Franchise financing refers to the means by which an aspiring or current franchise owner obtains money to start a new franchise, purchase an existing franchise or bring money into an existing franchise to fund current or future business activity. There are many ways to finance a new or existing franchise, each of which has its own pros and cons.
Traditional Franchise Financing Options – Franchise Funding Sources:
There have traditionally been two options available to aspiring or existing franchise owners looking to finance their franchise: borrow funds (debt financing) or sell ownership interests in exchange for capital (equity financing).
1. Debt Financing
The principal advantages of borrowing funds to finance a new or existing franchise are typically that the lender will not have any say in how the franchise is managed and will not be entitled to any of the profits that the franchise generates.
The disadvantages of debt financing include the following:
- The required loan payments may be burdensome, and especially so for new or expanding franchises.
- Failure to make required loan payments will risk forfeiture of assets (including possibly personal assets of the franchise owner) that are pledged as security for the loan.
- The credit approval process may result in some aspiring or existing franchise owners not qualifying for financing or only qualifying for high interest loans or loans that require the pledge of personal assets as collateral. In addition, the time required to obtain credit approval may be significant.
- Excessive debt may overwhelm the franchise and ultimately risks bankruptcy. For example, a business that carries a heavy debt burden may face an increased risk of failure.
The sources of debt financing may include the franchisor (i.e., the company offering the franchise), conventional lenders (banks, credit unions, etc.), friends and family, small Business Administration (SBA) loans, home equity loans and personal credit cards.
2. Equity Financing
The principal practical advantage of selling an ownership interest to finance a new or existing franchise is that the franchise may use the equity investment to run the business rather than making potentially burdensome loan payments. In addition, the franchise and the franchise owner(s) will typically not have to repay the investors in the event that the business loses money or ultimately fails.
The disadvantages of equity financing include the following:
- By selling an ownership interest, the franchise owner will dilute his or her control of the franchise.
- The investors are entitled to a share of the business profits.
- The investors must be informed of significant business events and the franchise owner must act in the best interests of the investors.
- In certain circumstances, equity financing may require compliance with federal and state securities laws.
The sources of equity financing may include friends and family, angel investors, and venture capitalists.
Alternative Franchise Financing Options – Franchise Funding Sources:
While there are several forms of alternative franchise financing options, most of these options are simply variations of debt and equity financing (e.g., crowd-funding and peer-to-peer lending). The ability to use retirement funds to finance a new or existing business offers a new type of small business financing/franchise funding source.
Rollover Retirement Funds to Start a Franchise or Finance an Existing Franchise
A lesser known but well-established means for entrepreneurs to finance a new or existing franchise is to rollover their 401k, IRA or other retirement funds into their franchise. This financing option is sometimes referred as “rollover as business startup,” “401k small business financing,” “ROBS financing” and “retirement owned business (robs).” It should be noted that this option does not consist of the franchise owner taking a loan from his or her retirement account.
This franchise financing option allows the franchise owner to obtain the benefits of debt and equity financing (including retaining control of the management and ownership of the business) while avoiding the disadvantages such as burdensome debt payments. Given these benefits, it is not surprising that over 10,000 entrepreneurs (including many franchise owners) have used their retirement funds to finance their start-up businesses.
While the benefits are clear and the IRS has clearly stated that the use of retirement funds to finance a small business is not “per se” non-compliant, this strategy requires compliance with technical requirements (e.g., see discussion of the technical requirements here). As such it is essential to employ experienced professionals to assist with this small business financing strategy.
To learn more about using funds in your 401k, IRA or other retirement to finance your franchise please visit MySolo401k.net or call 1-800-489-7571.