Franchise Development and Financing

Whether you're already a franchisor or franchisee or want to be one, franchise development requires financing. Franchise financing options and methods are available for all borrowers in a franchise development. Start-ups or established franchised operators need franchise loans when buying a business or expanding an existing franchise business.

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What Is Franchise Development?

Franchise development is creating a new franchise or expanding a franchise into a new market. If you're an existing franchisee and own a franchise location, you may want to create your own franchise. Franchise brands can bring in a lot of funding for the owners, but starting one takes work. In addition to following federal laws, you must create a franchise disclosure document. That document requires accountants, strategists, and lawyers to make sure you don't violate the Federal Trade Commission Franchise Rule standards.

Types of Franchise Financing

Studies reveal that franchised businesses generally experience lower default rates than independent businesses. This is why entrepreneurs have an easier time securing small business loans for a franchise than an independent business. Lenders and investors like franchised businesses because the franchisor typically has an established customer base and product or service.

Regardless of what type of start-up costs or business financing you choose for your new business or franchise, lenders and investors will want to see your:

• Business plans
• Established operator participation
• Credit history (personal credit score and business credit) to show your creditworthiness
• Net worth
• Last three years of financial statements to give them an idea of your financial situation

Before deciding on your financing option below, make sure you understand start-up financing.

Traditional Franchise Funding Options

Business owners know that a traditional bank loan is the first option for funding a start-up or expanding for working capital. Private bank financing likely has lower interest rates and lower down payments available to business owners with significant business experience or who pledge personal assets as collateral. A franchise owner with good credit may qualify for a line of credit outside a loan.

Other loan options exist for those who don't qualify for a traditional bank loan from traditional financial institutions. The Small Business Administration (SBA) is one option. An SBA lender may offer the SBA 7(a) loan as an option. Small business owners who don't qualify with their traditional loan applications may be eligible for an SBA loan. These loans have specific repayment terms, may have higher interest rates, and may agree to guarantee a portion of the funds loaned by a lending institution.

Exploring online lenders for short-term loans is another option. These loans may have a higher interest rate. But if your franchise is about to take off, this could be an option for you. If you can pay it off quickly, then this loan program could increase your business credit in a short time frame.

Innovative Franchise Financing

The traditional growth plan of franchise chains is to build company-operated locations in "safe" markets. The entrepreneur then offers franchise or development agreements in target markets identified by the company's growth strategy. One limitation of this growth strategy is that the franchisees' ability to raise capital limits growth in new or less attractive markets.

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

This is why franchisors now offer:

1. 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. The franchisor opens and operates the locations. Then, it sells the locations to a franchisee operator. The operator receives financial assistance from the seller. This assistance is 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 or development rights.

2. Franchisor Financing

Franchisor financing involves the franchisor offering loans directly to qualifying franchisee operators. This approach requires the franchisor to provide significant debt financing. The loan amount is large. The goal is for the franchisee to help the franchisor achieve many locations in a certain territory.

A variation of this is equipment financing. The franchisor leases the equipment the franchisee needs to operate. An example of this is the espresso machines needed for a coffee chain. Rather than buying the equipment at start-up, the franchisee pays the franchisor a lease fee until the equipment has been paid.

3. Programs Where Franchisees Buy Equity in the Franchisor

Franchisors also have developed programs where their franchisees buy equity in the franchisor. This is part of their development 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. Traditional royalties and cooperative advertising fees are fixed at a percentage of sales.

How Much Does a Franchise Cost?

A franchisor charges an amount for someone to purchase a franchise location or license their products or services. The amount depends on the franchise's size and the amount of goodwill the franchise has in the market.

A franchise usually has three main cost components:

• Initial franchise fee
• Build-out costs
• Inventory costs

Initial Franchise Fee

This fee is paid to the franchisor for the privilege of joining the franchise system. Initial franchise fees range from $2,000 to $200,000 for a single location. Franchisors often bundle territorial rights with the sale of single units. This can increase the initial fees paid directly to the franchisor. The initial franchise fee is typically funded by equity investments by the prospective franchisee. Prospective franchisees should plan to use their equity investments to fund their working capital requirements and other miscellaneous expenses.

Build-Out Costs

For a quick-service restaurant franchise, this cost can be substantial. It can include specially designed or special-use buildings, signage, and equipment. For other franchises that aren't as real estate intensive, these costs may range from the cost of computer software to the cost of manufacturing equipment.

Inventory Costs

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

How Does a Franchisor Make Money?

A franchisor makes money in multiple ways after the application process and the initial franchise fee. Other ongoing fees that a franchisee must pay allow the franchisor to generate cash flow continuously.

• Royalty fees are paid monthly in exchange for the franchise being able to use the brand name, logo, and products.
• Advertising fees are paid into a fund monthly. These fees allow the national franchisor company to spend funds on advertising at a national level.
• Technology fees are also paid monthly. This can include payment for a point of sale (POS) system or certain operating technologies.
• Franchise fees are usually paid yearly.

Ongoing Franchisee Costs

It costs to operate a franchise. These costs include:

• Staffing
• Rent
• Promotional items
• Supplies

Franchisees have operating costs that they don't share with the franchisor.

Talk to an Attorney About Franchise Development and Financing

The development and financing of a franchise involves many complex moving parts. Talk to a business and commercial law attorney in your state so you can start your new franchise correctly.