Item 10 of the FDD: Franchise Financing
Buying or starting a business requires a significant amount of research. The more informed you are before signing on the dotted line, the fewer surprises you’ll encounter and fewer opportunities for your investment to go sideways.
Although there are no guarantees in life, the good thing about buying into a franchise system is that franchisors must adhere to a set of rules and regulations for all new franchisees. These are well organized and explained in detail in the Franchise Disclosure Document (FDD).
The FDD serves as the go-to guide for prospective franchisees for the franchise offering. It breaks down each section of business operations and finances into 21 sections called Items. Item 1 through Item 21 cover topics like initial franchise fee, financial performance representations, how to handle dispute resolution, and the franchisor’s obligations once the franchise agreement is signed.
The FDD is designed to provide all the information you need to make an informed investment.
This article covers franchise financing options—Item 10 of the FDD.
What Is Item 10 in the FDD?
Prospective franchisees have a range of financing options to consider, such as traditional commercial bank and SBA loans as well as direct and indirect financing provided by franchisors. Item 10 in the FDD outlines the financing terms a franchisor or its affiliates might offer a franchisee.
The Federal Trade Commission's (FTC) Franchise Rule mandates these disclosure requirements to ensure consistency and transparency.
The disclosure items must include the material terms, including:
- Rate of interest plus finance charges expressed on an annual basis
- Number of payments
- Penalties upon default
- Any consideration received by the franchisor for referring a prospective franchisee to a lender
Financing terms can include leases and installment contracts.
Although franchisor offers of direct financing or by its affiliates are usually easy to recognize, identifying an indirect offer isn’t always easy to spot.
The FTC Rule provides clarity with the following examples of indirect financing arrangements:
- A written agreement between a franchisor or its affiliate and a lender, wherein the lender provides financing to a franchisee
- An arrangement where a franchisor or its affiliate receives benefits from a lender in return for facilitating franchise purchase financing
- A situation where a franchisor guarantees a franchisee's note, lease, or other financial obligations
Types of Franchise Financing Disclosed in Item 10
Five types of franchise financing are available to franchisees, and the franchisor must disclose any offers in Item 10.
Franchise financing can include any of the following:
- Direct Financing
- Third-Party Financing
- Lease Financing
- Special Financing Programs
- Factoring Arrangements
This can include financing directly provided by the franchisor, such as a straightforward loan agreement between the franchisor and the franchisee.
External financing can be arranged with the franchisor’s assistance, as they may have a good franchise relationship with a lender or financial institution.
A franchisor may provide or arrange for a franchisee to lease required equipment or property with financing terms that include the option to purchase the leased items.
To support a new franchisee, a franchisor may offer incentive-based payment terms such as discounted rates, deferred payments, or subsidized financing.
These are financing terms where the franchisor purchases the franchisee’s receivables at a discount. The purpose is to provide immediate cash flow to the franchisee and free up some resources.
Evaluating Franchise Financing Offers
Understanding and evaluating the financing options available is critical, especially if you plan to use any of them.
Here’s a breakdown of some positives and negatives of financing offers and what you should look for in franchise financing offers to make an informed decision.
Interest Rates
The interest rate is the cost of borrowing money expressed as a percentage. It can be fixed (the same throughout the loan term) or variable (it can change based on market conditions.)
But don’t take the interest rate offered at face value. Compare interest rates offered by the franchisor with rates from other lenders. A lower interest rate means a lower overall cost of borrowing.
Pay attention to the annual percentage rate (APR) as well. It includes interest and other fees and gives you a clearer picture of the total cost of the loan.
Repayment Terms
The time you have to repay a loan can impact your monthly payments and total interest paid. A shorter term might equate to higher monthly payments and less interest over time, while a longer term will offer lower monthly payments but more interest overall.
Always check if there are penalties for paying off the loan early. If you have a positive cash flow, you may want to pay your loan early, but some loans charge fees for early repayment.
Potential Risks and Benefits
While franchise financing can help you get the capital you need to purchase a franchise business, it also comes with some risks. If you can’t meet the repayment terms, you risk losing your initial investment and possibly personal assets, if you provided a personal guarantee.
Some financing arrangements offer flexibility in repayment terms that can be adjusted based on business performance. But if you’re stuck with a variable-rate loan, rising interest rates can increase your repayment amounts, impacting your business’s financial stability.
Importance of Professional Financial and Legal Advice
A financial advisor or franchise attorney can help you understand the implications of different financing options and compare terms to find the most cost-effective solution.
They can help you create a realistic budget and forecast your business’s cash flow to ensure you can meet your repayment obligations.
A franchise attorney specializing in franchise law can also review financial statements, explain complex legal terms, and advise you on the legal rights of a financing agreement.
Make Informed Decisions
There are pros and cons to accepting franchise financing that prospective franchisees should consider.
If you don’t have the capital to purchase a franchise outright, it could be the step that gets your foot in the door.
However, securing the right financing option is critical for the success of your business.
When reviewing the franchise disclosure document and assessing franchise financing offers, it's essential to go beyond the numbers, as there is no one-size-fits-all solution. Each financing option—direct financing, third-party loans, lease financing, special programs, or factoring arrangements—comes with unique benefits and challenges.
To find your new or next franchise, visit the BizBuySell Franchise Directory to find the perfect fit for your needs.