How to finance a franchise

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• Item 7 sets the amount you need to raise
• Franchise fees come off the top of every sales dollar
• Lenders judge the unit, and SBA requires the brand on its Directory
• Profit pays the loan, so test the unit's margin
• A new unit has no history, so projections carry the loan
• Read Items 19 and 20 before you call a lender
• A sequence that protects your money
• When a franchise loan is a bad idea

Item 7 sets the amount you need to raise

Item 7 of the franchise disclosure document sets the amount you need to raise. It estimates your initial investment: the franchise fee, real estate, equipment, inventory and extra cash for the early months. The extra cash covers at least three months, or a reasonable period for the industry (16 CFR 436.5(g)).

The FTC's consumer guide says you must receive the document at least 14 days before you sign or pay. Use that time.

Item 7 is an estimate. Budget for the high end of the range, then add living expenses. The FTC asks whether you have savings or other income to live on until the franchise opens.

Franchise fees come off the top of every sales dollar

Ongoing fees reduce cash flow before any profit exists. The FTC points you to Items 5 through 7 for initial and ongoing costs. Suppose the franchisor charges a 6% royalty and a 2% ad-fund fee. That is 8 cents of every sales dollar. On $1,150,000 of sales it is $92,000 a year, whether or not the unit earns a profit.

Lenders measure your cash flow after those fees. A projection that ignores them overstates what the unit can repay.

Lenders judge the unit, and SBA requires the brand on its Directory

Under SBA rules, a brand that meets the FTC definition of a franchise must be on the SBA Franchise Directory to obtain SBA financing. SBA updates the Directory weekly. A listing is not an endorsement of the brand, and it does not ensure the business will succeed (SBA).

The lender still does its own review. On a Standard 7(a) loan it must review the credit information the franchisor provides. Examples are the number of failed franchisees and the franchisor's cash flow projections (SOP 50 10 8.1, Sec. B, Ch. 1, Para. C.2.a).

The lender must also obtain your executed franchise agreement and any other document the franchisor requires you to sign. Reviewing the disclosure document is prudent, but SBA does not require the lender to keep a copy (SOP 50 10 8.1, Sec. A, Ch. 1, Para. G).

A loan approval is not a verdict on the brand. The FTC warns that bank approval of a franchise loan does not necessarily mean the franchise is a safe or good investment. It also warns that some franchisors give banks overstated profit projections.

Profit pays the loan, so test the unit's margin

Gross sales do not pay a loan. Profit does. The FTC notes that gross sales figures do not show a franchisee's actual costs or profits.

Suppose Item 7 totals $820,000 at the high end and you borrow 90% of it, or $738,000. Use a 10-year term at 10% for the arithmetic, not as a quote. The payment is $9,753 a month, or $117,033 a year. Suppose Item 19 reports average unit sales of $1,150,000. The margins below are after the royalty and ad-fund fees and before debt payments.

• At a 14% margin, the unit earns $161,000. Coverage is 1.38. The loan works.
• At a 10% margin it earns $115,000. Coverage is 0.98. The unit cannot pay the loan.

Four points of margin decide the deal. Ask the franchisor, and current franchisees, which margin is realistic.

A new unit has no history, so projections carry the loan

A new unit has no financial history, so projections carry the loan. SBA treats a business as a start-up if it has been in operation for 1 year or less. On a 7(a) loan a start-up needs equity of at least 10% of total project costs (SOP 50 10 8.1, Sec. B, Ch. 1, Para. C).

Expect the lender to compare your projections with what the franchisor discloses. On a Standard 7(a) loan, your projected coverage must reach 1.15:1 within two years of funding (Sec. B, Ch. 1, Para. C.2.a). A 7(a) Small loan of $350,000 or less uses 1.10:1 within one year (Sec. B, Ch. 2, Para. C.2.a).

Use the same $820,000 and treat it as the project cost. At least 10% is $82,000 in cash or other qualifying equity. Add six months of household costs at $6,000 a month, or $36,000, because the unit may not pay you at first. That puts the cash you need at $118,000. The FTC suggests estimating living expenses for up to two years, so treat $118,000 as a floor. These figures are assumptions for the arithmetic.

Read Items 19 and 20 before you call a lender

Item 19 holds any earnings claims. A franchisor does not have to make one, and the document must say so if it makes none (16 CFR 436.5(s)). A brand with no earnings claim leaves you and the lender guessing.

If there is a claim, ask the questions the FTC raises:

• Is the figure typical, and how many units reached it?
• Is it an average? A few very successful units can inflate an average.
• Does it show gross sales or profit?
• Does it come from company-owned outlets, which often have lower costs?
• Does it come from franchisees in your area?

Item 20 shows outlet counts for the last three fiscal years: opened, terminated, not renewed, reacquired, closed and transferred. It also lists current franchisees and some former ones. Call them. The FTC says talking to franchisees may be the most reliable way to check the franchisor's claims.

A sequence that protects your money

Follow the steps in order, and do not pay a deposit before step five.

1. Get the disclosure document. You must have it at least 14 days before you sign or pay.
2. Read Items 5 to 7 and add up every cost, including working capital.
3. Read Items 19 and 20, then call current and former franchisees.
4. Check the SBA Franchise Directory for the brand and for your agreement type.
5. Have an attorney experienced in franchise matters review the contract, and an accountant review the franchisor's financial statements. The FTC suggests talking to both.
6. Take your numbers to lenders and compare offers in total dollars.

When a franchise loan is a bad idea

• There is no Item 19 and no franchisee will share profits. You would be guessing at your income.
• Item 20 shows many terminations, closures or transfers. SBA lenders must review credit information such as the number of failed franchisees.
• The payment needs sales above what the average unit makes. Coverage that depends on beating the average is a bet.
• You cannot live on savings until the unit opens and turns a profit. The loan payment starts before the profit does.
• You are being rushed. The rule gives you 14 days with the disclosure document before you sign or pay. The FTC notes that franchise expositions can bring high-pressure sales tactics.
• Your agreement type may not qualify. SBA treats a master franchise (development) agreement as passive and not eligible. An area development or multi-unit agreement may qualify if you and your affiliated units are small (SOP 50 10 8.1, Sec. A, Ch. 1, Para. G). See the answer on area developers and master franchisees before you pay a deposit.