Before you begin your search for a franchise, it is a helpful to have an idea of what you can afford. This prevents you from wasting your time pursuing franchises that are beyond your means. It’s common to finance about two-thirds of the total initial investment. That means you are looking at making a down payment of around one-third of the total initial investment.
This is the logic behind the rule-of-thumb known as the “Rule of Two-Thirds,” which states, “The cash flow from the business must be able to service a debt of two-thirds of the selling price.”
In other words, after paying all the expenses involved in running the business, there must be enough money left over to cover the payments due on the debt incurred to buy the business. If there is a shortfall, it cannot be considered a high-profit business. If you still decide to buy the franchise, you will have to either increase the amount of down payment or increase the number of years over which the loan is amortized in order to reduce the amount of monthly or annual debt service.
Based on the Rule of Two Thirds, if you multiply the amount of cash you have available to invest in a franchise by three, you will have a rough dollar estimate of the total initial investment that is within your capabilities.
The franchisor will ask for a copy your net worth statement as part of your franchise application. This is usually included in the franchisor’s standard application form, and is typically called a “Request for Information & Consideration Form.”
The following questions will help in determining your financial investment comfort level so that you know how much cash you have available for a business.
- What is the maximum amount of investment you are willing to undertake including possible assistance from someone else?
- Are you willing to sign a personal guarantee for a business loan or financial assistance?
- If you don’t have enough collateral, are you willing to give up a share of the business to a partner or investor?
- What is the type and amount of collateral that you have available to back up a loan request?
- What is the maximum total initial investment that you can handle without assistance?
Assessing your potential investment level
The financial factors, which are most important in assessing your potential investment level, can be divided into two areas:
- Your net worth, which relates to your investment potential. In other words, do you have enough money on hand, or enough security or collateral, that you can go to a lender to acquire the capital needed to start the business?
- Your own cash-flow requirements. Are you able to survive during the initial start-up period of the business from your own resources, or from an alternative source such as your spouse’s income?
Next time, we will look at how to calculate your net worth and assess the risk of leveraging your assets to buy a franchise.
Part two: Calculating your net worth and potential for investment