Monday, November 8, 2010

Franchise Financing Overview

There are three primary ways that you can finance a franchise purchase. First, you can use what I like to call “traditional” financing, where you go to a bank and take out a loan, putting up your house or other assets as collateral in case you default. The second type of financing is called “equity,” which is when individual investors place their capital or retirement funds into your business in exchange for a return in the future. In some cases you may actually invest your own retirement funds, thereby becoming both the entrepreneur and the equity investor in one. Finally, the third type of financing is to go to friends and family for private loans. However, this is not always the best idea, for reasons I'll go into below.

Traditional Financing (Debt Financing)
This is the classic mode of financing, and the one that most small business owners have chosen in the past. Essentially, this consists of going to a bank and then submitting an application for a loan. The bank then has the option to accept or deny your small business loan, or in some cases negotiate its terms. Usually, the bank will require some form of collateral - a set of personal assets such as your house, your car, and anything else that you have that is valuable. If you cannot repay the loan from the proceeds from your new business, the bank will try to get what it can out of your collateral.

Once, you have obtained a loan, you will be required to pay interest on this loan as well as pay back the principle over a set period of time, depending on how this is written up in the loan contract. The main advantage to his type of financing is that it doesn't require you to put your own money into the business. However, you will lose a lot of money on interest in the long run, and expose yourself to a certain amount of risk.

Equity Financing
The great thing about equity financing is that you don't technically have to get into debt. With debt financing, you owe a fixed amount of money to the bank that you are liable for whether your business succeeds or not. With equity finance, your investors aren't lending you money, they are buying a portion of your business. This means that they are buying your successes right along with your failures. They have to accept all of the same risks as you do. Hence, in the unfortunate occurrence that your business fails, you are less likely to be personally responsible for any debt to your investors. However, since your investors carry a direct interest in the success of your business, they will have more of a say in how you operate it.

Some small business owners are now choosing to become their own equity investors. Essentially, they take money out of their retirement funds, their 401(k) or IRA, and invest it into their business. They act as both an equity investor and a small business owner at once. This allows them to invest in their business without getting into debt or having to answer to outside investors. Each dollar they make can then be invested directly back into the business. This type of investment is actually my specialty, as my company Guidant Financial is the leading provider of financial advice concerning converting your retirement funds into a small business.

Alternative Funding
The last option is to seek additional funding (generally a private loan) from friends and family. This is certainly a possibility, but be wary that this has a tendency to backfire. I've seen family relationships and close friendships deteriorate after the failure of a business enterprise that was funded in this way. My advice is to think long and hard about whether or not your friendship can take the strain of such a great loss of money. If the other party involved fully understands the risk, you may feel that it is worth it. But remember, you must frankly state that there are significant risks involved in your enterprise before accepting money from a close friend or family member. Ask him or her the following question: “If this business fails, and I am unable to pay you this money back, will we still be friends?” If the answer is no, or even a hesitant yes, seek another source of funding, even if you are certain that you will succeed. There are always unforeseen possibilities that you may be unaware of, and you don't want these to get in the way of your most important relationships.

My advice is to only use alternative funding as a small portion of your financing, if at all. And I'll say one last time that you must make your friend or family member explicitly aware of the risks involved.

Many new franchisees choose to finance their new enterprise using more than one type of funding, and I think this is a good idea. You might take funds from your 401(k), combine these with some from one or two outside equity investors, and fill in the cracks with a small loan from the bank or money from friends and family. Entrepreneurs are resourceful people which means that you have to be creative even when figuring out how to finance your new franchise unit.

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