A Franchise is a contractual relationship between two parties. One, the Franchisor, is the party that developed the business model, branded the products, and produced the system. The second party, a Franchisee, purchases a license, and usually pays an ongoing franchise fee or royalty, to use the name, products, systems, trade secrets, etc., of the Franchisor.
There are a number of options for financing a franchise business. All franchise funding sourcesprefer lending to a franchise with a nationally recognized name and long track records. Newer franchises won’t possess these two traits and will be considered more risky.
Types of Franchise Funding Available
Traditional Bank Financing
When a franchise has the track record and name recognition many of the banks will be interested in the funding opportunity. The borrower’s personal credit rating will be a factor, along with personal tax returns, and financial statements. The amount of required cash on hand and the verification of the source of the down payment will be critical.
The U.S. Small Business Administration (SBA) partially guarantees loans for franchise lenders reducing the risk exposure for the lender. A loan program called 7(a) is a standard for funding franchises. These loans can provide funds for franchise entry fees, real estate, property improvements, working capital, and equipment.
Borrowers must be creditworthy, without any bankruptcies, have ample down payment usually around 30% but there are variations here, and the business must be able to repay the loan from the cash flow of the business.
Terms can range from 5 to 20 years. Interest may be adjustable or fixed (both within SBA standards), and will be negotiated by the lender.
There are SBA fees for guaranteeing the loan. These fees, which are paid to the government and not kept by the bank, can be rolled into the financing.
Patriot Express Loan Program
This is another SBA loan program that can be used for franchises and is reserved for military veterans, active service members, their spouses, and survivors. The Department of Veterans Affairs will be involved in the loan process.
The Patriot Express funding program has relatively fast approval times, may only require 15% contribution from the borrower, lower credit scores may be accepted, and this loan program provides lower interest rate opportunities.
VetFran is a loan program available for honorably discharged veterans. This franchise funding program was started by International Franchise Association. (Link IFA to:
Financing is a usual subject matter for a franchisor. They should be able to direct potential franchisees toward funding programs that have been successful for their other franchisees. Preferred lenders will already be familiar with the franchisor and their systems.
Franchisors may also provide some funding internally. There may be an exchange for higher rates when only lower amounts of collateral are available. This may help with qualifying for the acquisition of a franchise, but may hurt the franchisee’s cash flow, so proper due diligence should be completed.
Not all prospective franchise owners have enough cash on hand. Part of the business financing may require the borrower to liquidate personal stocks, provide personal assets as collateral, refinance their home, or use their 401k, which is discussed below.
If the borrower still does not have enough personal assets then a family member or a friend may be required as a partner who can contribute other cash and assets. The partner’s cash and assets will be at risk of loss, so they may require some controlling interest in the new company.
Retirement Plans can be self-directed and used to invest into a franchise. The retirement plan purchases stock in the franchise similar to how the retirement plan currently may be investing in publicly traded stocks and mutual funds. This option may provide an opportunity of less external financing resulting in lower debt service and higher profit potential.
The downside is, if the business crashes, so does your
retirement fund. The cheaper financing needs to be weighed against the risk of failure.
Because of the factors involved such as deferred taxes,
early or improper distributions, and IRS involvement, this franchise funding option should be handled by a company who has expertise in this arena. Someone interested in using this financing
structure should research the Employee Retirement Income Security Act of 1974
Franchise Agreement Buyout
Understand that situations change, economic factors may spring up, recessions happen, or markets can shift. All of these can have a negative impact on the cash flow of a franchise. Franchise owners who may not survive the tightening, or non-existent, profit ratios during an economic downturn may only have the options of bankruptcy, or buying out franchise agreement when allowable.
This second option removes the franchisor from the equation allowing the business owner more flexibility in their business decisions. The franchisor sold the franchise with expectations of making cash flow from the franchisee, so they may not allow the franchisee to remove itself from the franchisor. However if it is allowable, the transaction of a franchise agreement buyout can also be financed.
1. Because there are many franchise financing options available, make sure you perform your due diligence, and obtain the funding that best suits your situation.
2. It is advisable to have an accountant or attorney that is familiar with franchise financing to review your loan documents.
3. There are consulting services and franchise associations who can help guide a prospective borrower.
4. Make sure your funding request is enough to get the business running and profitable. Less than ample funding may put the borrower in a position of needing more cash - and it might not available at that point.