Posted on Jan 02, 2011
Obtaining Financing for a Franchise
When seeking financing for a franchise, you have various options available to you. You can use debt, equity, create partnerships or do a combination of all the suggested techniques to create a financial package. In this section we will discuss the obvious merits and demerits of each of the financing options and why they should be considered or why they should not.
Simply borrowing money from a bank or financial institution is called using Debt Financing. These include approaching Commercial banks, Government sponsored bank loans, franchise system loans, home equity loans and credit card loans. The benefit of using debt financing is that you usually retain ownership of the assets and you are required to pay fixed interests on a set period of time. This is similar to paying on installments. You would need to provide some collateral to the bank or institution to get the desired loan and people who have poor credit scores or lack of assets to their names would find that obtaining debt is quite difficult.
Payments are necessary and there would be no compromise on them. Even if the business fails the owner would be required to pay the fixed payments until he has cleared his debt. There are often higher interest rates associated with debt financing which discourage most people from seeking it for long term purposes. Therefore, debt financing appears more suitable for short term financing whereas for longer terms, other options are suggested.
- Maintain Ownership
- Tax Deductions Possible
- Obligatory Repayments
- Higher Interest Payments
- Negatively affects credit rating if too much debt is taken
- Cash and Collateral would be required so that loan payments may be carried out regularly
Even though debt financing is more commonly found in franchising, equity financing is another successful way of raising money. The difference between the two is that the liability of payment is relatively less in equity financing, but your control over the company decreases as you are giving a share to the investors for their monetary support. The lenders also require payment in the form of dividends or growth in shares. The earning is therefore shared and rather than the owner keeping 100% of the profits, they are required to distribute it along the ownership ratios. Equity financing is usually preferable in the long run as the investors are not interested in making quick returns but are interested in a long lasting return possibility. Should the business fail, the investors share the risk and the obligation to pay them back is relatively reduced.
- Can launch start-up without the burden of debt
- Shared Liability, should business fail
- Investors may provide contacts or sound business advice
- Loss of total control over business
- Often requires significant paperwork and legal expenses
USING FAMILY AND FRIENDS
For many small scale startups, family and friends prove a valuable source of financing. This may be in the manner of creating partnerships, as their money makes them shareholders in the business, or it could be in the manner of a debt as they do not own any share and are paid back the principle amount with interest. Families and friends are more understanding of your situation and may allow lower interest rates or they may offer longer payback periods then that offered by financial institutions. They are also aware of your personality and wish you success so they may not be that profit minded as other financiers. However, this does not mean that they do not get feedback related to their investment and that you treat them any different than other investors.
A problem which exists in this role of investment is that this may lead to discourse in the family or among friends if they differ along your business practices. Family feuds are often initiated due to squabbles between the members over finances and profit sharing. Patience and tact is required for this mode of investment. It is recommended that the financial agreement is drawn out on paper with legal advice so that in the future everyone knows their specialization and the distribution of authority and the profit sharing system.
- Greater flexibility
- May offer Security free loans
- May require zero interest or lower interests than banks
- Risk of ruining relationships
- Overlapping jurisdiction based on family seniority
- Interference from other friends and family members
Partnerships are very common in franchise financing. In forming partnerships, the equity of the business is shared between the members according to the level of input put into the operations. This partnership may be between friends and family members or may be through some business contacts. The partnership may be established by oral or written consent, but it is recommended that documentary proof of the partnership exists. Legal attorneys can draw out the arrangements so that there is no conflict in the future over profit sharing or other issues regarding control of the organization.
Trust and confidence are the building blocks for any partnership, as with the lack of the two the partnership turns into a struggle to keep a check on each other and ensure that no one is cheating from each other. The partners share equal authority and either have the strength to make your business succeed or fail. Therefore both should strive for the same goals and there should be a mental homogeneity of the partners. The liabilities are shared in partnerships and should the business fail, both partners would be required to bear the loss.
- Shared financial commitment.
- Can pool resources, expertise, and strengths.
- There are limited startup costs.
- There are few formalities (mostly applicable licenses)
- Partners may have different visions or goals for the business.
- There may be unequal commitment in terms of time and finances.
- There may also be personal disputes.
- Partners are personally liable for business debts and liabilities.
- Each partner may also be liable for debts incurred, decisions made, and actions taken by the other partner or partners.
- At some time, there most certainly will be disagreements in management plans, operational procedures, and future vision for the business.
- May encounter difficulty in attracting investors.
Venture capital firms also offer the opportunity to raise capital. However for the new franchisee or someone who has only one franchise location, the venture capital firms have little to offer. Therefore, for people with heavy investment plans, venture capital firms are an option. But otherwise for someone starting a franchise business there is not much support from this group.
Leasing arrangements are one way of supporting your financial plans. This does not fall under traditional debt or equity financing, and is considered a separate branch. Leasing packages are often called “Franchisor-sponsored financing” and it entails paying a monthly fee to rent the equipment, machinery, real estate, or fixtures from the franchisor. Often times they offer a buy-out at the end of the period where the lessee has the option to buy the equipment or furnishings at a pre-arranged price.
This is a very attractive option even though it requires paying a greater net amount for the equipment. It helps eliminate the need of coming up with the full amount to purchase the equipment for start-up. Another benefit is that since more often than not, the equipment and fixtures change for the establishment, and when the lease expires, the franchisee can sign up for a new lease with the newer models.
In addition to franchisor-sponsored leasing, commercial leasing companies write leases on everything from computers to copiers, machinery, fixtures and vehicles. Most leases are for the long-term, maybe ten years, and require the lessee to pay all the expenses related to maintenance, insurance and taxes during the lease's term. Leasing often requires collateral from the lessee--such as the pledging of assets and personal guarantees.
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