You've read the literature, done your due diligence, considered the statistics on success, and know a franchise is the way you want to get into business.
But before you sign on the dotted line, answer this question first: Where will you get the money to finance the franchise, royalty fees, inventory and working capital?
The first thing you want to do before approaching any lender is determine what your net worth is. To do this, use a personal balance sheet to list both your assets (what you own) and liabilities (what you owe). Under assets, list all your holdings--cash on hand, checking accounts, savings accounts, real estate (current market value), automobiles (whether paid off or not), bonds, securities, insurance cash values and other assets--then total them up.
The second part of the balance sheet is liabilities. Follow the same steps. List your current bills, all your charges, your home mortgage, auto loans, finance company loans and so on. Subtract your liabilities from your assets. Once you've worked up this sheet, take a good look at your credit rating. There are three common ingredients that all potential lenders look for in a credit rating: stability, income and track record.
Most lenders are interested in how long you've been at a certain job or lived in the same location, and whether you have a record of finishing what you start. If your past record doesn't show a history of stability, then be prepared with good explanations. Not only is the amount of income you earn important but so is your ability to live within that income. Some people earn $100,000 a year and still can't pay their debts, while others budget nicely on $20,000 a year.
Most lending institutions look at your income and the way you live within that income for one very good reason. If you can't manage personal finances, the odds against you being able to manage your business finances are very good.
The third element lenders look for is your track record--how successful you've been in paying off past obligations. If you have a record of delinquent payments, repossessions and so on, you should get these squared away before asking for a loan.
Most lenders will contact a credit bureau to look at your credit file. We suggest you do the same thing before you try to borrow. Under the law, credit bureaus are required to give you all the information they have on file about your credit history. Once you have this tool, you should correct any wrong information or at least make sure your side of the story is on record. For instance, a 90-day delinquency would look bad, but if that 90-day delinquency was caused by being laid off or by illness, then that should be taken into consideration.
After you've determined your net worth and your credit rating, the final step to take before approaching lenders is putting together your business plan.
A well-thought-out business plan can make the difference between having your loan application accepted or rejected. A complete business plan should always include an intimate, technical study of the business you plan to go into; accurate pro formas, projections and cost analyses; estimates of working capital; an indication of your "people skills"; and a suitable marketing plan. It should also include certified statements of your net worth and several credit references.
Financing From the Franchisor
Traditionally, the first place franchisees turn for financing is the franchisor. Almost all U.S. franchisors provide debt financing only. Some carry the entire loan or a fraction thereof through their own finance company. We found fractions of 15 percent, 20 percent and 25 percent, all the way up to 75 percent of the total debt burden. The franchisors we talked to emphasized that these figures are simply guidelines and not hard and fast limits.
In addition, the loans made by the franchisor can be structured a number of ways. Some offer loans based on simple interest, no principal, and a balloon payment that's due five or 10 years down the road. Others offer loans with no payment due until after the first year.
Instead of financing the entire start-up cost, franchisors may offer financing for portions of the entire cost. They may have financing plans for equipment, the franchise fee, operational costs or any combination thereof.
In addition to financing a portion of the start-up cost, the franchisor usually has made arrangements with leasing companies to lease the franchisee the equipment necessary to run the franchise. This can be a significant part of the financing, since equipment often makes up between 25 and 75 percent of a franchise's total start-up costs.
If the franchise you're considering doesn't offer equipment leasing, look into nonfranchise, nonbank companies that specialize in equipment leasing for franchises. These types of financing companies will often provide asset-based lending to finance franchisees' furniture, equipment, signs and fixtures, and will allow franchisees to purchase the equipment at the end of the lease. Keep in mind that you may lose some tax advantages under the current law if you lease that equipment.
Remember that a business is franchised for two reasons: to expand the business and to raise capital. So if you have a reasonably good credit record and pass all the financial requirements, most franchisors will bend over backwards to get you on the team. The help that franchisors provide to help you get financing usually includes assistance with business plans and introductions to lending sources. In many cases, franchisors serve as guarantors of loans you take out.
Other Sources of Financing
After you've determined the extent of financing available from the franchisor, make a working list of all other available sources of capital. Most sharp operators use the following sequence of contacts: friends and relatives, home mortgages, veterans' loans, bank loans, SBA loans and finance companies.
Often, banks that aren't willing to work with you based on your financial profile become more amenable if you suggest working with an SBA loan guarantee; these loans are guaranteed up to 90 percent by the SBA. Small businesses simply submit a loan application to the lender for initial review, and if the lender finds the application acceptable, it forwards the application and its credit analysis to the nearest SBA office. After SBA approval, the lender closes the loan and disburses the funds; the borrower makes loan payments to the lender.
Some franchisors report being approached by financial brokers--historically more interested in big deals--to put together large pools of money using SBA and private funds. These funds would be available to franchisees through the franchisors like a trust fund. Groups of smaller banks with funds to invest would contribute to the fund from all over the country.
Other options would be to take out a home-equity line of credit or a second mortgage on your home. Be careful when utilizing this type of financing, however. The home-equity line of credit and a second mortgage are secured by your home. If you can't repay the amount you finance using this source, you risk losing your home.
You can also use assets such as stocks, bonds, and mutual funds to secure a loan as long as they're not part of a qualified plan like an IRA profit-sharing plan. Also, if you are over age 59 and have a lot of money tied up in an IRA, you could use it for part of your financing requirements. Although you'll have to pay taxes on the amount used, not to mention suffer the loss of income from interest, it can be a good financing tool.
If you are under age 59 and your IRA is one of your largest assets, you still may be able to take advantage of this avenue without accruing the 10-percent penalty associated with early withdrawal. By taking Substantial Equal Periodic Payments spread over a minimum of five years, based on your life expectancy, and a set of annuity tables published by the IRS, you can eliminate the 10-percent penalty, although the money is still taxable.
Tips to Consider
There are infinite sources of financing available to help you launch the franchise of your dreams. However, operating a franchise with no reserves and blinding yourself to unexpected business problems can lead to disaster. A good rule to remember: Never invest more than 75 percent of your cash reserves. If you have $10,000, invest $7,500. If you have $25,000, invest $18,750.
More important, remember that the price of a franchise doesn't always reflect the actual cost of the business itself. Additional costs can include down payments on the land, building, equipment, fixtures and signs, and can cover inventory, leasehold improvements, training, opening promotional costs, administrative costs and even sales commissions.
Be sure you understand the requirements of your cash investment. You will need a "pillow" of working capital to properly guide the business through its ups and downs. If you do your homework thoroughly, and remember that financing a business is the most important sale you'll ever make, then you'll be head and shoulders above the competition.
15 Fast Franchise Financing Tips
1. Talk to your franchisor before searching for outside financing; get approved or pre-qualified.
2. The most common source of start-up capital is friends and family. Use them.
3. Seek out lenders that understand not just small business but franchising as well.
4. Be totally honest and upfront with lenders. Hide nothing. Be prepared to explain everything.
5. Neatness counts. Fill out your credit and loan applications clearly. Typed is better.
6. Don't weigh down your loan application with attached documents.
7. Don't exhaust your liquidity by paying off outstanding debts before filing a loan application. Lenders want you to have capital available.
8. If you lack liquidity, find a partner with money.
9. Consider equipment leasing to conserve start-up capital and improve the appearance of your balance sheet.
10. Keep debts and expenses to a minimum. Many business owners take on too much debt, forgetting that cash flow must pay that debt.
11. Consider buying used equipment, furniture, vehicles, etc.
12. Let your fingers do the walking on the Internet before wasting time, energy, gas and phone calls. You'll find useful information. Some sites even allow you to file loan applications online.
13. Don't overlook angel investors and venture capitalists.
14. Avoid dipping into your retirement money or your kids' college funds. Any startup-even a franchise-is a risk.
15. Don't give up.
Source: The Small Business Encyclopedia, Start Your Own Business, Entrepreneur magazine and Entrepreneur's StartUps magazine.
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