Amie

Hello and welcome. My name is Amie Larter and this is the Buying a Franchise podcast, vital listening for anyone interested in buying or that’s in the process of buying a franchise. Now there are plenty of options for funding a franchise today and it’s something that has popped up on the pages of Franchise Business quite frequently.

I’m here with Franchise Business editor, Sarah Stowe, to discuss some of these options. Things like borrowing from family, mortgaging your house are common topics raised. And while this podcast is certainly not providing financial advice by any means, please seek independent advice, anyone and everyone listening to this, I am interested in discussing some of the regular themes coming through from readers around funding a franchise. Sarah, let me start by asking, can you buy a franchise without putting in some of your own money?

Sarah 

It’s a good question and it’s very unlikely really because franchisers want to see that as a franchisee you’re prepared to risk some of your own money to make the business work. It’s called skin in the game and it makes sense. People want to know that you’re taking the risk on your own. So typically purchases are made with a mix of savings and loans.

Amie

Yeah, well, and it makes sense, right? They want to see your personal investment. So the family home is often used as collateral, but should you mortgage it to take on a business? What are the arguments for and against this?

Sarah 

Well, a loan secured against your home can be a cheaper form of borrowing. Obviously, it depends on the economic circumstances, but that’s a kind of general rule. So not only are the interest rates lower than a credit card debt, for instance, but the interest can be deductible, tax deductible in the business. But it’s important to consider the full cost of the loan as part of your business investment. Remember that there will be monthly loan repayments that add on to the cost of operating the franchise. So the business revenue must be able to cover these costs. 

And there is always the possibility that you may not be able to keep up the payments. And that’s something that anyone taking out a loan has to consider. If you can’t afford your mortgage payments and you own a franchise, the worst case is that you may well have to sell your home in order to reduce the financial burden. 

There is another consideration. You might be left with a debt once you leave the franchise. So if you say increased your current home loan by $200,000, but in the, say the three years that you have the business, you only managed to repay 100,000 of that. When you sell your business, you’re going to end up with more mortgage debt than you started with. The disadvantage there of course, is that you have no business income that’s going to finance that extra cost, that extra loan. So it’s really important to think through the consequences of using a family home as collateral.

Whether that’s your own home or a family member who is putting up the house of security, it’s very common, but it is something that has to be considered very sensibly with the pros and cons.

Amie 

Most definitely and probably as we said earlier with that, with that financial advice, to be honest. And yeah, so what’s the alternative to mortgaging your home to buy a franchise?

Sarah 

Absolutely. There are several alternative sources of finance. There are personal savings, and that can come simply from people having saved. It could come from investments that they’ve withdrawn. Family money, opportunities for an unsecured loan or a credit card, which we’ve kind of mentioned in terms of higher repayments. And asset finance is another option. That tends to be something that is used to lease equipment or perhaps do a refit for a store, it’s not usually funded, it’s not usually funding the purchase outright, it’s part of the process of opening the business. It might be worth considering a combination of these to fund a franchise purchase rather than just looking at one option.

Amie

Makes sense. So you did mention that the economic climate does play a part in weighing up these particular options. How would you describe the funding environment right now?

Sarah

Well, I think everybody’s finding it, everyone’s finding things tough. Businesses are finding repayments are difficult. Home loans have gone up. You know, rent’s gone up. Everyone is, I think, struggling in terms of making the money that they were previously. Obviously, if you’re going into business, you need to take that into account. But you’re going in with a much longer viewpoint than just the next sort of 12 months. And what I am hearing anecdotally is that banks are once again [supporting] franchising.

And that typically means that they will partially fund a franchise purchase price. It varies according to the particular institution, but it will be a set percentage that they’re prepared to give you. Of course, what they’re looking for are credit-worthy franchisees, and they will inevitably favour businesses that are part of an established franchise system with whom they already have a relationship and one that will provide them with the relevant information, that is quite kind of transparent, where they don’t have to do too much work. If the franchisor is providing information for them, that makes it a whole lot easier. 

But it’s not always possible, it may not be the preferred option to turn to a bank. Some franchise buyers approach alternative lenders and this is an increasingly busy space. Lots of these funding institutions are geared up for loans to existing businesses though it is more challenging to source a loan to fund a franchise purchase from an alternative institution.

So that means that many would-be franchises also turn to family members for a loan when they’re raising money for a business. Families, I suppose, most commonly step in when there’s a shortfall between the money raised and the cost of the franchise. Although there are occasions where they may provide the whole upfront cost.

Amie 

That’s, you know, an awesome situation for them to be able to be in. So what are the pros and cons of tapping into family funds if it’s an option for you to purchase, to help purchase your franchise?

Sarah 

Yeah, and what’s commonly called the bank of mum and dad, I guess, is likely to be more cost effective option than a bank loan. And the borrower is usually paying a lower interest rate. I mean, that’s set between the two parties and it doesn’t come with the extra costs that you would associate with a bank loan. Of course, the loan has to make sense for the family members who are lending the funds, but it’s quite possible that they will earn a good interest on their investment, even if they charge less than the bank rate. 

There’s another clear advantage and that’s that families typically adopt a more flexible approach to repayments. So there are different ways of providing the money and there’s a whole suite of repayment options. The loose arrangements could be interest free and a bit of a ‘pay me back when you can’ approach, but other families might take a more structured and linear approach.

There’s also the option for family members to become shareholders in the business. And that means that they’re not technically lending money. But there is a caveat that there is a share in the responsibility if the business venture fails.

Amie

Okay and so what are the potential downsides to this type of arrangement?

Sarah

There’s a number of red flags and I mean it’s more of a kind of consideration than a you know’ don’t do’. It’s just something that needs to be considered. I think perhaps the first thing that people would think of is you know what happens if the franchisee who’s taken out the family loan if you like struggles to make the repayments. One side effect could be extra emotional pressure so on top of the you know the financial commitment to having to make these repayments. There’s the stress of perhaps letting down the family. And if there’s a risk that the family could lose its investment, that really does put a big strain on the family relationship. It is, it’s difficult, it’s difficult. So, I mean, I think the other thing is that if the banks have refused to lend money, there is actually a reason why. And so that should alert the family to look closely at the business opportunity. 

Amie

Yeah, it’s a little close to the home.

Sarah 

It doesn’t mean that they won’t necessarily go ahead with it but you need to take a very careful look at what the options, why the bank might have rejected a loan. So it could be that there’s perhaps less value in the business if there’s a limited time left on the premises lease. There might be old equipment that needs a lot of capital expenditure to replace it. There could be all kinds of reasons but it’s important to take that close look at why the bank might have rejected the opportunity.

Because at the end of the day, it doesn’t matter how good and committed you are as a franchisee, if the situation is kind of stacked against you, you’re starting behind the eighth ball, if you like, it’s going to be very hard to actually kind of pay back the investment.

Amie 

Yeah that makes sense and so in your perspective, Sarah, what’s sort of the worst case scenario here supposing that the business fails?

Sarah 

I suppose the worst case scenario actually is kind of the emotional. On one side it’s the emotional side of having to kind of deal with the fallout in the family and it is a risk that the business is going to fail no matter how hard, as I’ve said, everyone works on the business. Of course if it does fail and you’re unable to pay off the creditors, the franchisor and the bank, and you probably will have a bank loan to some degree, will have security over the business and priority over family members. It has been suggested that family members can take security for the loan and that does give them a better prospect of recouping some of the investments. So a personal guarantee does give them the power to enforce payments, but that means you’re taking a hard line. And that might be something that families don’t want to go down that path. There’s also the question of how involved family wants, who, which is the family members who are lending the funds want to be in the, in the business decisions.

I do know of one franchisee couple who’s helped fund their son into his own business by covering the cost of say the initial stock purchase. And through their agreement, you know, they had complete access to business financials and they could keep an eye on the profit margins and had regular meetings so they’re able to stay on track. And the loan was repaid sort of within two years as agreed. So that’s, you know, a sign of success.

But then another option is for the family to risk their own assets. We’ve talked about mortgaging your home. The family could provide third party security to the bank, either with a personal guarantee or by taking out a second mortgage on their home. You know, if the incoming franchisee doesn’t have that capacity, isn’t a homeowner, that might be something that the family is prepared to do.

But again, it…You’ve kind of got to go into those things with your eyes wide open and have a clear understanding and having taken financial advice as to what the best option is, because you need to be aware of the risks involved in whichever option you pick.

Going into a business undercapitalised is a risk, so it’s important to be you know cash flow, realistic about your cash flow projections and your options and the business needs to be stress-tested so that you understand what the potential is for the business to kind of repay back, to pay back the loans whatever nature that is. But the bottom line I think is that every loan should be well documented.

Amie

Definitely.

Sarah

And it can be registered under the personal property security act and that gives family members a little bit more security The other really crucial thing I think is that emotion, you’ve got to take emotion out of the equation Because it’s important that families retain a good relationship no matter the outcome of the business And I think one really obvious benefit with family funding is that there’s a huge emotional satisfaction that comes from a family backing a relative’s initiative and hopefully seeing it succeed. So that’s absolutely positive, but I think again, it comes down to speaking to financial expert to review your options and discuss the best solution for your personal circumstances.

Amie

All right, that makes sense. And thanks so much, Sarah, for talking us through the different types of ways that franchise buyers are funding that purchase. In the show notes below, we’ve got links and references. If you want to follow this further and get more in-depth information before you continue your journey to buy a franchise or if you’re some way into your franchise search, you might be ready to check out the franchise handbook that’s available on our website, practical tips that can help you navigate the journey smoothly. 

Visit franchisebusiness.com.au for more information. We hope you can join us on another Buying a Franchise podcast. Thanks for listening.