Opening a franchise can eliminate much of the hassle in terms of starting a small business. In many ways, the hard work has been done, as you just copy an existing business model. However, it is not an automated route to financial success. You need to do your homework and evaluate whether or not a franchise is for you.
What is Franchise Financing?
Franchise financing is essentially opening a local store in the name of an existing franchise. A typical example would be if you were to open a McDonalds or Starbucks. You use all of their standardized equipment and make their food/coffee the way it is made the world over. This takes away a lot of the mental strain, because you are following an existing format. And the format is one that is proven to work with extensive research completed.
The Pros and Cons of Opening a Franchise
Of course, this does not mean that opening a franchise is easy. First, it must be said that there is a huge upfront cost of opening a franchise. According to the Small Business Administration (“SBA”), typical franchise fees are between $20,000 – $50,000 outside of the master franchise agreements. These master franchises agreements relate to the right to buy and sell other franchises. They cost upwards of $100,000. There are also ongoing franchise royalty fees and advertising fees when opening a franchise.
Aside from the cost, you are giving away a significant percentage of control. You don’t really have a say in the running of the business. And this makes sense. If every franchise was to run differently, it would defeat the purpose of a franchise. But it can become problematic if you want to sell the company.
A huge benefit of opening a franchise is that your success rates are going to be far higher. Consider opening a Starbucks Franchise. They will tell you exactly what equipment to buy, what coffee to purchase, and how to train staff. The advertising/marketing has been done, and nobody can dispute the quality of Starbucks coffee.
What is the Difference Between Franchise Financing and a Small Business Loan?
You need to carefully evaluate the difference between opening a small business and opening a franchise. A franchise shop is one that you own and take profit from, once you adhere to the terms and conditions. The practical differences will include:
- Franchises tend to come with 10-year contracts. You can’t just up and sell. Small businesses offer more flexibility compared to franchises.
- Franchises are less risky – the marketing and operational research has already been done for you.
- The biggest difference is the cost. Setting up a franchise is far more expensive than setting up a small business. You must get specific inventory and pay the franchise fee, which can be quite costly.
Ultimately, the tradeoff is between success rates and control. This is a tradeoff found in all industries, and it comes down to you. Would you like to take 100% accountability for the risk and mental stress associated with running a small business? Or would you like to take a less risky option with a proven franchise while giving up some control?
How to Qualify for Franchise Financing
Opening a franchise is more costly than opening a small business. First, there is the upfront franchise fee ($20,000 – $50,000). Then there are monthly royalty costs (4% – 12%) and the marketing fee (~2%). The marketing fee is actually not really a fee – if you were to market yourself, then you would easily be spending a larger percentage. But remember, these fees are outside of the huge costs associated with setting up any small business.
Because of all these costs, the lending institutions will want to know that you can afford all of the fees. Like all loans, you will need a good FICO score (at least 600, preferably 650 and above). But you will also need to supply collateral. Simply put, the greater you collateral, the safer the lender will feel. The loan to value ratio (“LTV”) is the value of the loan against the security/collateral. Different lenders will have different criteria.
Before you apply, remember to get all of your affairs in order. Understand the typical requirements of applying for a loan. And ensure that you have a Franchise Disclosure Document. This details your relationship with the franchise company. On the back of this information, you can build a strong business plan. A good FICO score, a strong business plan, and a decent amount of collateral should be enough to qualify you for franchise financing with acceptable rates.
The 4 Most Common Franchise Loans
1. In-House Franchisor Financing
Major franchises can provide finances directly to applicants. For instance, UPS provides a franchise financing system for people looking to open stores. This program is conducted in conjunction with Guidant Financial. Financing through a franchisor can often eliminate much of the hassle of obtaining finance. You are dealing with one institution instead of a third-party (i.e the bank or alternative lender). In addition, the franchisor will be an expert in knowing how much funding you need and what everything costs. Rates vary depending on industry and franchise.
2. Commercial Bank Franchising
This is one of the more traditional routes to franchise financing. After the 2008 financial crisis, it became quite difficult to obtain loans from commercial banks without supplying large amounts of documentation. If you want to obtain franchise financing from a commercial bank, then make sure that you have a good FICO score, strong collateral (about $75,000 and above), and a solid business plan. As a very general rule of thumb, the higher your credit score, the lower the rates. However, expect to wait for this loan to be approved.
3. SBA Franchising Loans
The SBA has a directory of all franchises that are eligible for financing. If your franchise is on the list, then your application may qualify. Note that you still have to go to a commercial bank or lending institution to get this loan – it is simply a loan that is guaranteed by the SBA, which encourages lending to new business owners. The SBA has some basic guidelines that must be met for these loans. These include that you are based in the USA, are a for-profit business, and are qualified as a ‘small business’ under the official requirements. In addition, you will have to put up collateral and sign a personal guarantee in most instances – this is a requirement for nearly all franchise loans.
4. Franchising for Minorities
There are also a wide variety of franchise options available to minorities. These minorities typically include African Americans, Asians, Native Americans, and Hispanics. It may also include women, medically challenged individuals, and veterans. The SBA gives top priority to minority franchise loans. The International Franchise Association runs a VetFran program to assist veterans in getting franchise loans.
Best Business Loans for Franchises
Online providers can also offer a variety of options that are similar to franchise financing. They do not offer franchise financing loans specifically, but new franchises can simply apply for a loan for business purposes. Application and funding is quick, and the requirements are quite low.
Kabbage offers business lines of credit with a linked business credit card. The requirements are a year in business, $50,000 in annual revenue, and a minimum credit score of 560. Kabbage is known for its sleek and intuitive interface, making it easy to see what is owed and spent on a monthly time horizon.
LoanBuilder is a PayPal invention designed to facilitate a variety of business loans. It is now a serious rival to existing online lenders with ultra-low requirements of $42,000 annual revenue, 550 minimum credit score, and 9 months in business. These requirements are deliberately less than the minimums offered by other online providers, such as Kabbage. A personal guarantee is required with this loan.
OnDeck are one of the most well known online lenders. They provide term loans and business lines of credit. Applicants need $100,000 in annual revenue and a credit score above 600 to qualify. They are more suitable for small businesses that are already up and running.
Lending Club are a massive peer-to-peer lending marketplace connecting borrowers with lenders. They provide a large range of term loans up to $500,000 and have facilitated over $28 Billion through the platform. Applicants need a credit rating of 600 to qualify.
Fundbox is one of the easiest online providers to qualify for, offering business lines of credit and invoice financing. The minimum requirements include $50,000 in annual revenue and that the applicant is located in the USA with 3 months of activity in a business checking account. There are no minimum credit requirements.
Franchises are an excellent option for those looking for a safe way to get a business up and running. Though you need to have some additional capital for franchises, it is definitely more reliable. Franchise loans can be provided by commercial banks or directly from franchises. In addition, there are multiple online loan providers with more flexible financing options for applicants.