When it comes to funding a franchise, how much is enough? The answer is simple — more than you need.
Consider this: More startup businesses fail because of undercapitalization than for any other reason. So where do you start? You need to determine how much you can invest and how much you are willing to invest. You might find those two numbers are different.
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How much can you invest?
This answer lies in your net worth. To determine that, you should create your own personal balance sheet.
Start by adding up all your assets to determine how much you own: cash, checking accounts, investments, home value, personal property, retirement accounts, business interests and other assets of value. Next add up everything you owe (called liabilities): credit card debt, mortgage debt and other loans.
Your net worth figure represents an approximation of the capital available for you to invest in a franchise. You must next decide how much of that you are willing to risk on the franchise.
The amount of capital you are willing to risk is not necessarily the same as the amount you have to invest. You may choose to invest only a fraction of your net worth in the franchise, or you may choose to invest more using the sometimes dangerous magic of leverage.
Leverage is like wine — wonderful if you know your limit
In quantifying how much you are willing to risk, you must understand the concept of leverage. Leverage, or your ability to use borrowed money for an investment, is like wine — it’s great in the right quantity, but too much can kill you. While leverage increases your potential return, it also increases your risk.
To understand the power of leverage, let’s use the everyday example of buying a home. If you were to purchase a $200,000 home today, you might be able to buy it with 10 percent down. With monthly payments of perhaps $900 per month (without taxes and insurance), you figure you can afford it because you and your spouse each take home $2,000 per month.
Over the next three years, let’s say you increase your paid-in principal by about $9,000. Thus, the average equity you have in that home will be a little over $24,500.
If you then decide to sell the home, the selling price is dictated based on the market, regardless of your equity position. Thus, if real estate has been booming, you may be able to sell your property for $230,000. Without factoring in closing costs or commissions for the sake of this analysis, your three-year return on your total investment of $200,000 is around 15 percent. But your three-year return on the $24,500 in average equity you invested will be $30,000/$24,500 — or about 122 percent!
That’s great news, but things don’t always work out that well. Anything can happen, from unexpected medical bills to natural disasters. What if you or your spouse is laid off? Can you still afford that home on only $2,000 a month?
Apply this same principle to your investment in a franchise. Perhaps you have a net worth of $500,000. But since a lot of your capital might be tied up in your home and retirement savings, you only have $100,000 to invest in your franchise. You will need to decide whether to leverage yourself into a higher investment with a higher potential return.
So how much is too much?
There are two factors influencing the answer to that question. The first is you — how much of an appetite for risk do you have? Remember, your banker is going to take a security interest in your assets.
So even though you invested $100,000 of your capital out of pocket, if your franchise business fails, they may go after your house or other assets. While your equity investment may only be $100,000, your total investment will include the money lent to you by your bank.
The second part of this equation is your banker or other lender. Generally speaking, bankers and/or Small Business Administration (SBA) lenders like at least 30 percent of the initial investment to come from your personal equity. So conceivably, you could leverage a $100,000 investment up to $300,000 or so.
Your ability to leverage your investment will be dictated by a variety of factors:
- Any collateral you can offer in the business
- Anticipated cash flows
- Your credit score
- Other sources of income (e.g., passive income or spouse’s earnings)
- Your banker’s opinion of the franchise
- Your banker’s opinion of you as a franchisee
Meet with your banker
One step you can take early in the process is to speak candidly with your banker. While you will certainly need to have a more detailed conversation once you have chosen your franchise, your banker (or several bankers, if you have the time to speak to more than one) can give you a great idea of acceptable risk.
At this stage, the one thing you cannot show them is your projected earnings or the operating costs of the franchise. Bring what you have to your banker and ask for advice on how much you could reasonably afford to borrow.
Once you have met with your banker and have a good feel for your available capital, your risk tolerance and your ability to leverage your way into a franchise, you are ready to begin the screening process to help you narrow the field.
Get started with The Franchisee Handbook
In The Franchisee Handbook, franchise expert Mark Siebert walks you through the process of vetting and buying a franchise, helps you ask the right questions of franchisors and yourself, and gives you the resources you need to decide if franchising is right for you. Siebert shows you how to do your homework before making what could be the greatest financial decision of your life. You will learn how to:
- Accurately assess the risks of buying a franchise
- Determine if a franchise is a good fit for your personal goals
- Research and vet potential franchise opportunities
- Create a startup plan that meets your business goals
- Prepare your franchise for success
Why dream about owning a franchise when you can take concrete steps to make it happen today? With The Franchisee Handbook as your guide, you have the power in your hands to start your own franchise journey right now.