The first question a franchise candidate must ask is “how much does it cost?” The answer is almost always more than you think. Often new franchisees get in trouble if they don’t have enough money to get off to a running start. We call that “undercapitalization.”
“Undercapitalization” – a big word that means “not enough money is put into the business” – is one of the main reasons that business start-ups and new franchisees fail. You must have adequate funds to get started and keep the business going through the first year. This is in addition to having enough money to keep your household running.
How do you know how much you need? Most franchisors spell out all the initial expenses in the Franchise Disclosure Document:
- Franchise Fee
- Expenses During Training
- Lease (deposit and monthly costs)
- Build-out of location
- Furniture, Fixtures, Equipment & Supplies
- Utility deposits
- Business licenses and insurance
- Training costs
- Grand Opening & Other Marketing Expenses
You must also calculate ongoing expenses and marketing costs if you want a viable business. Make sure the math works. You can work hard and follow your passion, but if the math doesn’t work, neither does the business. T hose are just the business expenses. You can’t live on passion alone, so calculate your living expenses too. When buying a franchise business, I recommend having one year of living expenses in reserve as it can take up to that long before the owner can take a salary from the business. Use a budget worksheet, or online budget calculator to help you determine the amount you’ll need for living expenses.
It Takes Money to Get Money
In the “good old days” before 2009, bank loans were easy to come by. Post- recession, there is no guarantee of readily available business start-up loans. Lenders are wary of taking a chance on a business start-up. Chances improve if your franchisor is on the SBA Registry.
Why Franchisees Fail
It seems contradictory, but to get the loan, you need to be able to show that you have assets to cover the loan. Banks are businesses too. They’re not going to just give you the money — they want it repaid, with interest. For this reason, franchisors ask for a lot of personal financial information. This serves to both qualify you as a serious candidate and protect you by making sure that you have the resources to cover the necessary expenses required to succeed.
Be prepared, and know what qualifies as acceptable assets. Some examples include:
- Cash on hand
- Home or other owned real estate equity (value minus liabilities). See note.
- Investments (stocks, bonds, , IRA & 401K)
- Life insurance cash value (not the same as the death benefit)
- Outstanding loans owed to you
Note: When calculating equity, lenders allow just 80% of the appraised property value.
Also, if your state has a Homestead Act, the bank may not accept a primary residence as collateral on a business loan. At this point, you may be asking yourself, “Why is this business that I am creating not listed above as part of the assets?” Simply put, the bank can’t finance a business that doesn’t yet exist. The bank is only moderately interested in the ability of the business to repay the loan. While the bank secures the assets of the business, it does not rely on the liquidation value of the business to repay the loan if the business fails.
The bank makes a loan based on your credit history and personal assets. They must determine your ability to repay the loan. They are making sure that there is enough in assets that can be liquidated to recover the loan.
Also consider your liabilities, for example:
- Home mortgage balance
- Credit card debt
- Outstanding loans you owe
- Accounts payable from a current business that you may own
Any monthly obligations must be calculated into your expenses to determine your ability to pay on the loan.
Making Ends Meet
Now that you have a clearer picture of what it costs and how much you have to spend, you can compare your resources to the franchisors requirements.
Be sure to consider all the start-up costs, not just the franchise fee. Discuss with your family, too, the financial implications of buying and owning a franchise.
What if a franchise is a great fit but your financial situation does not meet the franchisor’s requirements? Don’t despair. First, know the exact size of the gap. Then you have several options:
- Look for potential partners.
- Create an aggressive savings plan to fill in where there are financial gaps.
- Consider working for a franchisor’s corporate unit until you are ready.
- Ask the franchisor or the Small Business Administration (SBA) for advice.
- Research creative financing.
Given the complicated nature of financing a franchise business for sale, be prepared for the financing to take longer than expected to come through. That’s par for the course whether you take a loan or take on partners.
You may be able to reduce the time required to secure a bank loan if the franchisor is on the SBA registry. Franchisors on the registry have gone through a “prequalification” process so that each individual bank does not have to review the franchisor in order to qualify the franchisee for an SBA loan. There are certain requirements a franchisor must meet to be approved by the SBA. The registry ensures that the franchise brand has complied with these requirements.
Show Me the Money
Franchisors ask for a lot of personal financial information. Why? They want you to succeed.
Therefore, they are going to inquire about your personal financial resources. Some will ask for proof in the form of bank statements, brokerage account statements, commitment letter from a lender, or letters from family members or investors agreeing to assist with the financing required.
Keep in mind that it is just information and not a judgment about you personally. It is designed to protect you and make sure that you have the resources to cover your expenses. A franchisor will not award a franchise to someone who does not have enough assets to succeed.