Latest / Franchise Conversations with Fexingo: Buying, Running, and Scaling Franchise Businesses / Franchise Financing Options Beyond the SBA Loan
Transcript
- Lucas: So a lot of people hear 'franchise financing' and they immediately think SBA 7a loan. That's the default. But in reality, the most interesting franchise deals are the ones where the capital stack looks nothing like a standard government-guaranteed loan. Luna: Right, it's almost like the bigger the deal gets, the more creative the financing becomes. What's a recent example you're thinking of? Lucas: There's a 15-unit Jimmy John's deal that closed last quarter — it's a multi-unit acquisition, not a ground-up build. The buyer put together a capital stack with four layers. First, a conventional term loan for about 40 percent of the purchase price. Second, seller financing from the outgoing operator — that covered another 20 percent. Third, an equipment lease line for the ovens and refrigeration. And fourth, a minority equity partner who put in the remaining 15 percent. Luna: That's a lot of moving parts. What was the interest rate on the seller financing piece? Usually that's a bit below market. Lucas: Exactly — it was priced at six and a half percent fixed, which at the time was about a hundred and fifty basis points below where a conventional loan would have landed. And the seller got to defer taxes on the gain through an installment sale structure. So both sides won on the rate. Luna: And the equipment lease line — those are typically quoted as a factor rate, not an APR. Did they get a good deal? Lucas: They did — one point one two five factor over 48 months. That works out to about a 12 percent effective APR once you amortize it. For equipment financing, that's competitive. Especially since the lessor took title to the equipment, so the buyer's other lenders had less collateral risk. Luna: So the whole structure is designed to isolate risk for each lender. The real estate lender gets the buildings, the equipment lender gets the gear, the seller holds a note subordinate to the bank… It's almost like a private equity capital stack. Lucas: That's exactly what it is. And the key number that made it work was the debt-service coverage ratio — it came in at one point four to one across the whole portfolio. That's the number every lender looks at first. If that's below one point two five, the deal doesn't happen without a rate adjustment or more equity. Luna: I want to talk about the other end of the spectrum — the single-unit buyer who doesn't have a ton of liquid cash. What's the most interesting structure you've seen there? Lucas: The most creative — and I'll be honest, the most controversial — is the 401k rollover for business startups. The ROBS structure. It's where the franchisee rolls their existing retirement funds into a new plan that buys stock in the franchise entity. No tax penalty, no early withdrawal. The franchisee effectively becomes their own pension fund's investment. Luna: I've seen those. The compliance costs are real, right? You need a third-party administrator to set up the plan, and the Department of Labor has gotten more aggressive on audits. Lucas: Yeah, the setup fee is typically three to five thousand dollars, and then an annual TPA fee of about fifteen hundred. But the bigger hidden cost is the opportunity cost — you're concentrating your retirement savings in a single location-based business. A lot of advisors will tell you that's too much unsystematic risk. Luna: But for someone who has a hundred and fifty thousand in a 401k and no other collateral, it's sometimes the only path. I've seen it work for a few franchisees in the home-services space — ServiceMaster, that kind of thing. Lucas: Right, and if the franchise performs well, it's a home run. But the default rate on robs funded franchises is higher than the industry average. I've seen data from one administrator that puts it at about 22 percent versus the overall franchise failure rate of around 10 percent. So it's higher risk. Luna: Which brings us to the question of what a franchisee should actually look for when evaluating financing options. What's the single most important metric, besides the rate? Lucas: It's the total cost of capital over the life of the loan, including fees, points, and prepayment penalties. A lot of franchisees get fixated on the monthly payment — they think, 'I can afford fifteen hundred a month' — but they don't calculate the all-in cost. I'll give you a concrete example: one franchise lender offered a rate of eight and a half percent but with a three percent origination fee and a prepayment penalty of five percent in the first two years. Another lender offered nine percent but no origination fee and no prepay after year one. On a $300,000 loan held for five years, the second option was actually cheaper by about eleven thousand dollars. Luna: That's a huge difference. And it's the kind of detail that never makes it into the marketing materials. So how does a buyer even find these niche lenders? Lucas: The best source is usually a franchise broker who specializes in financing — not the franchisor's preferred lender list, which often has a captive arrangement. There are about a dozen independent firms that focus exclusively on franchise lending. They know which banks are active in which verticals. For example, there's a regional bank in the Midwest that's very aggressive on quick-service restaurants right now, but they won't touch a fitness concept. And a credit union in the Southeast that does a lot of home-services franchising. Luna: So it really is a matching problem. And the more units you're buying, the more options you have, because the deal size justifies the due diligence. Lucas: Absolutely. A single-unit deal under $500,000 is hard to place outside of SBA because the bank's underwriting costs are the same regardless of loan size. So the fixed costs eat into the margin. That's why seller financing is so common in that segment — it avoids those costs entirely. Luna: Hey, this is a good moment to mention — if today's episode was useful to you and you want to keep it ad-free, buy me a coffee dot com slash fexingo helps. It's a small ask, but it literally funds these deep dives. Lucas: Yeah, we don't run ads — that's a deliberate choice. So if you get value from the show, that's the link. And now back to the capital stack — I want to talk about one more structure that's becoming more common: the holdco-opco split. Luna: Oh, that's where the franchisee forms one entity that owns the real estate and a separate entity that runs the operations. Right? Lucas: Exactly. The real estate holding company gets a traditional commercial mortgage — lower rate, longer term, amortized over 25 years. The operating company rents the space from the holdco at a market rate. That rent becomes an expense that reduces the operating company's taxable income. And the holdco's equity grows as the property appreciates. Luna: It also protects the real estate from any liability that arises in the operating business. If a customer slips and falls, they can sue the opco, but they can't touch the building. Lucas: Right. And the lenders like it because the real estate loan is secured by a hard asset, while the opco's working capital line is unsecured or only backed by equipment. The separation actually lowers the blended cost of capital because the real estate piece is cheaper. Luna: What's the typical leverage in those deals? Are lenders okay with a holdco that's 80 percent loan to value? Lucas: In the current rate environment, most commercial lenders want loan to value under 70 percent for a franchisee-operated property. But if the franchise concept is strong — well-known brand, long operating history — some will go to 75. The opco's working capital line is usually capped at one times monthly revenue. So total leverage across both entities is typically around 65 to 70 percent of the overall enterprise value. Luna: That seems prudent. And it's a structure that scales well — once you have the holdco set up, adding another property is just a new mortgage under the same umbrella. Lucas: Exactly. I know a franchisee who started with a single-unit Subway in 2018, used an SBA loan. By 2022, he had six units and converted to a holdco-opco structure. He refinanced his first three properties into the holdco at a lower rate, and now he's at 12 units. His blended cost of capital dropped by about 200 basis points after the restructuring. Luna: So the lesson is: don't just accept the first loan offer. Build a capital stack that fits the specific deal. Use seller financing where you can, isolate real estate, and always calculate the total cost. Lucas: Exactly. And if you're a single-unit buyer, don't be afraid to ask the seller to hold a note. It's more common than you think. The key is to have a clear exit strategy for all parties. That's what makes a franchise finance deal work over the long term.