Unlike the venture capital industry, that provides equity investments in technology startups, the most common source of funding for a franchise is debt.  The reason is that debt is the least expensive form of investment compared to buying shares in a company for a piece of ownership.

The old saying – “There is more than one way to skin a cat.”  That same expression applies to debt financing – there is more than one way to fund a business.  At its core, there are three different forms of debt, ranked in order of priority or who gets paid first.  This becomes relevant if you default on all of your debt at once — such as if you file for bankruptcy or decide to dissolve your company.

3 Forms Of Funding

  1. Senior Debt – Senior debt is borrowed money that a company must repay first if it goes out of business. Each type of financing has a different priority level in being repaid if the company decides to liquidate. If a company goes bankrupt, senior debtholders, who are often bondholders or banks that have issued revolving credit lines, are most likely to be repaid. [Investopedia]
  2. Mezzanine Debt – Mezzanine debt occurs when a hybrid debt issue is subordinated to another debt issue from the same issuer. Mezzanine debt has embedded equity instruments attached, often known as warrants, which increase the value of the subordinated debt and allow greater flexibility when dealing with bondholders. [Investopedia]
  3. Equity – A stock or any other security representing an ownership interest.  When a business goes bankrupt and has to liquidate, the amount of money remaining (if any) after the business repays its creditors. This is most often called “ownership equity” but is also referred to as risk capital or “liable capital.”  [Investopedia]

Characteristics and Use Cases Of The 3 Forms Of Funding

Type of Funding Example/Characteristic Use of Funds
Senior Debt
  • Revolving/Line of Credit
  • Term Debt/Notes
  • Letters of Credit
  • Secured or unsecured
  • Lowest interest rate
  • Working Capital
  • Equipment/asset purchases
  • Facilities expansion
  • Inventory
  • Balance Sheet Management
  • Receivable Management
  • Growth/acquisitions
Mezzanine debt
  • Subordinated/junior Debt
  • Higher Interest Rates
  • Warrants
  • Unsecured debt or “Last Out” debt
  • Multi-faceted instruments
  • Growth/Acquisitions
  • Recapitalizations
  • Management Buyout
  • Liquidity (partial or full)
  • Intergenerational transfer
Equity
  • Common Stock
  • Preferred Stock
  • Options
  • Last on capital structure
  • Can include interest
  • Can have multiple classes
  • Aggressive expansion
  • Significant acquisitions
  • Incentive Options
  • Liquidity (partial or full)
  • Change of Ownership

The initial costs associated with opening a franchise include the franchise and advertising fee, paid to the franchisor.  The additional cost that goes into the entire investment in an opening a franchise – rent, utilities, equipment, inventory, signs, real estate developments, training, and licenses.  The cost of each opening of a franchise may vary.  The franchise fee ranges from $20K up to $100K for high-end franchise brands.  The total capital investment could range from $10K for a mobile/stay at home business to a $5M for a high-end hotel.  The average franchise cost ranges from $50k-$200K according to Franchising.com.

The expenses are normally financed with an SBA loan, 401(k) plan, home equity loan, savings, credit cards and/or family & friends.  Laura Novak Meyer, Founder of Little Nest Franchising Group, which is a photography studio, states that majority of her franchisees utilizes an SBA loan, home equity loan or credit cards to finance one of her photography studios.

An SBA Loan is not exactly a loan, rather a flexible loan program that provides guaranteed financing for startups and existing small businesses through commercial lending institutions.  In other words, the SBA helps banks to offer loans to risky startups and small businesses by guaranteeing the note if the company defaults.  This is an example of senior debt, which has a low-interest rate and has to be paid first if the company goes into bankruptcy.  However, it is very difficult to obtain.  There is a lengthy application, collateral and waiting for approval from the underwriter.

However, using your savings or family & friends is quicker but it may cost you more in the long run.  Just make sure you evaluate the pros and cons of each funding source prior to raising capital for your business.  As a small rule of thumb, the quicker and easier it is to obtain capital the most costly it will be.