FINANCING A FRANCHISE
By Gina Petrone

One of the major challenges any potential franchisee will face is financing. In the late 1930's in Chicago, my great uncle Stephen owned a bank. One day, a fellow Czechoslovakian by the name of Ray Kroc submitted a loan application for a business he wanted to start. My uncle turned him down. No, it wasn't for the concept that became McDonald's and the loan documents have long been destroyed. Still, it illustrates the point that finding financing is an obstacle that every one who dreams of business ownership faces at one time or another.

Start-up costs for franchises range from a low of $5,000 to a high of more than $50,000. In some cases the franchisor will assist with financing, but generally that is left to the buyer. Five steps will assist you in qualifying financially:

Determine Your Net Worth

Net worth is figured by determining your assets and liabilities. Most banks or lending institutions have a printed form to assist individuals in preparing this analysis.

Determine Your Credit Potential

Some loan officers recommend that potential buyers of a business carefully consider the basic components of credit analysis (or the Five C's) which are:

* Capacity to repay is the most critical of the five factors. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships--personal or commercial--is considered an indicator of future payment performance. Prospective lenders will also want to know about your contingent sources of repayment.

* Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Prospective lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding.

* Collateral or guarantees are additional forms of security you can provide the lender. Giving a lender collateral means that you pledge an asset of your own, such as your home, to the lender with the agreement that it will be the repayment source in case you can't repay the loan. A guarantee, on the other hand, is just that--you and/or other individuals or businesses sign a guarantee document promising to repay the loan if liquidation of collateral is insufficient to repay the outstanding balance, including the lender's collection and liquidation expenses. Some lenders may require such a guarantee in addition to collateral as security for a loan. All SBA-guaranteed loans require the personal guarantee of shareholders of 20% or more of the business.

* Conditions focus on the intended purpose of the loan. Will the money be used for purchase of real estate, construction, equipment, inventory or working capital? The lender also will consider the local economic climate and conditions both within your industry and in other industries that could affect your business.

* Character is the general impression you make on the potential lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be reviewed. The quality of your references and the background and experience levels of your employees also will be taken into consideration.

Develop a Business Plan

Before going to a lending institution, prepare the following in written form:

* A resume of your past business experience. Include past positions held and any management experience.

* An estimate as to what you expect your income and expenditures to be for the first year of your business.

* A marketing plan that outlines how you will generate business.

Consider Carefully the Major Sources of Financing Available to You

* Friends and relatives

* Banks

* Second mortgage on home, savings and loan institutions

* Borrowing against insurance, stocks and securities, or a loan from the Small Business Administration.

Select the Most Probable Source of Financing Available to You

* Take your business plan with you.

* Be prepared to discuss the five C's of credit.

* Have available your statement of net worth.

A Sample Business Plan Outline

A.

• A description of the business
• Brief description of the franchise
• Nature of the business

B.

• An analysis of the competition
• What other businesses will be your competition

C.

• Reasons why this business will succeed
• Location
• Population factors
• Other similar businesses that offer a comparison

D.

• Methods for generating business
• How you will sell your product or service
• Special advertising or marketing methods

E.

• An estimate of income/expenses for a 6-12 month period

F.

• A resume of your past business experience.

How Fees and Royalty Payments Work

Most franchises--especially entire business system franchises--require monetary contributions by franchisees consisting of some or all of the following: An initial franchise or license fee; training costs (tuition and/or room, board, and transportation) and on-site start-up aid and promotion charges (some or all of which may be included in the initial franchise or license fee or may in whole or in part be separately stated); periodic royalties or service fees and an advertising contribution (usually payable monthly or weekly and based on a specified percentage of sales).

Sometimes there is a charge for centralized bookkeeping, accounting and data processing services. There may also be initial payments for premises, equipment, supplies and opening inventory, if acquired from franchisor. If acquired from other approved sources, the payment for them is nonetheless part of your initial opening cost. Get specific details on all cost items: amount, time of payment, financing arrangements. Terms like "initial cost", "initial fee", "total cost" and royalties should be specifically defined and made quite clear to you.

The terms "cash required", "initial cash required", "investment", "down payment" and "equity investment" mean different things in different offerings. "Initial fees" probably do not include any equipment or product inventory down payment. Make certain your investigation is complete and your understanding clear in the following areas:

(a) Initial license fee

* Is there one? How much is the total fee? Is it payable in a lump sum or in installments? If in installments, with or without interest? Is it refundable? Is it nonrecurring?

* If the initial license fees are not the same for each franchise concurrently granted, on what factors are the differences based?

* Does an initial license fee include compensation in full for any or all of the following? Does it include use of the then current operation manual, training and start-up aid, including personal on-site and promotional assistance, at franchisor's cost? It does not in many cases. The understanding should be clear, the contract explicit.

(b) Continuing regular fees

* Are there periodic royalties? How much are they? How are they determined? In business format franchising, generally, there is a periodic royalty (usually payable monthly or weekly) commonly based on a percentage of sales.

* How and when are sales and royalties reported and royalties paid?

* Royalties are not only payment for use of a trademark and trade name (and, where available and applicable other commercial symbols, patents or formulas) but may also constitute a fee for services to be performed by franchisors. If the periodic payment is in part a service fee, what ongoing services are you to receive from the franchisor? Are accounting services included or available? Are they computerized? Will updated merchandising services, operating manuals and training be furnished without additional, or at nominal, cost?

(c) Other fees

What other fees and charges, if any, are payable (for example, advertising and promotion)?

(d) Total cost

Do not confuse "initial fees", "initial cash required", "initial investment" or "initial costs" with total costs. Initial cost or initial investment may require computation and inclusion of some or all of the following, in addition to initial franchise or license fees and royalties, concerning which inquiries should be made:

* Are you required to purchase or rent business premises? Who finds the site? What is its cost to you as purchaser or lessor? How is it to be financed, if purchased?

* Does "initial cost" or investment include an "opening" inventory of products and supplies; a down payment on equipment and fixtures; a lease security payment, or all or part of the franchise fee? What amount is attributable to each such item?

* Don't confuse down payment or initial cost with ultimate cost. What are deferred balanced? Who finances any deferred balanced? At what interest? If the franchisor doesn't, is help in finding a source of financing offered? Have you receive commitment for financing offered? Have you received commitment for financing before committing yourself? May you seek competitive financing sources or is use of the franchisor or its designated source mandatory? (It should not be).

* What, if any, are construction, remodeling and decorating costs, security deposits, if any, and initial equipment and inventory requirement costs?

* In determining total costs, check every aspect of the deal. Do not overlook the cost of finding, buying or leasing, and improving and equipping a business location, and obtaining zoning licenses for the operation at that location and the financing costs involved. In determining total opening costs, do not overlook working capital and rent (where applicable), inventory, payroll, insurance, and your own promotions and salary during the first year. Know what your monthly debt service will be under your deferred payments financing.