Financing Through Franchising and Employee Financing
When searching for financing, looking to franchising opens you up to over half a million franchisers throughout the U.S. And don't forget your own employers can be a valuable source of financing.
Franchising is the transfer of the right to sell a trademarked product or service through a system prescribed by a franchisor, who owns the trademark.
Franchising has been one of the fastest growing areas of new business development during the last 15 years. There are currently over half a million franchise businesses in the U.S. While traditional franchise businesses such as gasoline stations, auto dealers and soft drink bottlers continue to grow, the most rapidly expanding industries for franchises are service businesses involving recreation and leisure activity and business services.
Franchise arrangements are usually either:
- product and trade name franchises or
- business format franchises
The former involves product distribution arrangements within a specified geographic territory. For example, a gas station can be a product and trade name franchise. A business format franchise includes not only a product and trade name, but also operating procedures such as facility design, accounting and bookkeeping procedures, employee relations, quality assurance standards and the overall image and appearance of the business. For instance, restaurants and convenience stores are often business format franchises.
For the franchisee, franchising is a way to reduce the risks of a new business by buying into an established product or concept. For the franchisor, franchising is a way to expand your business more quickly, by sharing some of the costs, risks and rewards with franchisees.
Franchising for the Franchisee
A primary advantage of franchising is that you can reduce the risks associated with a new business by buying into an existing business that has established goodwill and a marketable reputation. While purchasing a franchise may often be a more expensive way to start a business, franchises can also provide a "blueprint" for business operations that's especially valuable if you don't have much experience in the type of business you want to start.
The conventional wisdom is that franchised businesses have a much greater likelihood of success than independently started firms. However, some recent studies have reached an opposite conclusion. It's probably safest to say that the jury is still out on this one.
Using Franchising as a Source of Financing
Franchising can be a form of capital financing, and franchisors may offer financing assistance in securing fixed assets and occasionally even working capital. For example, where real estate and building costs are high, the franchisor may be able to secure financing because of its creditworthiness or by use of a real estate limited partnership. The franchisor would then lease the property to the franchisee. A franchisor may also sign a guarantee or assume other contingent liability on loans or leases made directly between a third party and the franchisee. Less direct methods of financing assistance can take the form of the franchisor's subordination of certain claims to franchisee lenders or assistance in preparing loan packages for commercial lenders.
A franchisor may provide benefits relating to advertising, research and development, economies of scale, quality assurance and other important operating factors.
Financing Through Franchising: Startup Costs and Potential Liabilities
While franchisors can assist in financing, franchise start-up costs may run from $25,000 to $500,000 or more,
depending upon the particular franchise and the nature of the business.
Professional service franchises, such as tax preparation office,
usually are significantly less expensive than, say, hotels or gas
Franchisors rarely, if ever, cover all initial costs for a franchise.
You will almost certainly need to raise some capital on your own,
besides the fees required by the franchisor. In fact, the additional
financing that would not be necessary in an independent start-up is
often required for a franchised business.
Protecting Yourself from Franchisor Abuse
At least 10 days prior to a franchisee's execution of a franchise
agreement, the franchisor must send you certain disclosures as
stipulated by the Federal Trade Commission (FTC). The disclosure must
- the names, addresses and telephone numbers of other franchisees
- an audited financial statement of the franchisor's business
- background information on the officers of the franchisor
- a statement of estimated costs for setting up and operating the franchise
- the respective responsibilities of the franchisee and the franchisor
If you don't receive the disclosure—or you are uncomfortable with any
of the language—we recommend you delay signing any contracts until you
are satisfied. Like most situations involving a contract, having a
lawyer review before you sign on the dotted line can save you from grief
down the road.
Understanding all the Fees
The costs of franchising include a variety of fees and contributions
typically required by the franchisor in exchange for the assistance and
experience of the franchisor.
Usually an initial franchise fee or license fee will be required. The
fee may be a lump sum or may be payable in installments. Interest
varies and is often nonrefundable.
Other fees may be assessed for training costs (tuition, room, board
and transportation) and on-site startup assistance and promotions,
advertising (2 percent to 8 percent of gross sales), periodic royalties
(4 percent to 6 percent of gross sales) or fees. These fees are
typically tied to a percentage of sales and payable weekly or monthly.
Royalties usually represent the cost of using trade names and commercial
symbols, as well as any trade secrets, patents or other intellectual
property rights, and advertising contributions (often payable monthly or
weekly, based upon a percentage of sales). If bookkeeping is
centralized, separate accounting and processing fees may be assessed.
Additional payments for equipment, supplies, property and beginning
inventory may be required. Note that "initial fees" do not generally
include product inventory or equipment down payments.
In addition to the monetary expenses
associated with purchasing a franchise, remember that one of the
unavoidable costs of franchising is the sacrifice you make in control
and ownership of the business.
For more information on franchising, see our discussion of starting a new business under a franchise agreement.
For the Franchisor
Some entrepreneurs may begin their business with the intent of
franchising their operations; other businesses may elect to franchise an
existing business because it has been so successful. For franchisors,
franchising is a means of equity financing in which the franchisor
"sells off" expansion rights in the business. In return, the franchisor
typically receives an initial franchise fee, service fees, equipment
sale or lease fees, and royalties.
The advantage of this form of financing is that the franchisor passes on
much of the cost of expansion to the franchisee, thereby permitting
much faster growth in a wider geographic market. This is particularly
true when the startup costs of a new facility entail high capital
Disadvantages of franchising are the unique development and overhead
costs associated with franchising, the heightened legal risks from
vicarious liability for the acts of franchisee operations, increased
regulatory costs, and a dilution of ownership.
If you think that your business is a good prototype for similar
businesses in other locations, we recommend that you establish at least a
couple of other sites yourself. If the expansion is successful for at
least a year, talk to a good franchise attorney about testing the waters
by selling one or two franchises. Contrary to popular opinion, slow and
steady growth is the best route to success in franchising.
Employee Stock Ownership Plans as a Financing Source
Equity financing may be available in the last place you'd ever think to look for it: your hardworking, dedicated employees.
Financing Through Employee Stock Options
If you have employees who are looking to invest locally, and you are
willing to share some ownership control, you may have the perfect
opportunity to use your employees as a source of financing.
To allow employs to invest in your company with equity, you'll need to create an Employee Stock Ownership Plan (ESOP). This is simply a qualified retirement benefit plan in which the major investment is securities of the employer's company.
In an ESOP, your employees can purchase shares of stock in your company by:
- paying in cash
- agreeing to reductions from salary or benefits
Like anyone who purchases stock in your company, employees become
part owners of the business, and, most importantly, you have additional
funds for other business purposes.
Your company will contribute to the ESOP by either making an annual
cash contribution to the plan for the purchase of company securities or
by directly contributing stock to the plan.
The Benefits of ESOPs
Either way you contribute to the ESOP, your company's contribution
results in the cash price of the stock being returned to the company.
And better yet, you'll receive a tax deduction for the ESOP contribution
while effectively retaining the cash.
ESOPs give employees a vested interest in the business and generally
promote productivity and a commitment to the long-term success of the
If the funding from your employees doesn't quite cut it—or you're
hoping to expand your operation—you can leverage your ESOP for borrowing
additional funds for the business. You have two basic funding options
when you use your ESOP as means to attaining more capital:
- Borrowing funds from lenders in order to purchase additional securities in the employer's business.
- Borrowing funds from a lender and re-lending the funds to the ESOP, enabling the ESOP to purchase company stock with the cash.
In both scenarios, you end up with the cash price of the stock.
Most small business owners use ESOPs in this manner for large stock
purchases when funding is necessary to finance mergers, acquisitions or
The Limitations of ESOPs
If you have no or very few employees, and ESOP obviously won't solve
your financing needs. But even if you have the necessary employees, you
still have some potential disadvantages to consider:
- implementing an ESOP can be expensive and time-consuming, thus
it may not be sensible for many startup and existing small businesses.
- plan participants who terminate employment may demand
distribution of stock itself, rather than simply the stock's cash
value—you may not want disgruntled former employees voting as
- If the trustees of the ESOP are also the business owners,
conflicts of interest between their duties to act in the best interests
of the ESOP and their duties as directors and/or officers of the company
Using ESOPs to Stage Your Retirement
If your small business has grown to the point where you have a fairly
large number of employees, an ESOP can provide an excellent way to, in
effect, sell your business to your employees because the ESOP provides a ready-made buyer for your stock. Then, you can relax on the beach.
If you've weighed the risks and rewards of an ESOP and decided it's a
great financing option for your business, consult an attorney and an
accountant about the details. ESOPs are incredibly complex to establish
and maintain, and we can't overemphasize the importance of using a
professional to handle the paperwork and provide the guidance you'll
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