Franchise Development and Financing

Whether you're a franchisor or franchisee already or are interested in becoming one, franchise development requires financing. It is important to keep up to date on the franchise financing options and methods available for start-ups as well as established franchised operators seeking capital for expansion. Regardless of the financing method chosen, however, prospective franchisees must understand that lenders are requiring franchisees to have "more skin in the game."

Additional articles about franchises can be found in FindLaw's Buying a Business section.

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Financing Franchise Development

Studies reveal that franchised businesses generally experience lower default rates than independent businesses. Consequently, franchised businesses have had a somewhat easier time securing financing than their independent business owner counterparts. Lenders and investors like franchised businesses because the franchisor typically has an established trademark and goodwill, as well as marketplace experience.

Nevertheless, the days of easy credit appear over for virtually all participants in the franchise industry. The chances of landing zero-down acquisition financing are a thing of the past. Lenders and investors are demanding to see strong business plans, established operator participation, and a significant equity investment by the operating party.

See Startup Financing to learn more about raising money for your small business.

What Does a Franchise Cost?

A franchise usually has three cost components:

1. Initial franchise fee. This fee is paid to the franchisor for the privilege of joining the franchise system. Depending on the strength of the franchisor and the philosophy of the franchise system, initial franchise fees range from $2,000 to $200,000 for a single unit. Franchisors often bundle territorial rights with the sale of single units, which could substantially increase the initial fees paid directly to the franchisor. The initial franchise fee is typically funded by equity investments by the prospective franchisee. In addition, prospective franchisees should plan to use their own equity investment in order to fund their working capital requirements and other miscellaneous expenses.

2. Cost of the physical plant and build-out. For a quick service restaurant franchise, this cost can be substantial and can include specially designed or special use buildings, signage and equipment. For other franchises that are not as real estate intensive, these costs may range from the cost of computer software to the cost of manufacturing equipment. The cost of a physical plant is financed typically though conventional bank loans, government guaranteed loans and loans from equipment vendors. Less common are direct financing programs, loan guarantees and other credit facilities offered directly by the franchisor.

3. Cost of inventory. This can substantially vary depending on the nature of the business. Product distribution franchises, such as computer retailers and automobile dealerships, will naturally have extraordinary inventory costs compared to service businesses. Product distribution franchises typically offer direct financing from the franchisor, such as inventory floor planning arrangements, and outside vendor credit facilities.

Traditional Franchise Financing

Traditionally, private bank financing has been available to potential franchisees that have significant business experience or personal assets to pledge as security. The Small Business Administration ("SBA") may agree to guarantee a portion of the funds loaned by a lending institution.

Innovative Franchise Financing

The traditional growth plan of franchise chains is to build company-operated restaurants in "safe" markets, and to offer franchise or development agreements in target markets identified by the company's growth strategy. One limitation of this growth strategy is that system growth in new or less attractive markets is limited by the franchisees' ability to raise capital.

Today, franchisors, especially publicly traded franchisors, are dependent on rapid growth in new markets. Rapid growth fuels sales and hopefully, earnings. Rapid growth also allows franchisors to grow their brand(s) faster than their direct competitors and to capture market share.

As competition among franchisors for talented operators increases while available credit simultaneously decreases, a franchisor's prospects for success will be driven increasingly not only by the strength of the franchisor's concept and brand, but also on the competitiveness and creativeness of franchisor-sponsored financing programs. Accordingly, franchisors are developing new approaches to franchise development and finance, including the following innovative techniques:

1. The Development and Sale Method

Under this approach, the franchisor seeds system growth by developing and building franchised units in target markets. The franchisor supplies the equipment and then opens and operates the franchised units until they are sold to a carefully cultivated operator. The operator receives financial assistance from the seller in the form of a sublease of the property and equipment. By selling the franchisee operating, turn-key units, the franchisor may be able to achieve higher profits through the sale of a strong cash-flowing business and/or additional area development rights.

2. Franchisor Financed Area Developer Program

Another technique being used by some well-capitalized franchisors is to offer franchisor financed area developer programs in select major markets. Such an approach requires the franchisor to provide significant debt financing with the goal of the franchisee building out and achieving a critical mass of locations in the chosen market.

3. Programs Where Franchisees Buy Equity In The Franchisor

Franchisors also have developed programs where their franchisees buy equity in the franchisor as part of a development strategy. In this strategy, the franchisee purchases convertible preferred stock in the franchisor. The preferred stock otherwise has the attributes of a franchise agreement with development rights. The preferred stock is convertible into shares of common stock if the franchisor goes public. The convertible preferred stock issues no dividend for some fixed period of time (perhaps, five years) at which time an annual dividend is paid. In exchange for their investment in the franchisor, the franchisees pay a nominal initial franchise fee upon opening their franchised units, with traditional royalties and cooperative advertising fees fixed at a percentage of sales.

Common Theme for Successful Financing Programs

Irrespective of whether the financing technique is considered traditional or innovative, the common theme of all successful financing programs is partnering between the franchisee and its franchisor. Too often the franchisee-franchisor relationship is seen as a zero sum game where development responsibilities are borne primarily by the franchisee. History in the franchise industry demonstrates, however, that greater growth is likely where the franchisor facilitates the franchise development process on behalf of its franchisees.

Have Questions About Franchise Development? Talk to an Attorney

The development and financing of a franchise may involve a number of complex moving parts. Depending on your situation, you may greatly benefit from one or more legal consultations before you get started. Talk to a business and commercial law attorney in your state if you have questions about franchise financing and development.