcy history.
Financial Factors. The franchisor must disclose the costs involved in purchasing a unit. This includes initial franchise fees, other startup costs, and an estimated range of the total cost of getting into the business. The FDD must specify additional fees such as the royalty, marketing, and renewal fees required throughout franchise ownership.
Obligations and Restrictions. The FDD must set forth the franchisee’s and franchisor’s obligations under the terms of the franchise agreement. It must spell out any restrictions that apply to franchisee behavior.
Other Considerations. The FDD must include relevant information pertaining to a number of other factors such as financing programs, territory, trademarks and patents, renewal or transfer provisions, and public figures.
Exhibits. The company must provide additional materials including audited financial statements, a list of current franchisees and their contact information, contracts, and receipts.
Earnings Claims. The FTC makes it optional for franchisors to supply information about the earning potential of a typical franchise unit. If the franchisor chooses to make earnings claims, it must follow stringent requirements. The data provided must be as accurate and representative as possible. The franchisor must clearly label any assumptions or qualifications.
Individual state requirements
In addition to the federal laws, many states have enacted legislation to further protect franchisees. These laws may mandate additional disclosures or specify rules governing the terms of the franchise agreement.
The following states have franchise registration and disclosure laws that require franchisors to register the franchise before making an offer or sale. A state examiner then reviews the FDD, and in some cases, may designate specific changes or additions that must be made.
- New York
- North Dakota
- Rhode Island
- South Dakota
Hawaii and Wisconsin require that the franchise be registered before a sale. Oregon has a state franchise sales law but does not require registration.
The most important point to remember regarding the FDD is your role: to read and understand the material that the franchisor is providing. The FTC requires this information to be clearly stated. That protection won’t make any difference, however, unless you carefully review the material.