How To Fund Your Franchise

How To Fund Your Franchise

As a potential entrepreneur, there are a myriad of factors to evaluate before deciding if business ownership is right for you; one of the most important being how you are going to fund your business. Most prospective owners finance part or all of their purchase with debt funding (borrowing money), equity funding (selling shares to a partner or investor), personal cash, or a combination of the three. And while you may be wary of wading into a daunting loan acquisition process, the good news for franchise buyers right now is that the current lending environment is highly favorable for financially viable candidates.

With the government guarantee of the Small Business Administration (SBA), most banks these days are not only willing to fund small business owners, but actively looking for these types of loans. The SBA guarantees a portion of the loan amount (between 50% and 80% depending on the specific program) which decreases the bank’s risk and increases their willingness to fund these smaller loan amounts. But even with the guarantee, since the SBA itself doesn’t lend the money, the lender is still the ultimate decision-maker who will approve or turn down a loan. The key to finding the right lender for your specific opportunity is to approach the process with the following key strategies.

Step One – Preparation

The key qualifiers for any loan are as follows:

  • Good character, experience and personal/business history
  • Ability to repay the loan with reasonable (to strong) collateral
  • Owners must have personal equity invested

It is important to remember these qualifiers as you prepare for the loan acquisition process. Acquiring a loan is the only kind of transaction where you the customer have to ‘sell’ yourself to the seller (the bank). The more you can prove your knowledge, character, and repayment ability, the better chance you will have of getting your loan approved.

With that in mind, start putting together a well thought-out business plan before you approach a lender to discuss potential funding solutions. This business plan will be an asset when presenting your case to a potential lender and a good foundational document to reference and update as your business grows. Important items to include in the plan are:

  • An Executive Summary of the total project. A polished and professional business plan with a well-articulated executive overview will send a positive message to the lender about how you will approach business ownership.
  • “Owning a franchise allows you to go into business for yourself, but not by yourself” is a well-worn phrase in the industry. It is also an advantage from a lender’s perspective to have the support of an established product or service behind you. Even with that knowledge, the performance of the brand itself does not guarantee to the lender that you will be a successful operator. Demonstrating your industry segment knowledge and how you will approach your target market will be important.
  • For a start-up operation, the lender will be interested in what experience you have that prepares you to run that business. Perhaps you held a position in the past that required a similar skill-set that will be beneficial to the franchise you are considering.
  • Financial viability of the proposed business is crucial. Demonstrate your knowledge and detailed understanding of projections and cash flow expectations. Be realistic in your forecasts, but not pessimistic. Key measurements such as time to break even will be important in the lender’s assessment.

Step Two – Pre-Qualification

Knowing the details of your personal financial health is important before approaching a lender. If you know your personal FICO score, consider that most SBA lenders look for a personal score above 680 for a start-up business. Another score used by SBA lenders in addition to the personal FICO is called SBSS, or Small Business Scoring System. This score takes into account the financial track record of an existing business. Even more powerful, is a tool called FranScore. This combines information from all three major credit bureaus with 20 years of predictive loan behavior specifically from the franchise industry. FranScore (www.franscore.com) provides you with the most accurate assessment of your probability of obtaining a loan for the business you are considering. Having this information in hand before approaching a lender gives you the confidence of knowing what you qualify for and shows the lender you’re prepared.

While your credit rating plays an important role in helping you qualify for a loan, another major consideration are the Five C’s of Credit. This is common banking terminology used pervasively as a method of determining credit worthiness. The Five C’s are:

Character may be the most important part of the overall assessment process. Lenders look for critical character traits such as trustworthiness, demonstrated good judgement, credibility and reliability. Business experience or previous employment/management, education and overall integrity are considered.

Capacity is understanding whether the borrower will have the capacity to repay their debt obligations over an acceptable timeline. The lender will determine whether the business will generate sufficient net earnings to service (repay) both short and long term credit obligations.

Credit is the assessment of your credit history. It is important to proactively divulge all credit obligations both business and personal as part of the loan request package. Not revealing or attempting to conceal financial issues (both current and previous) may be detrimental to receiving a bank approval. A lender does not necessarily expect perfect credit, and there may be a credit concern that could be mitigated by a strength elsewhere.

Capital is the owner’s personal financial commitment to the business. Regardless of how compelling the business plan may be lenders generally expect owners to provide a reasonable level of their own cash into the business. This is commonly referred to as ‘skin in the game’ or the equity injection.

Collateral is the value of assets available to support and secure the loan request. For a new borrower or start-up when there is no financial history on the business, a lender may require an additional level of security to support the loan. Understanding these 5 C’s of credit and addressing them in your loan package and business plan will put you in the best position to successfully approach a bank or lender.

Step 3 – The Loan Package

Putting together a comprehensive loan package, with all of the required information, topped off by a professionally-prepared business plan with an impressive executive summary can be a daunting task. If you have experience in this area you may be comfortable working through this process on your own. Alternatively, there are companies, such as FranFund, Inc., that specialize in assisting potential entrepreneurs with preparing the loan package and presenting the best foot forward to multiple lenders simultaneously to obtain the best rates and terms.

A loan package is comprehensive as it will answer all of the lenders questions. For example:

1) Sources and uses of funds – where is the equity injection coming from?

2) Amount of revolving credit utilized

3) Length of time credit has been established

4) Derogatory public record (Bankruptcies, collections, DWIs, repossessions)

5) Prior year tax returns to illustrate proof of income

6) Personal Financial Statement to outline assets, liabilities and net worth (total liquidity)

7) Outside source of income or living expenses

8) Business projections and justifications

9) Details of the lease (if applicable)

The first question that all lenders ask is “How will you repay the loan?” The natural answer to that question is that you will run your business productively and produce enough cash flow to cover the loan payment and any other costs that are incurred. Though that is the overall idea, there is a lot more to it than that, especially for a start-up. To show the lender your repayment ability, the lender will expect a cash injection of the total project cost from the borrower, usually 20% to 30% of the loan amount. This cash injection cannot come from borrowed funds.

There are a number of options you may use to cover this, such as cashing out an investment or finding a business partner, but one of the most popular is 401(k)/IRA business financing. Through an IRS program called Rollover for Business Start-Ups (ROBS), you are able to use qualified retirement funds to invest in your business tax and penalty free. Many entrepreneurs use this to obtain the required cash injection for a loan, and others utilize it to fully fund their business and open their doors debt free. You will also need to show the lender an outside source of income or cash to cover 9-12 months of your personal living expenses, plus the loan and (if needed) lease payments. You are not allowed to use the loan to cover these expenses.

In conclusion, we recommend that you start considering the funding piece of the business ownership equation early in the process so that your funds are ready to get started when you are. If you have followed these steps, the process of obtaining funding for your new business should no longer scare you, and your chances of obtaining approval are much improved.

About the author

Sherri Seiber is Chief Operating Officer of FranFund, a total funding solution for franchising and small businesses, a single, expert resource that will search the marketplace for the best options to fund your franchise or independent business.

 

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