Should you borrow to invest in a franchise?

Franchise financing options are plentiful. But should you finance a franchise purchase with borrowed money?

Pros and cons of franchise financing

Credit is a way of life. Especially for major purchases, like a home or a car. So why not borrow to buy a franchise, and use other people’s money to build something of real value? A business that will pay you a wage and bank profits for your future?

Should you borrow to become a franchisee?

Franchise financing is available

Before we examine the pros and cons of franchise financing, let’s take a quick look at how you could finance your franchise investment.

If you don’t have the cash to finance all your investment, there are several ways you can access extra funds. These include traditional loans and modern methods of raising cash. Here are the main types of funding available:

·         Franchisor financing

If the franchisor believes in you, they may be willing to offer financing to help you buy a franchise business. This type of financing is the most common for franchise investors, and has the advantage that the franchisor knows exactly how much you will need.

·         Business loans

You might fund your business with a business loan from a bank, repaying it with interest over the term of the loan. You’ll need to supply your business plan and your personal credit history. The better your credit history and business plan, the lower your interest payments are likely to be.

·         SBA loans

SBA loans are backed by the U.S. Small Business Administration. However, they are offered by banks and other institutions in a similar way to traditional business loans. One thing to be aware of if you are considering an SBA loan is that the application process is rigorous and long.

·         Crowdfunding

Crowdfunding is becoming more popular as a funding option to start a business. There are online companies that offer crowdfunding opportunities for businesses, or you may decide to set up your own crowdfunding page.

·         Friends and family

For some business investors, borrowing from friends and family is a step too far, but it remains one of the most common ways to raise the extra funds you may need if you are short of what is required. Just be careful to repay your ‘loan’ and not fall out with those you love.

Why you should borrow to fund a franchise purchase

Now you know the most common forms of franchise funding, is it a good idea to borrow money to start your business? Here are the advantages of doing so:

·         How you spend your money is up to you (usually)

If you borrow from a bank, how you spend the money is your choice. You won’t have an investor breathing down your neck, telling you what you can do. That might not be the case if you borrow from friends and family, or the franchisor – though, the franchisor, of course, knows how you should be running your business, and you will be expected to stick to their formula and business model.

·         Reasonable interest rates

Business loans usually have lower interest rates than most other types of debt.

·         Repayments can be planned

With known repayments to make, you can plan for these in your business plan and financial forecasts.

·         It helps you access profits

Without financing your franchise, you wouldn’t be able to buy it. And the profits it makes will line someone else’s pocket.

Why you shouldn’t borrow to fund a franchise purchase

There may be a few good reasons to finance a franchise by borrowing, but there are at least as many reasons not to. These include:

·         Security/collateral

A bank is not going to lend you money unless they believe it is likely to be repaid. It’s critical that you have a strong business plan (though this is something you should have before starting a business, in any case).

No matter how solid a business plan you have, the bank is most likely to want some security against the loan. That probably means putting your home on the line. If your business goes belly up, you’ll lose the roof over your head, too.

·         More difficult to borrow later

Your business loan may be secured by your business. No matter how much you have repaid, this means that you won’t be able to offer any part of it against a further loan – making it more difficult to raise funds later if you should need to.

·         Free cash isn’t available to invest

The business is doing well. It’s profitable. But you want to invest to expand. The problem is that you have no free cash to invest – most of your profits are paying the interest on your business loan.

·         The loan must be repaid, even in poor months

Most lenders don’t care whether your business makes money or not. All they care about is that you make your repayments on time. In good months, part of your profits will go toward repaying the loan – meaning you earn less.

In poor months, you won’t have the flexibility to put payments on hold. And that could harm your income and ability to sustain your business.

Boost your cash returns by self-financing your franchise purchase

Most of the franchisees we help self-fund their franchise purchase from cash in the bank, releasing part of their 401(K) or other options available to them. And there are good reasons for doing so. Not least of which of the boost to your cash returns.

Let’s take the example of buying a franchise using a business loan of $100,000:

  • You pay an interest rate of 7%, with a loan term of 10 years
  • Your monthly repayments are approximately $1,150
  • The business makes a profit of $2,500 per month, or $30,000 per year, before loan repayments

After 10 years, you have banked $162,000 in profits, and the loan has been repaid. Your home has been at risk throughout.

Now, if you had used your own funds to purchase, you have not risked your home. And the profit you make? $300,000. Almost double the profit you would make by borrowing to purchase.

(Remember, this is an example only, and has been simplified for illustration purposes. The financial dynamics of each franchise purchase depends upon the franchise considered and your own unique situation.)

We’re not saying that it’s wrong to seek franchise funding, but in our experience the best franchise investments are made when you have the funds to do so – though of course, there are some notable exceptions.

Whatever your financial circumstances, if you are considering life as a franchisee, get in touch with New Ground Consulting. Your success is our success – which is what has made us so successful.

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