- Opening a franchise of an already-established business chain may seem like a fast track to entrepreneurship, but taking that route requires a serious financial investment.
- There are multiple financing sources for people who are looking to open a franchise, including the Small Business Administration, traditional banks and the franchisors themselves.
- As with other styles of loans, details such as your business plan and personal credit score will factor heavily into a lender's decision of whether to offer you a franchise business loan.
- This article is for small business owners or entrepreneurs who are looking to obtain a loan to cover franchising costs.
Starting a business as a franchisee has some advantages – for instance, you won't need to create an entire business model by hand – but opening your own location still comes with substantial costs that may require you to find financing. Just as there are myriad business loan options for traditional entrepreneurs, there are multiple lending options that can help you get your franchising journey off the ground.
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What to consider when choosing a franchise loan
Before you start your own franchise location, it's important to consider some of the costs that are often overlooked, along with the expected expenses associated with starting a business. Generally, you need thousands of dollars for each step, and unless you have the cash on hand, you're going to need to secure at least one franchise business loan.
Here are some of the expenses you should expect to cover with franchise loans:
- Legal fees for a franchise attorney to review the franchise agreement for you
- Real estate and build-out costs for your newly selected franchise location
- A franchise fee that can range from $20,000 to $50,000, on average
- Any additional costs for supplies, inventory and day-to-day operations
When selecting a franchise business loan, make sure that it is large enough to cover some or all of these costs. Some lenders apply stipulations for what constitutes approved use of their funding, so be sure to double-check the lender's rules before applying.
As with any other type of loan, there are certain things you should consider before applying. In the case of franchise business loans, look at how much money you need to borrow, how long the repayment term will be and what interest rate will be charged each month in addition to the principal. Those three points should be among the most important considerations, since they will determine your minimum monthly repayment costs and how long those payments will last.
Other considerations include the potential need to pledge collateral, how extensive the application process may be and how much time it takes for you to receive the actual funds provided through the loan.
Key takeaway: Franchise loans operate similarly to other business loans. When applying, be sure to keep in mind all of the franchising costs the loan will need to cover.
Franchise business loan options
When you're thinking about opening a franchise location, you should begin researching your financing options. Though you may ultimately end up taking out a loan, keep in mind that there's more than one way to get the capital you need. Here are some financing methods to consider:
1. Financing from franchisors
As a potential franchise owner, you are in a unique position because you're effectively helping a much larger business expand into a new market. As such, that business has an incentive to make it easier for you to get your business running. That's why, in many cases, parent companies offer an in-house financing option to help cover costs.
"Your first port of call for finance should be your franchisor, who may be able to offer you money," said Ethan Taub, CEO of Debtry.
If this is your first time opening a new franchise, this may be your best and easiest line of financing. As you begin discussing this option with the franchisor, be sure to get a rundown of the requirements and terms before agreeing to anything. After comparing the franchisor's offer with the offers from outside lenders, you will have a better picture of what option best suits your situation.
2. Loans from friends and family
Sometimes, your best option is to ask for loans from friends and family. It may not be the most comfortable thing to ask people, especially during uncertain financial times, but this kind of loan will usually come with little or no interest and lenient repayment terms.
However, be aware that this kind of agreement can become a wedge between even the closest of friends and family members, so be sure to draw up an agreement in writing and commit to meeting repayment expectations.
3. Commercial bank loans
One of the most common ways of obtaining franchise financing is by applying for a bank loan. Traditional term loans are business loans provided by a bank. These loans provide the money up front, and you repay that amount over time, with interest, each month.
Lenders are risk averse, so they will want to make sure your financial situation makes you a creditworthy borrower. You'll need to provide some additional information, including your credit score, collateral, a business plan and yearly revenue, said Emily Deaton, a financial journalist at LetMeBank. The better your financial standing is, the better rates and terms you'll receive.
The fact that a franchise is backed by an already-established business could work in your favor, Deaton said.
"Banks will feel more confident in providing you a loan if you're franchising an established company rather than starting your own company from scratch," she said.
4. SBA loans
If you don't qualify for a traditional bank loan, one of the best avenues for small businesses to explore next is an SBA loan – specifically, the 7(a) loan. SBA loans are approved and funded by banks and other lenders, but they're partially guaranteed by the SBA. As such, lenders are willing to offer a lower interest rate and a longer term, so your monthly repayment costs can be lower than they would be through other financing vehicles.
5. Alternative lending options
Though the previous options are more commonplace, there are numerous other lenders you can consider when you're looking for financing. However, there are some caveats to keep in mind. Options such as unsecured loans, business financing that borrows against your 401(k) or investments, and various types of credit often result in a quick infusion of cash at the expense of higher interest rates and shorter repayment periods. These options are more expensive but may be worth considering if you have bad credit and are unable to get approved for a more traditional financing option.
Key takeaway: There are numerous ways for you to get financial backing for your franchise. The best option for you depends largely on your individual needs and financial standing.
How to get approved for a franchise business loan
Now that you know the different types of franchise business loans, you might be wondering how to apply and get approved. Keep in mind that all loans and lenders are different, so make sure to get a detailed list of requirements for every option. Here are some general tips to get you started:
Have a business plan.
Lenders are risk averse, and they don't give loans without having extensive knowledge of what their funds will finance, so most lenders will want to understand your business.
"You need a business plan to be able to get a business loan, with prospects that you can pay them back the amount that you want to borrow, with evidence where possible," Taub said. "You have to have a plan in place so that you can pay the money back. That is the most important thing that they ask for when you borrow money for a business."
As a franchisee, you have a leg up in this regard over entrepreneurs of brand-new businesses, especially if the franchisor is a well-known business. Still, you will likely be required to provide a business plan when applying for a loan, so it will do you good to draw one up. [Read related article: Writing a Business Plan? Do These 5 Things First]
Work on your credit score.
Your credit score matters a lot when you're applying for a franchise business loan. Credit scores are determined by a number of factors, including the amount of credit you have, how much credit you're using at any given time and how frequently you make your payments on time. If you have a high credit score, lenders offer lower interest rates and longer terms, since your score shows that you're responsible with the money lent to you. The opposite effect happens if you have a lower credit score.
Because you won't have a business credit score, your personal credit score will likely come into play when you're applying for a franchise business loan. If you know you're going to need a good credit score ahead of time, you should work on increasing that number.
Be prepared to make a down payment and/or pledge collateral.
Some lenders feel comfortable providing a franchise business loan only if the borrower provides a down payment or some sort of collateral. If this is the case, it's important to determine how much of a down payment or collateral you will need for your loan to be approved.
If you go the collateral route, draw up a list of your assets, determine their market value and decide which ones you're willing to put up as collateral. Remember, if you fail to pay your loan and things get dire, the bank will collect on that collateral by selling the assets to make up the lost funds. Assets can include things such as real estate, business equipment, stocks and home equity.
Down payments serve as another method for lenders to reduce risk. A down payment demonstrates how serious you are about obtaining this loan and investing in your business, since it usually requires a substantial investment.
"Down payments do vary depending on the type of franchise you are interested in, but initial fees can be from $500 to $2,000," Taub said.
Key takeaway: When you apply for a franchise business loan, lenders will consider your business plan, personal credit score, and down payment or collateral.