What You Need to Know about Early Stage Funding as a New and Emerging Franchisor
Franchising is, arguably, the best example of the axiom “It takes money to make money.” As an emerging franchisor, you will need plenty of capital to develop infrastructure, grow and support your franchise system.
After you’ve completed the planning stage, which should include a franchise feasibility study to determine if franchising is right for you and your brand and you’ve created a startup budget, it’s time to find funding to get the ball rolling. Here are some sources for early-stage funding for franchises and what you should know about them:
Small businesses and large companies alike can receive funding from commercial banks, which offer several loan options. The ones that make the most sense for funding the early stages of your franchise are:
- Traditional term loans – Range from $5,000 to $5 million, which you pay back with interest over a certain amount of years. Traditional term loans are usually used to help grow businesses. To qualify, your business must be operating for at least two years, generate annual revenue of more than $100,000 and your credit score must be over 600. You may qualify for a lower interest rate if you have a financially strong franchise and a higher credit score.
- Equipment loans – Just as the name implies, these loans are used to purchase equipment essential to your business. Similar to a car loan, the cost of the equipment is the amount of the loan you’ll receive, which you pay back over a set amount of years with interest. The equipment itself serves as collateral, so you don’t have to put up any other surety. Usually, you are required to make a down payment on the equipment; if your credit score is low or your business generates low revenue, you may be required to make a larger down payment.
- Business line of credit – Unlike a loan, a line of credit offers great flexibility. Like your credit card, the bank issues you a line of credit with a cap amount – usually between $10,000 - $1 million or more. You can purchase whatever you need to grow your business. After you make the purchase, you repay that amount, and your credit amount resets. For example, if you have a $900,000 line of credit, and you spend $200,000 on a fleet of vehicles, you’re left with $700,000. But, when you pay back the $200,000, your credit allowance resets to $900,000. The line of credit allows you to make purchases whenever you want without having to apply for one loan after another. The terms for qualifying for a line of credit from a commercial bank is more stringent than qualifying for a traditional term loan – your credit score must be higher than 700 and your business must be profitable for a few years.
Loans through the Small Business Administration are typically long-term and carry low-interest rates for amounts ranging between $500 and $5 million. These government guaranteed loans are offered through a dozen programs - each with their own terms and conditions.
Generally speaking, you can use SBA loans for myriad business purposes, from building up working capital to purchasing equipment and real estate. While SBA loans are easier to qualify for than traditional term loans, you typically still need good credit and a profitable business. You can apply for SBA loans through authorized lenders, which include some banks.
Investment banks are a segment of banking that specializes in helping typically larger companies manage their money primarily through issuing loans, underwriting debt, or assisting with mergers and acquisitions. Investment banks also help governments and institutions achieve their financial goals. They primarily help their clients by selling shares of companies to investors.
While sourcing investment banks might yield better results for large corporations that want to begin franchising, small emerging franchisors should not dismiss these banks as a resource. Some investment banks will assist small and emerging franchise companies. For example, in November 2018, JP Morgan Chase, one of the largest investment banks in the world, announced the launch of a group charged with helping raise capital for franchises of all sizes as long as they are established and have high-growth potential.
Private Equity Firms
Interest in franchise companies by private equity firms has increased over the years thanks to the steady growth of the franchise industry. And, franchisors are turning to private equity (PE) firms for a number of reasons, including help with expansion.
PE firms have a lot of money in funds investors contributed to, and they’re looking for privately-held companies with great ROI-potential to invest in, such as franchises. While PE firms have traditionally sought out established companies, they are beginning to venture into startups if they look promising. Although PE firms can provide a tremendous shot in the arm for companies and there’s no loan to pay back, there’s more risk for the franchisor because PE firms typically dictate the terms of the deal and those terms are intended to reward the investors, not the franchisor or franchisees. The PE firm may even replace the founder and management team if it buys the company in a control sale – which they often do – and bring in a team they think can generate better results. At the very least, PE firms will streamline operations for maximum efficiency, which means wresting some power away from the franchisor and his/her team.
Typically, PE firms hold an investment in companies for a term of about five to seven years, after which time they may sell to another investment group. The frequent control changes can feel disruptive to franchisees who value relationships and predictability.
Venture Capital Firms
Like PE firms, venture capital firms look for companies to invest in. However, venture capital firms (VC) traditionally have invested in startups, small- and medium-sized companies with strong growth potential. VC firms usually do not seek to buy out companies, but may invest in up to 50 percent of the equity. They make smaller investments with their funds and spread them out over multiple startups. That way, if one startup fails, the firm does not experience a total loss.
Because venture capital investments are considered a high-risk/high return, your franchise startup should have a unique concept with excellent expansion and revenue potential in order to attract venture capitalists. While venture capital firms do not typically seek to take controlling stock of companies, they do want an active role, such as providing guidance and/or holding a seat on the board of directors.
Like PE firms, VC firms work for their investors and usually hold their investments for a limited amount of time – eight-10 years. When the VC firm exits a company, they take the company public to sell the stocks they own, sell to another company or sell back their shares to the company.
Wealthy friends or family members who are willing to invest in your startup are often referred to as “angel investors.” Because of the personal connection, angel investors usually offer friendlier terms than traditional lenders. Typically, they’re more interested in seeing you successfully get your business off the ground than seek a return on investment. But, that does not mean they don’t want something in return; they may ask for a percentage of ownership or convertible debt.
Keep in mind, angel investors are typically individuals, so the amount they can invest is often smaller than what a private equity firm, venture capital firm or institutional lender can provide. There’s some risk involved, too – your relationship with the angel investor can become strained if your franchise fails.
Be Prepared to Pitch Your Concept
Funding for franchisors can come in many forms, but in order to secure any of it, you must make sure your concept is going to succeed. Lenders and investors alike want to be assured that the business they’re providing franchise funding for is going to yield strong returns. Therefore, the planning stage is not something that should be rushed. Before asking for capital, you must be sure your concept is unique, proven and sound; you should know who your competition is and have conducted a competitive analysis; your business plan should include a timeline of steady growth; existing locations must be profitable – and much more.
For help deciding on the appropriate early-stage funding sources for emerging franchisors, turn to Winmark Franchise Partners. With 30 years of franchising experience and more than 800 franchise owners representing over 1,225 locations for five brands, Winmark Franchise Partners can you help grow your brand through sound strategy and expert franchising advice. Contact us here or at (844) 452-4600.