Long gone are the days when banks would lend money to anyone who could fog a mirror.
Since the credit crises occurred in 2008, entrepreneurs have found it more difficult to get the funding required to purchase a new franchise. Home equity loans, historically one of the more popular ways to fund a new business, are now seldom used due to the soft real-estate market.
Despite the tight credit markets, there are a variety of programs that make it possible to get the funding you need to purchase the franchise of your dreams. Recent changes in the SBA (Small Business Administration) loan parameters have made it easier to obtain smaller loans under $350k.
Every funding program has advantages and disadvantages. It’s important to know that the strategy you choose is appropriate for your individual needs. Every business is unique, and every entrepreneur has a different tolerance for risk. What works for one may not be acceptable to another with the exact same set of financial circumstances.
Because of these differences, it’s often advisable to have a trusted funding specialist review your goals and your financial situation. The specialist should then work with them to design a personalized funding strategy for your business. A well thought out, long-term strategy is particularly important if you are considering purchasing multiple units.
The ability to use your retirement funds such as an IRA or 401(k), tax-deferred and penalty-free, has allowed many entrepreneurs to purchase a franchise without even needing a loan. Another program that permits you to use the equity in your investment portfolio to secure a loan. It allows you to purchase a franchise without having to sell your investments.
Let’s look at a few of the more popular funding options.
In recent years 10% of all franchises sold in the US used this type of funding.
Many people believe you can only use your retirement funds to purchase investments like publicly traded stocks, bonds, or mutual funds. In fact, you can use most retirement plans to purchase a business tax-deferred and penalty-free.
When it comes time to arrange funding for a new franchise, many entrepreneurs turn to their savings, which are more often than not, locked away in retirement plans such as an IRA or 401(k). If an individual withdrawals money from one of these plans, they may be subject to severe penalties and tax consequences.
For example, if you take an early withdrawal from a $300k IRA or 401(k), you may be required to pay a 10% penalty, plus as much as 30% in state and federal income taxes, leaving you with only $180k of your original $300k. Losing $120k of your savings to taxes and penalties before you even open your doors is not the best way to start a new business.
However, a popular program known as a Rollover for Business Start-Up (ROBS) enables you to use your retirement funds to purchase a business without paying any penalties as well as deferring the taxes. In the above example, this program would allow you to retain the full use of your $300k savings to start your business.
This program has other benefits as well: You are not borrowing money or applying for a loan and your credit score is not a factor. If your savings are sufficient, it can eliminate the need for a loan and the associated monthly payments. It can also provide you the ability to pay yourself a salary until your business becomes profitable, and it can be used to provide capital for the equity injection on an SBA loan.
If you are considering using your retirement funds as part of your funding strategy, it’s important to work with a company that specializes in this field and has the experience and expertise to ensure your plan remains compliant with current IRS and Department of Labor codes and regulations.
An SBA loan is the most common type of loan for purchasing a franchise. Because the SBA provides up to an 85% guarantee to the bank, they are more willing to assume the risk of lending money to a start-up business. It’s a common misconception that the SBA approves loans. The SBA only provides a guarantee to the bank; if the bank is a PLP lender (Preferred Lender Program) then the bank is still the entity approving the loan.
A bank will typically require you to provide 20% to 30% of the total cost of the business and the needed working capital. For example, if you need $150k to purchase your franchise and $50k in working capital, for a total project cost of $200k, the bank would want you to put $40k to $60K towards the project and the bank would provide a loan for balance. In addition to the capital injection, the bank will require some form of collateral. This can be a combination of business and personal collateral such as the equity in your home, real estate, or other investments.
Banks all differ on what criteria they focus on when deciding whether or not to approve a loan. These parameters are known as the bank’s credit box. Some banks place more emphasis on your credit score, other banks may be more interested in the amount of collateral you can provide. Some banks may avoid certain industries because they already have enough exposure to that industry in their loan portfolios.
Knowing a bank’s credit box can avoid the frustration of applying to a bank that will have little or no interest in approving your loan. This is one of the reasons many entrepreneurs choose to use a loan consultant to help them obtain an SBA loan. A good consultant will know which banks will have an interest in your loan application and will only apply to those banks, thereby increasing your chances of a quick and painless approval. When you are preparing you loan application you will need to include a comprehensive written business plan, three years of tax returns a personal financial statement and a personal resume.
Many entrepreneurs look to their investment portfolios when comes time to buy a franchise. While selling your stocks or bonds can be a quick and easy way to buy a business, depending on your goals, it may not be the best strategy.
Selling your investments will trigger taxes such as short-term capital gains which are taxed as ordinary income or long-term capital gains which are taxed at a rate as high as 20%. In addition to the tax consequences, selling your investments can often disrupt carefully designed asset allocation strategies.
Securities-backed loans are an attractive alternative to selling your investments. This type of loan is similar in concept to a home equity loan, the difference being that the loan is backed by securities held in your investment portfolio rather than the equity in your home. By utilizing this type of loan, the funds needed to purchase your franchise can be obtained without disrupting a carefully constructed investment plan, asset allocation strategy, or creating unexpected tax consequences.
Because the investments remain in your name, you still benefit from all the portfolio’s appreciation and dividends as your portfolio grows. Because the loan is fully collateralized, your credit score is not a factor, and the interest rate is typically lower than a comparable SBA loan. Depending on the type of securities in your portfolio, you can borrow 70%-90% of your portfolio’s value. With these advantages, more and more entrepreneurs are choosing not to sell their investments, and instead using this strategy to fund their business needs.
These are just a few of the many options available to fund your new franchise. Whichever program you choose, you need to be sure you have enough capital to cover not only the startup costs of your business, but also enough working capital to fund the business until it reaches positive cash flow.
Under capitalization is one of the most common reasons businesses fail. An experienced funding expert and a carefully constructed business plan can help you create a customized funding strategy that will provide you the funding you need and help ensure the success of your business.
Benetrends has been helping entrepreneurs fund businesses with a comprehensive suite of option. If you are interested in learning more, download Innovative Funding Strategies for Entrepreneurs.