How to Finance a Franchise

Interest rates for small-business loans are low, ranging from 3% to 5%, but tighter credit standards have made them difficult to get. Loans backed by the Small Business Administration, which are offered by private lenders, are sometimes easier to qualify for than non-SBA loans. (Read about SBA-backed loans.)

Before the housing market collapsed, many franchise buyers used home-equity lines of credit to finance their operations. Some still do, although this source of financing puts your home on the line.

Another potential source of financing is your 401(k) plan or individual retirement account, although depleting your retirement nest egg calls for careful consideration of the pros and cons. Ordinarily, pulling money from a tax-deferred account triggers income taxes and an early-withdrawal penalty if you’re younger than 59½, but there is a strategy you can use to avoid the tax hit. Read about how one couple funded their business by tapping home equity and their 401(k)

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First, set up your business as a C corporation with its own 401(k) plan. Once the company’s 401(k) is established, you can roll your personal 401(k) into the plan and invest the money in company stock. The proceeds may be used for “any necessary and ordinary business expense,” says David Nilssen, chief executive officer of Guidant Financial, which helps franchises and other small businesses arrange financing. Most tax-deferred retirement plans are eligible for the rollover, and the strategy appeals to franchise buyers who don’t want to go into debt, Nilssen says.

To avoid trouble with the IRS, hire a lawyer or financial firm that specializes in these transactions and understands the rules. Otherwise, you could get stuck with a hefty bill for taxes and fees. Guidant Financial charges an upfront fee of $4,900 plus $119 a month for ongoing recordkeeping and administrative support.

Whether you use home equity, a loan, your 401(k) or personal savings, be sure you set aside enough money to live on until your business turns a profit.