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When to Use Which Financing Options by Franchise Type
There are three types of financing available for franchises including debt, which can be loans or lines of credit, equity where you have investors and give up part ownership, and alternative financing, where you could use personal assets, home equity lines of credits, or your retirement account. Choosing the right one depends on your situation.
If you’re a first-time franchisee, options like SBA loans can help you get off the ground when large banks turn you down. Or, if you’re experienced and have a bunch of locations, but don’t have the capital or knowledge needed to get to the next level, private equity investors can help with money as well as operations and expansion.
The right choice between debt, equity, and alternative options depends on your unique business and objectives. Here’s a guide to franchise financing with situations, and alternatives if these main options don’t match your needs.
Debt Options to Fund Your Franchise
Taking a small business loan for your franchise keeps you in control of your new franchise business and how you expand if the funding is to increase your footprint. For a gym or fitness studio, you can decide what equipment is needed first based on the classes or clientele you’ll be bringing in or, for a beauty spa empire, you can choose which services to begin offering.
Debt financing has drawbacks like interest expenses that eat into your bottom line. You’ll need immediate cash flow to start making payments on the loan principal. But on the plus side, you can deduct interest payments to lower your tax bill and you won’t give up future profits to other investors like you would with equity financing.
SBA Loans
SBA loans are a great option for most franchises as you can use them to cover short-term cash flow issues, including payroll, expanding inventory, and even buying commercial real estate. Standard SBA loans range from $50K to over $5 million and they’re lower risk for lenders because the government takes partial liability, so you may get better interest rates on them.
These same benefits are why SBA loans are in high demand, and eligibility requirements make them tough to access if you have bad credit. If you’re a current business owner and your established business has large credit lines from other lenders, causing you to get declined for additional funding, this could work to your advantage with SBA loans.
If you don’t get approved for an SBA loan, try a small business loan from an alternative lender or small bank, as these loans can have similar levels of flexibility, keep you in control of your business decision-making, and give you monthly payments without having to report to investors.
Traditional Term Loan
Big banks, local credit unions, and alternative lenders all offer traditional term loans that work for almost any franchise purpose. Most lenders will require a couple years of successful business history, good credit, or lots of collateral, so term loans aren’t a great option for new franchisees or if your business is struggling.
If you qualify, term loans will work for small or large amounts and for short or long timelines, and you can use them for almost any purpose from buying tables and chairs for a restaurant franchise to financing a fleet of vans and trucks. While you shoulder all of the risk with a traditional term loan, you also reap all of the profits as long as you pay back the lender.
When a term loan won’t come through, find out the reasons you were declined. If the bank didn’t feel your business plan was enough, look for investors as an alternative. You may gain access to their network, which could resolve the concerns the larger lenders had. No, you won’t call all the shots anymore, but when it comes time to grow again, the concerns larger lenders had may not apply. As a bonus, you gained the knowledge from the investors’ network and can keep that for free moving forward.
Pro-tip: There is a practice called stock lending where you temporarily give stock to investors with the intent of buying it back. This is not right for everyone, but could be one option if you need cash fast and intend to take back complete control of your company.
Equipment and Inventory Financing
Equipment financing loans are one of the best options when you need a large sum of money to cover purchases like multiple pieces of machinery like ovens and fryers for a fast food chain, and products for customer use like weights, treadmills, and other equipment for a gym franchise.
The equipment serves as the collateral for this loan, making it less risky for the lender and helping you get better terms. The collateral in the franchise itself reduces the need for personal guarantees, making it a good choice if you’re concerned about risking your personal assets like with a home equity line of credit (HELOC).
Inventory financing loans are similar as they use collateral for the loan and may come with shorter payback periods as the lender expects the inventory to sell fast and to recoup their money. Approval is usually quick, as lenders know you’re prepping for a large order or seasonal business boom.
If your franchise is a hardware store, you don’t need to stock summer project supplies or gardening tools in the winter. These loans are perfect for when demand rises in the spring, so you can have cash flow to self-fund as summer approaches.
Working Capital Loans
Working capital loans are the go-to for growing an existing franchise or opening a new location as they let you hire staff, cover cash flow shortages, repair equipment, or train employees before you open. Approval is quick, so they’re also great for emergencies or unplanned opportunities, but not all providers offer large working capital loans for major purchases or investments.
And while interest rates might be higher than other options, the payback periods are short, so your low total interest cost is likely less than the opportunity cost of not having the cash. Plus, the interest is tax deductible, so the total cost of debt could be less than you think. If you don’t get approved for a working capital loan, look for debt financing options that meet the specific current need.
There are equipment loans, retail inventory loans, payroll and operations loans, as well as standard small business loans from alternative lenders that can be matched to your current needs.
Equity Financing Options
Equity financing is better than debt financing and alternative lenders when you do not mind giving up some control of the business, or you know where your weaknesses are and want outside assistance. The investors in your company can use their strengths if they get involved in the day to day, or they can open their networks to bring the experts to you and help you make the tough decisions.
Friends & Family
Equity investment from friends and family can be the best option if you’ve never been in business before, don’t have the credit history a bank might require, or if you don’t have the net worth a franchisor requires as part of their agreement. If you have friends that complement your own skills, and you can work together without friction, building the business can be fruitful for both your personal and professional life.
When your friends and family don’t want an active role, or they know you can run the business smoothly, you’re working to help build your future and theirs. You’re in charge and helping the people you care about succeed, making it even more fruitful when you do. If you don’t like the idea of having friends and family involved, but need outside expertise, try angel investors instead.
Personal cash
Using personal cash to fund or buy a franchise means you’ll own 100% of the business, and there are no outside delays because you’re using your own assets. Personal funding is a good option for diversifying your franchises as you open complementary ones.
Fast food franchises can be a good example. If your primary franchise business is a Mexican-inspired restaurant and you want to venture into fried chicken as it is also in your expertise, you are taking the risk on your experience. Plus, you can act fast, which is important if there are location limits in a specific radius or a profitable restaurant is being sold and you want to buy it.
Tapping your own cash is also a great way to convince other equity investors to buy in. It shows them you have “skin in the game” and you’re not relying solely on “sweat equity,” which can give them the confidence needed to commit their own cash. If you’re not ready to use your own assets, try a business acquisition loan for buying an existing business.
If you’re a chef or restaurant manager and looking to go in on your own business, a startup loan may be a good option if you decide putting personal assets into franchising is not right for you at this current moment.
Private Equity
Private equity focuses on the potential return of an investment, so companies will work with most types of franchises, from math tutoring to moving companies. While you don’t have to own a billion-dollar business to work with private equity, the more structured firms will be too big or want too high of a return for new or limited-location franchisees.
Smaller equity investment groups are good options if you’re starting out fresh since they’ll typically offer lower investment levels. Another option is to find investors that will kick start your franchise by opening doors with introductions to large customers or helping you navigate the local regulatory landscape.
Larger private equity firms can be great expansion partners if you own a franchise with multiple locations or multiple franchise brands. These firms can invest huge amounts of capital, often more than you might find from a traditional debt lender.
Unlike debt lenders, the larger equity firms often dive into the day to day, helping improve operations, structure the org, and manage growth. This can be a huge help if you have never run a business at a large scale. When private equity is not an option, look to traditional banks and alternative lenders for a standard business loan, as they will use your existing business, collateral, and history to make a decision on funding your growth.
Alternative Financing for Franchises
Alternative financing is a combination of personal investments, traditional equity, or finding alternative lenders. It’s where you get a bit creative because traditional franchise funding is either not available or puts too many restrictions on your plans, making the prospect of becoming your own boss less appealing.
Home Equity Line of Credit (HELOC)
A home equity line of credit is technically a loan or debt financing, but since you’re using your own house to secure the loan, you won’t face as much scrutiny as most business debt options. A HELOC can provide the cash needed to start or buy an already-operating franchise, or you can use it for large purchases like new equipment for a dental franchise, for example.
Retirement Accounts
Rolling over your retirement account to fund a franchise may be a good option for franchises that cost less to launch, like a home-based travel franchise, as there is minimal equipment needed to get off the ground. If you’re less risk averse, a corner store gas station could work too.
This option comes with scrutiny from the IRS and not all retirement accounts are eligible. Make sure to consult a tax professional if you want to go down this road.
An alternative to using your retirement account to start a franchise is taking a loan from your 401(k). This also comes with IRS restrictions. If you cannot get the money to start a franchise from your retirement accounts, a HELOC on your home is similar in that you’re using your personal assets and maintaining business control with no investors as you would with an equity option.
Crowdfunding
Much like crowdfunding a product or an emergency fund, you can crowdfund a franchise. This works similar to equity financing where the crowd invests for shares in the business, but it lets you access money that you couldn’t find through normal equity options.
Crowdfunding a franchise is new and rare and may come with restrictions from the parent company. Always check your franchise documents to see if there are any restrictions you might face.
An added bonus of crowdfunding is that it can generate buzz through the crowd and encourage regular customers who own company stakes, giving a boost to your advertising efforts. The investors also have a reason to send friends, family, and others to your location.
Franchisor Financing
Some franchisors offer their own financing programs that can include standard loans with better terms than other debt options. They can also offer alternative features like deferred fees and payments. These differ by franchise brand, so check with reps at the company about what they offer.
If you cannot use the franchisor’s program, talk to a local investor that is looking to expand their portfolio. It can be a local corporate executive. If you have a local bank, traditional debt financing like a small business loan is a great alternative, because you call the shots and they know your market, so they may see the same opportunity you do.
Grants
Many franchisees never consider grants, but they can get you free or mostly free financing if you’re willing to research and apply for them. Grants aren’t an option for many franchises since they usually limit who can apply, like the Amber Grant for Women and the Warrior Rising for Veterans. Most grants will also restrict the type of franchise business or industry, and many come with requirements where you have to regularly update and report back to the granting organization.
But if you qualify and you’re willing to do the extra work, grants can be far better than debt and equity options by giving you free (or cheap) money that doesn’t take away from your business ownership. To find one, you can cull through potential federal grants to see if your franchise qualifies. You can also find grants from states, charities, other non-profits, and even some for-profit organizations that run contests for grants.
There is no shortage of ways to finance a franchise business, and now you know which options could work as a starting point based on your situation. If debt financing like a small business loan or franchise loan is an option, connect with us today. You can apply in minutes with minimal paperwork.
