There are many steps that need to be taken before diving into the complex task of buying a franchise, the first of which is to check your current credit score. The best place to do this is at CreditKarma.com. This service is completely free and no credit card is required to sign up.
Your credit score is determined by a number of factors: length of credit history, current debt, number of pending credit inquiries, etc. Typically, the higher your credit score is, the more likely you are to get approved for additional credit. Credit scores can range anywhere from 300 to 845. (This useful Credit.org infographic explain what each score range means.)
Once you’ve established that your credit score is good, you can apply for a small business loan. One of the most popular ways to do this is through the Small Business Administration’s 7(a) loan program. The SBA 7(a) program does not directly loan money to businesses; instead, the SBA guarantees only a part of the loaned amount. These loans can range anywhere from $5,000 up to $5 million with a prime 2.75 percent interest rate over the course of 5 to 10 years.
Collateral, on the other hand, is determined by your credit worthiness and the loan amount that is requested. Needless to say, it’s highly unlikely that anyone will receive 100 percent financing, regardless of how pristine your credit score may be.
The SBA also reviews the franchisor thoroughly to ensure they meet all the SBA lending guidelines. The SBA has traditionally looked unfavorably at those franchisors that exert strict controls on the franchisee.
The next option to finance your business is a home equity loan, in which your home is used as collateral. The benefits of this are low cost, quick turnaround, and generally low interest rates. Here, the lender is calculating the loan-to-value ratio, which is the amount you owe less the equity.
Unsecured loans where equipment is used as collateral typically carry higher interest rates. Security-backed lending is when CDs, stocks, bonds, and other securities (outside of retirement plans) are used as collateral. Here, up to 70 percent of the security value can be loaned, with usually low interest rate and a fairly quick turnaround.
Another viable funding alternative is a 401(k)-IRA Rollover Plan, in which your franchise can be started with retirement funds rather than SBA loans. This generally carries a 10-20 business day turnaround, but since it’s a tax-, penalty-, and debt-free funding resource, it’s worth the wait.
This option is structured as an “investment” as opposed to a loan, meaning you have the ability to make a profit much sooner. We have seen higher success rates using this funding approach, which will not affect the debt ratio or credit rating. There are a number of exit strategies and tax benefits built in, and you can also receive a salary from the funds. This product was built to help bridge the financial funding gap between SBA funding and other funding options, as mentioned above.
Each franchisee will need a specific analysis to determine his or her best funding options. This is a complex matter that deserves the attention of experienced professionals who work directly with franchise lending. My best advice is to begin the process early so you can perform your due diligence to make an informed and educated financial decision.
For more information, be sure to check out Improve Your Chances of Getting Franchise Funding.