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When to Use Which Financing Options by Franchise Type
There are three main types of financing available for franchise owners:
- Debt financing where you borrow money from lenders and pay it back over time with interest.
- Equity funding where you sell a portion of your company to investors that share in the risk and profits of your franchise.
- Other financing options like crowdfunding and grants.
Making the right choice depends on your situation. If this is your first franchise, then options like SBA loans can help you get a business loan when banks and alternative lenders turn you down. If you already have a large number of franchise locations and are looking to go national or global, private equity investors have both the capital and operations knowledge needed to get to the enterprise level.
The right choice also depends on your cash flow, how much risk you’re willing to take, and whether you’re willing to give up control. With debt financing, you keep total control and lenders don’t weigh in on operations (with very few exceptions), but you need cash flow to start making regular payments immediately, and the interest expense lowers your profit.
With equity financing, you sell pieces of ownership and have to give up a portion of future profits to the new owners. The benefit is that you’re spreading the risk among more people, and you have no obligation to pay anything back, so there’s no need to have cash flow right away.
Collaborative financing can include debt financing, equity financing, and sometimes grants. It’s limited in how much money you’re able to get, so it is usually for smaller needs. Sometimes going with a hybrid approach may be the right option for you. Here’s a quick table and guide you can use as a reference when you’re looking to make a decision.
| Debt | Equity | Other | |
| You keep total control of company decisions | Yes | No (unless equity agreement prohibits other investors from voting, or you can buy back the shares or ownership) | Usually |
| Other owners/lender may want to actively participate in operations | No | Yes (unless they only want passive investment) | No |
| Cuts into your profit | Yes (from interest expense until you pay off the loan) | Yes (through a share of profits going to other investors) | Sometimes (when selling shares via crowdfunding or borrowing from the franchisor) |
| Tax write-offs available | Yes (write off interest expense) | No | Only with alternative debt style financing |
| Requires immediate cash flow | Yes (unless you negotiate deferred payments with lender) | No | Yes, in most situations |
| Good for large purchases | Yes | Yes | No |
| Good for short-term operating expenses | Yes | No | Yes, if the amount is recovered quickly |
| Good for large risks | No | Yes | Only when you can afford the loss |
| Helps your business with outside expertise | No | Yes | No |
Wherever you are in your franchise journey, here’s an easy-to-use guide to franchise financing options and when to choose each.
Debt Financing for Your Franchise
Debt financing is the right franchise financing choice when your situation includes:
- Your wanting to keep full control of operations without outside input or investor expectations.
- Your ability to take on all the risk of failure in exchange for the full profits from success.
- Your business’s ability to generate enough cash flow to make monthly loan payments in addition to all other expenses.
It is called debt financing because you are taking a debt that needs to be repaid to the lender. This kind of financing includes loans, lines of credit, credit cards, and any other type of funding that gets paid back. In addition to repaying the amount borrowed, you’ll also have to pay interest on the money you borrow through debt financing, which will lower your profits.
But the interest expense is generally tax deductible if the funds are only used for business purposes, so it will also lower your tax bill. With most types of debt financing for franchises, you will need immediate cash flow to start making payments unless you’re able to negotiate deferred payments with your lender.
Debt financing is a great choice whether you need larger amounts of money to make big purchases like real estate or only need a small amount to cover cash flow gaps for a short time. This is where knowing the types of debt financing, including the variations of small business loans, comes in handy. You can get loan terms including payback periods and interest rates that match your specific franchise needs. Here are a few examples:
- SBA Loans
- Traditional business term loans
- Equipment financing
- Inventory financing
SBA Loans
Small Business Administration (SBA) loans range from small microloans for up to $50,000 to over $5M SBA 504 Loans. The government partially backs these loans, which lowers risk for lenders and lets them offer low rates compared to traditional business loans. The downside is that SBA loans can take longer than a traditional bank or online lender loan in terms of approval because the government needs to do an additional review on them.
The SBA has different types of loans depending on your franchise’s need, including:
- Traditional 7(a) loans, which can be used for anything from buying machines to purchasing real estate. Depending on your exact needs, there are different types of 7(a) loans including specific options for international trade and lines of credit.
- 504 loans to help you make large real estate purchases or improvements to your property.
- Microloans that work for small, short-term cash flow issues like payroll or late customer payments.
If you’re able to get enough funding from other sources at reasonable rates, then you might not be eligible for SBA loans. One common requirement for SBA loans stipulates that you must have exhausted all other financing options.
Note: If you qualify for financing with other lenders, but their terms and rates are unaffordable, you may still qualify for SBA programs.
You also can’t use an SBA loan if your franchise falls into one of the prohibited categories, including:
- Companies that provide or produce adult content.
- Gambling.
- Political companies like lobbyists and non-profits.
- Financial institutions including banks, lenders, and insurance companies.
The SBA has caps on the interest rates, but also penalties on certain types of curtailments, so you may not be able to clear the debt as fast as a different type of debt financing.
An SBA loan may also be a good option if you have bad credit or if you’re a first-time entrepreneur with no credit, as these could prevent you from getting other forms of financing, but the approval process will be more thorough. If you don’t qualify for SBA loans or need funding faster than the government process allows, there are plenty of other options to fund your franchise.
Traditional Small Business Loans
Big banks, local credit unions, and alternative lenders like us offer different types of small business loans depending on your franchise’s needs, including the following:
- Short-term business loans are simple and fast when you need to stock inventory, meet payroll, or cover a customer’s delayed payment.
- Emergency business loans give you quick access to cash after disasters so you can operate while you wait for insurance payouts to come in.
- Industry-specific business loans cater to unique industry needs whether your franchise has seasonal revenue or typically incurs upfront expenses before taking on a project.
Most lenders require 2-3 years of financial statements and tax returns to show you’re running a successful business, have good credit, or have enough business assets to pledge as collateral for the loan. This makes traditional business loans a good fit when you’re already established, but not when you’re just getting into the industry. Alternative lenders may only require 6 months in business, so don’t stress if you tried a large bank and got rejected for financing.
That doesn’t mean it’s impossible to get a loan for your first franchise, even if you hit a rough patch and have bad credit. If you can’t find a bank or alternative lender to approve you, keep their denial letters and use them as proof that you can’t get traditional financing when you apply for an SBA loan.
Equipment and Inventory Financing
Business equipment financing is the best option when you need to buy or lease equipment like a fleet of vans for your delivery company or new steamers for your dry-cleaning franchise. Equipment financing works for used or new equipment but isn’t for maintenance or repairs. Lines of credit, business credit cards, or working capital loans are better in those cases because of their flexibility.
Unlike other types of debt financing where you need to have assets you already own for collateral, the equipment may be able to serve as the collateral, making it easier to get approved for the financing. The equipment serving as collateral limits the lender’s risk.
Inventory financing is similar to equipment financing where items like cases of burgers, packs of shipping materials, or any other franchise inventory works as collateral, so rates will be lower than those of short-term loans without collateral. Payback periods are short because you’ll recover the money quickly and be able to pay the total plus interest when you sell. Just keep in mind that you can’t use this financing for other business needs.
Working Capital Loans
Working capital loans are flexible loans that you’re able to use for almost any operating expense in your existing franchise. These include:
- Buying ads to bring new customers to your current business or build brand awareness for a new franchise location.
- Hiring more stylists for your barber shop, specialists to come in and assist with a project, or an admin if you have a need for a front desk and reception area.
- Covering payroll for staff, whether business is status quo or having pre-opening training at your new location.
- Paying for rent and utilities during slow seasons so you can keep your lease and operations in good standing.
Working capital loans are designed for immediate needs instead of long-term investments, so they have shorter payback terms (usually up to one year) and sometimes a higher interest rate. The total amount of interest you pay won’t be as much as with long-term loans though, because working capital loans have fewer payments in a shorter time period.
Equity Financing Options
Equity financing is better than debt when you have uncertain cash flows, want to share risk with other owners, or need outside expertise to grow your franchise. There are no monthly payments like with debt financing, so there’s no need for immediate cash flow, as equity investors get paid from future profits.
Investors that provide equity financing buy a portion of your company, meaning that you have to share profits with them, and you also share the risk of losses. This makes it a perfect option for first-time franchisees where success is uncertain or for existing business owners starting with a new franchisor or opening locations in new geographies they don’t know.
Equity funding also has the unique benefit of involving investors in the operations of your business when they have strengths. For example, they can introduce you to large customers, teach you how to manage teams in multiple locations, help you source better inventory at a lower cost from new suppliers, or improve operations for a better customer experience at a lower cost.
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.
These are the three main sources of equity funding:
- Friends and family
- Personal cash
- Private equity
Friends & Family
Friends and family may be a good option if you’ve never been in business before. They may share your belief and trust in your judgment, so you likely won’t need to provide a credit history like with a bank. They could also be some of your biggest supporters and market your business via word of mouth to everyone they know.
Friends with complementary business skills can make great partners in addition to being investors. Or if they prefer a passive role, that can work as well. In the end, you’ll be working to build your future as well as theirs with the business.
If you’re concerned about risking money from friends or family, personal cash is another option.
Personal Cash
Using personal cash to finance your franchise makes you the equity investor and gives you 100% ownership. You will keep all of the profits without interest expense or profit sharing with equity investors, but you also take all the risk.
The benefits of using personal cash are that you can act immediately without waiting on approvals, and you may be able to get lower rates on personal home equity lines of credit or loans from your 401k or IRA compared to standard commercial loans. That also turns you into the de facto “lender,” so your personal finances can recover as your business pays them back.
The downside of using personal cash or taking equity out of your home or retirement account is that you bear all of the risk, so this option is only a good idea when you are confident in your business plan. For most entrepreneurs, it’s too risky for a first franchise. But it’s a great option when you already have a couple of locations. In this case, when you expand, you can use the cash flow from the other franchises to support the newest location while it gets up and running.
Another option for personal cash is using it as a way to attract other equity investors. By showing them you have “skin in the game,” you’ll give them confidence to invest their own money alongside you since they know you’ll be a motivated franchisee.
For bigger franchise enterprises, personal cash might not be enough for you to grow as big as you want. So, the next option is private equity.
Private Equity
Private equity pools funds from a large number of individual investors and uses them to invest in businesses and participate in operations to help those businesses grow. This makes private equity a perfect option to finance a national or international expansion of your franchise business.
If that is too big of a scale, local or regional equity investment groups can be good options. Search your area for angel investment groups or find a small business investment company (SBIC) near you. These are private funds that are licensed by the SBA and are specifically designed to support small businesses.
Remember that you are selling ownership in your business when you work with private equity, so make sure you understand how active they will be in operations if you sell more than 50% of your company. Keep in mind: They may be able to completely take over the company if they see fit in some cases.
A big benefit of the private equity team participating is their experience. With a group that has a track record of success, they may be able to take your business and help it expand exponentially, as they’ve likely seen similar challenges and various economic environments and know how to manage them.
In addition to debt and equity, there are a few alternative sources of franchise financing.
Other Financing for Franchises
There are other financing options for your franchise that share common traits with both debt and equity, but the key difference is the source of funds. These include:
- Crowdfunding.
- Franchisor funding.
- Grants.
Crowdfunding
Crowdfunding sometimes works like equity financing where you sell ownership in your business. Sometimes it works like debt financing where you pay back crowdfunders. And it could also work like pre-payment where future customers give you money now to get products or services later.
The main difference with crowdfunding is that the money comes from a large number of people instead of a few investors or a single lender. This makes crowdfunded franchises rare since you need to create a lot of buzz to get the money you need.
If you can create that interest, then you could have a built-in network of excited fans to spread the word about your franchise.
Franchisor Financing
Franchisor funding can also look like either debt or equity financing. Some franchisors may provide low-interest, easy-approval loans, while others may offer deferred franchise fees or co-invest with their franchisees. Check with your direct contact if you’re interested because terms and availability depend on your franchisor.
Grants
Grants are a fantastic alternative funding source that many franchisees never even think about. Grants often don’t make you pay them back, but their application requirements tend to be narrow and focused on specific groups, like the Amber Grant for Women and Warrior Rising for Veterans.
Most grants will restrict how you’re able to use the money or what type of franchise you can use it for, so you lose some of the flexibility that comes with debt financing. But when you meet the requirements, grants are the lowest-cost money you can find.
With debt financing, equity investment, and alternative sources of funds, there is no shortage of options to finance your franchise. Debt is your go-to when you want to keep total control and all future profits, whereas equity is best for uncertain cash flows and riskier ventures, or when you need external help to get to the next level. Alternative financing options are great when available, but they take some research to find ones that fit.
We do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
