Franchise loans: what they are & how they work

If you’re buying a franchise, want to scale your business, or need a cash flow injection to operate effectively, you may be wondering how franchise loans work. We’ll cover several popular financing options and answer some frequently asked questions. That way, you’ll learn what, if any, franchise loan is right for your situation and goals.

Franchise loans & financing: A guide

If your personal savings and investment accounts are tapped out (or you don’t want to deplete them) and you’ve already asked your family and friends for their financial support, one of the franchise loans below could be your next step. Let’s dive into some details about each.

SBA loan for franchise: 7(a) loans

The Small Business Administration (SBA) doesn’t issue loans directly, but it does provide guarantees to lenders, which can make it easier to qualify for funding. You can borrow up to $5,000,000, and use the money for various purposes, including, but not limited to:

• Working capital
• Real estate
• Equipment
• Machinery
• Supplies
• Change in ownership

You’ll have up to 25 years to repay the debt. Your interest rate could be fixed or variable.

Here are the basic parameters you and your business will need to meet to be eligible for a 7(a) loan: 

• Your business is in operation, is for profit, and is based in the United States.
• Your company must be classified as a small business per the SBA and must not operate in a prohibited industry, such as politics.
• You’ve been unable to secure sufficient financing from a non-government source.
• You have adequate income to repay the debt.
• Your credit score is higher than the lender’s stipulated minimum (varies).

You may need to put up collateral or make a personal guarantee to secure financing. Check with your lender.

SBA loan for franchise: 504 loans

SBA 504 loans are available through Certified Development Companies, which are non-profit partners of the SBA that exist to help develop businesses in communities. You can borrow up to $5,500,000 and use the funding to cover major fixed assets, including, but not limited to, buildings, land, machinery with a decade or more of useful life, and debt consolidation of qualified debts. 

Unlike the 7(a) loan, you can’t use the 504 loan for working capital. Funds from a 504 loan should be put toward growth, expansion, and job creation.

Eligibility criteria will vary somewhat from lender to lender. However, in order to qualify, you and your business must meet these parameters:

• Operate a for-profit company in the United States that meets SBA’s size and other guidelines
• Have management experience and a business plan
• Have a tangible net worth of less than $20,000,000
• Have good character and the ability to repay the debt
• Earned an average net income of under $6,500,000 for the previous two years before applying

You’ll have up to 25 years to pay off the fixed-interest-rate loan. Like the 7(a) loan, you may need to put up collateral or make a personal guarantee to get approved for funding.

Conventional bank loan for businesses

Many banks offer business loans, all with different rates, terms, maximum loan amounts, and eligibility criteria. Here are some general trends you may see with conventional bank loans, compared to ones backed by the SBA:

• Lower funding amounts
• Shorter repayment terms (and, thus, potentially higher monthly payments)
• Faster application processing and loan funding
• Higher money down or collateral requirements
• Stricter financial metrics to meet

If you like the bank you use for your personal finances, it may be worth a quick meeting with a commercial banker from the institution to review your options. There are also many business loans from online banks you can research and compare.

Personal loan

Many new (or prospective) business owners consider getting a personal loan to jumpstart their enterprise because it may be easier to qualify for than a business loan. In addition, most personal loans are unsecured, so there’s no risk of losing an asset if you default. Plus, some online lenders issue funds quickly, so you can make progress sooner rather than later.

However, using a personal loan to finance your business has some potential downsides, such as:

• You may have to pay a higher interest rate than you would with a business loan.
• Your personal credit could be severely damaged if your business fails.
• The line between your personal and business finances will be blurry.
• You won’t be able to write off the interest you pay on your taxes.
• You may not be able to borrow as much as you need.

If you decide that using a personal loan is the right move, be sure to read the fine print before signing anything. Some lenders prohibit using personal loan funds for business purposes.

Financing with an equity investor

If you borrow from an equity investor, you give up shares of the business in exchange for upfront capital. Your investor may not charge you interest. 

However, they may want an ongoing say in business operations. After all, they are part owner. Make sure your arrangement is clearly spelled out in writing – especially if your investor will be involved long-term or permanently.

Financing with home equity

If you own a house, you may be able to borrow from your home equity. Your home equity is what your property is worth, less what you still owe on it. For example, if your house is valued at $500,000, and your mortgage balance is $350,000, you have $150,000 in home equity.

Popular home equity financing options include:

Home equity loans:

• Lump sum funds disbursement
• Fixed interest rate (typically)
• Stable principal and interest payments for the entire loan term (typically)
• Full payments begin immediately
• Default could lead to foreclosure

Home equity lines of credit (HELOCs):

• Access to a credit line you can tap into throughout the draw phase (often 10 years)
• Variable interest rate (usually)
• Interest-only payments during the draw phase (usually)
• Full principal and interest payments during the repayment phase (up to 20 years)
• Default could lead to foreclosure

Home equity investments (HEIs):

• Lump sum funds
• No monthly payments, sharing in percentage of home appreciation
• Settle the investment anytime during a flexible 30-year term
• No income requirement or impact on mortgage rate
• 500+ credit score requirement

Financing with your 401(k)

If you have a 401(k) or individual retirement account (IRA), you may be able to use it to finance your franchise without having to pay income tax or early withdrawal penalties if you follow the Internal Revenue Service (IRS) rules for a Rollover as Business Start-up (ROBS). This option allows you to roll eligible retirement funds into a new business without taking on debt, paying early withdrawal penalties, or triggering income taxes—so long as it’s set up and maintained according to IRS rules.

In simple terms, a ROBS arrangement lets you use your 401(k) funds to invest in your new business, often by purchasing stock in the company you’re forming. This can be appealing because it provides access to capital without monthly loan payments or interest charges.

However, there are important considerations. Because you’re investing retirement savings into a business, your financial future becomes directly tied to its success. If the business doesn’t perform well, you could put a significant portion of your retirement funds at risk. There are also ongoing compliance requirements to ensure the structure remains in good standing with the IRS, which typically requires professional setup and administration. It's best to consult a financial advisor when it comes to leveraging your nest egg.

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The bottom line

Starting, running, and growing a business takes initial and ongoing capital. A franchise loan could help you achieve your dream of entrepreneurial success. However, it’s critical to research your options thoroughly before borrowing. That way, you select the best funding for your circumstances and goals.