As an aspiring franchisee, you may be considering an SBA franchise loan to get your business off the ground. And why wouldn’t you? Buying and operating a franchise offers a happy medium between bootstrapped entrepreneurship and traditional employment. As a franchise owner, you’ll step right into the franchisor’s unparalleled resources, stability, and proven business model, but you’ll also enjoy the autonomy of small business ownership. And an SBA franchise loan is a great way to get you there.
SBA loans are among the most coveted loan products on the market for their high capital amounts (into the millions), low interest rates (single digits), and long terms (decades, potentially). But there’s a lot of competition among small business owners, including franchise owners, to secure these loans. Only the most eligible borrowers are approved.
We’ll tell you what you need to know about government SBA loans, how to figure out whether your franchise is eligible for an SBA franchise loan, and which type of SBA loan will best suit your particular franchise.
Best SBA franchise loan options
Essentially, your best SBA franchise loan is one of two options (or a combination, more on that later): An SBA 7(a) loan, or an SBA CDC/504 loan.
SBA 7(a) loan: This is a great loan option for opening a franchise and covering day-to-day expenses.
SBA CDC/504 loan: This loan option is a better choice for franchisees who need to purchase real estate, heavy machinery, or make another kind of large expense.
Figuring out which loan type works for your franchise depends largely on what you intend to use the loan for—one of the many perks of an SBA loan is its flexibility, but each SBA loan program comes with its own restrictions on use of proceeds.
Brian Smith, VP of SBA lending at Capital One, says:
“An SBA 504 loan is appropriate when a business wants to purchase real estate or heavy equipment with an expected life of 10 or more years. The SBA 7(a) is appropriate for all other uses, as well as real estate and equipment. Frequently, a SBA 7(a) loan is the most appropriate option for a franchise.”
So, unless you intend to use your SBA loan to purchase real estate, chances are you’re going to apply for an SBA 7(a) loan due to its flexibility. But we’ll run through the details of both SBA franchise loans, so you’ve got your bases covered.
SBA franchise loans comparison
Prime rate + 2.25% – 4.75% (depending on loan amount and repayment terms)
Starting and running a franchise
Large expenses related to your franchise, such as real estate or equipment
Funding a franchise with an SBA 7(a) loan
As Smith notes, SBA 7(a) loans often make the most sense for opening and running franchises, because you can use those funds for almost anything you need to get your franchise going. Here are the details.
SBA 7(a) loan use cases
How exactly can you use your SBA 7(a) loan to fund a franchise? The short answer is: for almost anything. Scott Amatuccio, vice president, SBA manager at Axiom Bank says:
“Common uses of an SBA 7(a) franchise loan are owner-user commercial real estate, leasehold improvements, equipment, inventory, startup costs, and working capital. A 7(a) loan can cover mostly all project costs, including initial franchise startup costs (advertising, personnel expense, initial training expenses, etc.), leasehold improvements, initial franchise fees, equipment, furniture and fixtures, inventory, and required working capital to fund operational costs until business cash flow stabilizes.”
Seems like an SBA 7(a) loan can do it all—with one exception. “Ongoing franchise or royalty fees are not covered by SBA 7(a) proceeds,” Amatuccio says.
SBA 7(a) terms and fees
For a standard SBA 7(a) loan, loan amounts can reach up to $5 million, and terms can be up to 25 years for real estate, 10 years for equipment, or seven years for working capital.
All SBA interest rates are based on the U.S. Prime Rate and vary from that base depending on the loan amount, the length of the repayment term, and the use of the loan. The intermediary lender is responsible for determining a borrower’s interest rate, but the SBA sets a maximum that the lender can’t exceed. Currently, SBA 7(a) interest rates range between 7.25% and 9.75%.
You’ll also be expected to pay a down payment of 10% of the total loan cost, at a minimum.
Funding a franchise with an SBA CDC/504 loan
Although SBA 7(a) loans are more flexible than SBA CDC/504 loans, the latter makes sense for those that need high-capital, long-term loans specifically to purchase, refinance, or renovate major fixed assets, like real estate or equipment.
SBA CDC/504 loans are a bit more complex than their 7(a) counterparts. Technically, SBA CDC/504 loans are funded through three separate entities:
The SBA Certified Development Company, a community-based nonprofit that promotes local economic development, will lend about 40% of the total loan amount.
The bank or intermediary lender will lend about 50% of the loan.
The borrower is responsible for the remaining loan amount, in the form of an SBA loan down payment. Required equity injections can range between 10% and 20% of the total project cost.
In this case, the SBA only backs the CDC portion of the loan, not the lender’s portion. However, the lender is placed in the first lien position (the CDC takes the second), which ensures that their debt is still protected—and which incentivizes them to offer longer terms and lower interest rates.
SBA CDC/504 loan use cases
If you’re financing a startup franchise rather than purchasing an existing franchise that’s already stocked with functioning machinery, you may opt for an SBA CDC/504 loan to help you pay for your necessary equipment. Or, you might need an SBA CDC/504 loan to modernize, expand, improve, or convert the real estate for an existing franchise location.
SBA 504 loans can cover any soft costs attached to those projects, too, like appraisals, architectural fees, and interest on additional loans required for construction. However, SBA 504 loans won’t cover any other soft costs associated with launching and running your franchise, like working capital—for that, you’ll need an SBA 7(a) loan. But if you need to cover both costs, you might actually be able to roll both loan programs into one.
“Typically, the 7(a) loan is the go-to solution for franchise financing,” Amatuccio says, “but sometimes the deal is structured as a combo 7(a)/504 if there is owner-occupied real estate involved. The 504 finances the real estate and/or equipment and the 7(a) finances the startup costs including franchise fees and working capital.”
SBA CDC/504 loan rates and terms
SBA 504 loans stand out for their super-long terms, which extend between 10 and 25 years. The CDC’s portion of the loan maxes out at $5.5 million. Generally, additional collateral beyond a personal guarantee isn’t required, since the asset the loan is funding itself acts as collateral.
Like SBA 7(a) loans, interest rates for SBA CDC/504 loans are based on the Prime Market value. Banks then blend their own interest rate into that base, without the total exceeding the SBA’s set maximum. SBA CDC/504 loan rates currently range between 4.27% and 6.43%, and rates are fixed over the life of the loan.
SBA franchise loan eligibility
To secure an SBA loan, you’ll need to meet fundamental SBA eligibility requirements—for starters, your business must be for-profit, U.S.-based, and operate in an SBA-approved industry (the SBA doesn’t loan funds to businesses in the lending, gambling, or life insurance industries, for instance).
And be aware that, to qualify for an SBA 504 loan, you’ll also need to prove that you’ll create or retain at least one job per $65,000 of funding that the SBA provides.
Franchise-specific SBA loan requirements
To qualify for an SBA franchise loan, you’ll need to meet other standards as well. If the SBA determines that the franchise holds too much control over the franchisee, they may determine that the franchise is ineligible for SBA funding—by definition, the SBA loan program only extends funds to independent small businesses.
Also, your franchise must be listed in the SBA franchise directory, which includes all the franchises that are eligible for SBA funding. The directory currently includes over 2,500 franchise brands; but if your franchise of choice doesn’t yet make the cut, you can request to add your business to the list by following the SBA’s standard operating procedure. Just know that it’s not guaranteed that the SBA will approve your franchise and that the request and subsequent determination will slow down your application process.
Other eligibility factors
Meeting those basic requirements alone isn’t necessarily enough to qualify you for an SBA franchise loan—that’s just enough to ensure that your application will be considered. Next, your lender will evaluate both you as the borrower, and the franchise itself, to assess your combined risk.
Some factors that lenders consider about the borrower include:
Personal and business credit history
Business financials, including balance sheets and cash flow
Considered together, these credentials, which you’ll provide on your SBA loan application, help your lender determine whether you’re financially solvent, personally responsible, and professionally qualified enough to honor such a major debt agreement.
Of course, it’s not just your competence that the lender cares about in this scenario—their repayment hinges largely on the strength of the franchise too. Smith says, “Lenders look at the strength of the brand, growth of the brand, what training and support are provided, the costs that are charged (royalties, franchise fees, marketing fees), and the financial stability.”
Just like any other lender, the SBA and your intermediary bank need to be certain that they’re not risking their capital on a borrower (and, in this case, a franchise) that’s unlikely to meet their debt obligations. But because SBA franchise loans are so competitive, the agency and your lender are in the privileged position of picking and choosing among the absolute strongest borrowers on the market—so expect to jump through quite a few hoops to secure your SBA loan, and be able to prove your credentials on your application.
Common uses for SBA franchise loans
We’ve told you all about your SBA franchise loan options, but we haven’t talked about exactly what you’ll need that money for.
Most franchise owners need the help of business loans to cover their startup and operational expenses, either on a one-time or rolling basis—and small business loans don’t get much better than SBA loans. But how you use your SBA franchise loan really depends on which stage in the acquisition or development of your franchise you’re in.
Smith says, “there are three very common uses for SBA franchises loans: starting up a new franchise location, purchasing an existing franchise, and expansion.”
Aspiring franchise owners may seek an SBA loan to help cover the extensive costs of buying or financing a brand-new franchise location. But established franchise owners can turn to SBA loans, too, if they need a capital injection to maintain their operations.
“An SBA loan will cover most costs that a business incurs in the normal course of operations, outside of payments to the owners or taxes, such as supplies, marketing, and employee training,” Smith says.
Here are the specific costs your SBA franchise loan can help cover:
Franchise fees: Right off the bat, franchisors charge an upfront franchise fee, which licenses new franchise owners to operate under the larger franchise umbrella. Franchise fees typically range from $20,000 to $50,000, but master franchises can cost $100,000+.
Royalty fees: Most franchises charge an ongoing royalty fee, which might be a fixed amount, but is usually a percentage of the franchisee’s gross sales. Royalty fee payments are due to the franchise either on a weekly or monthly basis. If they’re charged as a percentage of sales, royalty fees can range anywhere from 1% to 50%, but they’ll usually stick within the 4% to 6% range.
Startup and ongoing expenses: On top of covering franchise-specific costs, buying and running a franchise is just like starting and running any other small business. You’ll need to account for your startup costs like purchasing real estate, business insurance, equipment, training and hiring, and decor and furnishing. Once you’ve launched, you’ll need to budget for your ongoing expenses: wages, taxes, inventory, facility upkeep—whatever costs it takes to keep your business going.
Alternatives to an SBA franchise loan
You likely won’t find a franchise loan with a higher capital amount, longer term, or lower interest rate than an SBA franchise loan. But it takes time, patience, and dedication to gather together your SBA loan application and wait for approval—it can take weeks, or even months, to complete the entire SBA loan process.
And SBA franchise loans aren’t necessarily the right financing tool for every franchise owner. If you’re in a time crunch, you’re not yet eligible for SBA funding, or you simply don’t need such a large loan amount, know that your options certainly don’t begin and end with the government. One of the following types of funding might better suit your franchise’s needs.
Depending on which franchise brand you work with, you might not need to lob in a business loan application at all—the franchisor itself might provide financial assistance for their franchisees, and some of these funding programs are fairly comprehensive. Every franchise will offer a different type of financial aid: Some offer straightforward business loans, others contribute toward their franchisee’s down payments, and still others reduce royalty and license rates for multi-store owners.
Even if a franchisor doesn’t offer internal financial assistance, they may still help franchisees obtain funding by providing resources and logistical help. For instance, some businesses might partner up with third-party loan brokers, like BoeFly, so their franchisees have the best shot at securing loans through trustworthy lenders. It’s also possible that your franchisor has developed relationships with specific lenders whom they’ll recommend to you.
Short-term loan from an alternative lender
Consider a short-term loan from an alternative lender if you need a smaller loan amount than the SBA typically offers, you’re not yet eligible for an SBA franchise loan, or if you’re in a time crunch.
Typically, alternative lending platforms offer short-term loans with three- to 18-month repayment periods, in amounts of up to $250,000. If approved, you might be able to access your funds in as little as a single day.
Relative to the time-intensive, somewhat complex SBA loan application, applying for a short-term loan from an online lender is quick, automated, and pretty painless. Their eligibility requirements are much less strict too; these lenders may approve borrowers with lower credit scores, which is often an aspiring SBA borrower’s Achilles heel.
However, higher-risk loans translate into higher APRs, lower capital amounts, and a more demanding repayment schedule. If you do opt for a short-term loan through an online lender, know that your loan might not cover all of your startup costs or the purchase of major equipment or real estate as an SBA franchise loan would. So these loans might be a better fit for established franchise owners to maintain their operations or fast-track their growth. It might also be a good idea to plug quoted rates into a business loan calculator to determine whether you can really afford your loan and all of its attached fees.
If you’re not yet a candidate for an SBA CDC/504 loan—or if you simply need the cash to purchase equipment much faster than the SBA will allow—consider applying for an equipment loan, instead. Both banks and online lenders offer this form of financing.
As the name suggests, equipment loans are intended specifically to pay for the purchase of the expensive machinery and tools you need to run your franchise. If your lender approves your application—in which they’ll most closely consider the equipment’s expected resale value, rather than your business’s finances—they’ll front you up to 100% of the capital you need to purchase that machinery. You’ll repay your loan, plus interest, over time.
If you can’t repay your loan, your lender will collect the equipment itself to make up for the missing debt. Thanks to that baked-in collateral, equipment loans pose much less risk to lenders, so they’re willing to accept borrowers with challenged credit, lower revenue, or less time in business. That’s a wildly different scenario from SBA franchise loans, which are only available to borrowers with the strongest business and personal financials possible.
The bottom line
Clearly, you can’t secure an SBA franchise loan unless you’re qualified for one. But if you are, your franchise will benefit from one of the most generous business loans you’ll find anywhere.
There are several SBA loan programs, but your two best SBA franchise loan options are an SBA 7(a) loan or an SBA CDC/504 loan—but it may be possible to secure a combination of the two if need be. And unless you specifically need to purchase, refinance, or renovate your franchise’s real estate or machinery, an SBA 7(a) loan is the way to go. It’s the most flexible SBA loan available, which you can use toward almost any expense required to buy, operate, or expand your franchise. Just know that neither type of SBA loan can be used to cover your franchise’s ongoing royalty fees.
But if you’re not a candidate for an SBA franchise loan, you have other choices. Franchisor financing, shorter-term loans, or equipment loans may offer you just the right amount of funding for your needs and may provide you with your required funds on a much shorter timeline and looser eligibility standards.
If you’re still unclear about which franchise loans you’re eligible for, you always have the option of working with a loan specialist who can walk you through the whole process.
This article originally appeared on Fundera, a subsidiary of NerdWallet.