SBA Loans vs. 401k Rollovers: Best Way to Fund a Franchise?

This is a transcript from Episode 19 of The Franchise Champion Show. Listen to the full episode on Apple Podcasts, Spotify, or YouTube.

Alan: Today's guest is a colleague and friend of mine who has been in franchising for over 30 years. He's owned multiple businesses, both independent and franchise, and he's helped hundreds of people launch their franchise businesses. Welcome to the Franchise Champion Show, Kent Craven.

Kent: Thank you, Alan.

Alan: Kent, how are you doing today?

Kent: Doing great. Every day I get to talk with you is wonderful.

Alan: Excellent. Likewise. So Kent, start us off—tell us, how did you get into franchising?

Kent: So the long story is, I got fired from my first job out of college. I left school with two master's degrees from the Ivy League, including an MBA. It only took a year and a half for the corporate world and me to figure out we weren't a match made in heaven.

I launched my first business with a private equity investment at that time. Ran that business for about six years before it crashed and burned. And so I was looking for something new to do. That was about 1990, 1992. I was in my young 30s, and my father, who had had a career in the franchise world, had just joined an upstart franchise opportunity consulting network and suggested I give it a try. And 32 years later, here we are rolling.

Alan: Wow. Wow. Okay, so that's a long time.

Kent: It's a long time.

Alan: So what kind of roles have you been in with franchising? Because you are a franchise consultant now.

Kent: Yeah, I just started out as a franchise opportunity consultant, which you are mastering, helping people find the best franchise for whatever their personal set of goals and circumstances are. I've also been partners in some franchise brands. I took a turn for five years as an area developer in the state of Arizona for a particular franchise brand. So I was more on the franchisor side in that role, helping people get opened.

In my consulting practice at that time, I had a number of associates who continued with the opportunity consulting for clients. And all along the time, I've been helping my clients get funding to help launch their franchise business. And in the last year and a half, I've had more and more colleagues like yourself who asked me to help their clients with funding strategies. And so that's a new boutique funding strategy practice that just started recently.

Alan: Yeah, that's fantastic. And that's exactly what I'd love to learn more about on the show today. So walk me through the steps—what are the options out there for funding a new franchise business?

Kent: You know, there's lots of options. First, it's important to realize that the biggest reason for small business failures is under-capitalization. "I thought I could start this business and reach breakeven with an investment of $100,000." You know, after eight months, I realized, "Hey, I need an extra 50 grand, and I don't have it." And hence, you know, when you stop paying your employees, sometimes they stop coming to work—those types of things.

So it's really important that people plan for the worst, hope for the best. And there's lots of different strategies for franchise funding, starting with the SBA Guaranteed Loan Program, which is a great resource for the U.S. economy. An SBA loan still requires the borrower to come in with a cash injection or a down payment on their business. So people are going to have to come up with some amount of cash.

There are multiple strategies to be able to access funds in a retirement account without triggering early withdrawal penalties or current year tax consequences. Multiple strategies for that. There are unsecured loans. It's good to have a corporate credit card with a big balance on it, just in case. Friends, family—all of those can come into play.

The important part is that the funding strategy matches what the goals of the owners are. I work with clients—I'm sure you do—who are planning to keep their current income source, a corporate job for instance, and hence their immediate need for income from a business might not be so great. They're looking more for tax benefits for their personal tax return and maybe long-term capital gains appreciation. Other people who maybe have been separated from their company already and severance is running out just over the horizon—they have a more immediate need for income. And so the strategies to fund the business can be different because the goals of the owners are different.

Alan: Yeah, that makes sense. So before we go into these different methods—because you gave a few different ones there—we've got the SBA loan, tapping into retirement accounts, friends and family, unsecured loans, corporate credit cards, all those things. Before we dive into those, can you tell us about the business plan and what goes into that? Because I'm guessing that applies for a lot of these things.

Kent: So the bank is going to look at the business plan because they're going to decide, "Hey, if this person defaults on repayment of the loan, the SBA guarantee will kick in, which means the U.S. government is going to pay me back." The SBA will then be left holding the bag for any remaining repayment obligations on the loan. So the government's kind of on the hook. They guarantee up to 90% of SBA loans up to a cap of $5 million on what's called the SBA 7(a) loan program. So the SBA wants to make sure that only qualified borrowers get these great loans.

One of the ways they do that is by requiring, as part of the documentation the borrower provides to the bank—they're going to submit a resume, they're going to submit tax returns for the last three years, they're going to submit a personal financial statement, and they're going to submit a business plan. And the business plan is meant to help the bank or the lender understand, "Okay, how is this person going to make money at this business? And from the money they make, how are they going to pay us back?"

So part of the business plan is, if I'm buying a franchise, here's information about the franchise system. Here's information about the market I'm going to be in. Here's what the numbers have looked like in my market or markets similar to mine. And then here's a projection for my business—how long it's going to take to get to breakeven, when I'm going to be cash flow positive, when I'm going to start taking a salary or a distribution, how I'm going to pay off the loan.

All of that gets incorporated into a business plan. And so typically, there's a written part that's going to be maybe five or eight pages long that explains the business model, the market, the team. And then there's a financial section that's going to be, you know, maybe some spreadsheets that show month by month, here's what revenues and expenses are going to look like, here's when I get to breakeven, here's when I start to pay myself a salary. That type of thing.

Alan: Okay. And when you're working with a client, are you helping them build that out?

Kent: So I provide templates. I provide all the coaching and the guidance through the process. The client still needs to do the work, though. You know, the client needs to, you know, crunch their own numbers. The client needs to tell their own story. But I provide the outline, the template. I'll help them understand what needs to be in there and what doesn't need to be in there. I'll review it. I'll give them feedback. "Hey, this section is really weak. You need to shore this up." Or "You're overthinking this. This is plenty. You know, don't do anything more on that section."

Alan: Yeah. Okay, great. So SBA—you mentioned already that they guarantee up to 90%, I believe you said, of the loan?

Kent: That's correct. On SBA 7(a) loans.

Alan: Okay. So the bank is looking at this and they're going, "Okay, well, we're only really on the hook for 10% of this." So they feel a little better about it. And is there a certain percentage that the person buying the franchise needs to come in with as a down payment?

Kent: So there is. The down payment is part of the total project cost. So if you're going to buy, you know, let's say a fast food franchise or a fast casual food franchise—maybe the total project cost is $700,000. You need the cash for the franchise fee, you need cash for a build-out, you need cash for equipment, you need cash for working capital to support yourself and your team, you know, for several months as you ramp up.

All of that is going to be, you know, maybe $700,000. The SBA is going to require you to come in with 10% to 20% as a down payment. So $70,000 to $140,000 of that $700,000. The rest of it can be borrowed. In some circumstances, if you can show the bank you have liquidity above what you're injecting as a down payment—in other words, they want to see that you have, you know, a cushion, a reserve—they'll give you a little bit lower down payment requirement. So it might be 10%. In other circumstances, where you're really kind of putting all of your eggs in this basket, they're going to want to see a higher down payment—might be 15 or 20%.

Alan: Okay. And does the interest rate change based on the down payment? Like if you put in more, does the interest rate go down?

Kent: So the interest rate on an SBA loan is regulated. The SBA determines the maximum interest rate that a bank can charge, and it's based on something called the prime rate, which the Federal Reserve, you know, sets. The current prime rate as we're recording this is about 7.5%. The SBA says, "Okay, banks, you can charge prime plus 2.75% for loans under $50,000. You can charge prime plus 2.25% for loans between $50,000 and $250,000. And you can charge prime plus 2% for loans over $250,000."

So if I'm getting a $600,000 loan and the prime rate is 7.5%, my interest rate would be about 9.5%. Now, some banks will charge less than that. They'll say, "Hey, we're going to charge you prime plus 1.5% instead of prime plus 2%." So they're being competitive. But the SBA sets a ceiling on what they can charge.

Alan: Okay. And what's the typical term for an SBA loan?

Kent: So for working capital and equipment, it's typically 10 years. For real estate, it can be up to 25 years. So if you're buying a building or if you're doing a significant build-out that's going to last for many years, you might get a 25-year term. But most of the time, for franchise businesses, it's a 10-year term.

Alan: Okay. All right, so we've covered SBA loans pretty thoroughly. Now let's talk about retirement accounts. You mentioned there are multiple strategies to access funds without triggering penalties or tax consequences. Can you walk us through those?

Kent: Sure. So the most common strategy is called a ROBS, which stands for Rollover for Business Startups. It's also sometimes called a Rollover as Business Startup or a Retirement Account Business Funding. All of those mean the same thing.

The way a ROBS works is—let's say I have $200,000 in an old 401(k) from a previous employer. I'm going to form a C corporation. That C corporation is going to sponsor a new 401(k) plan. I'm going to roll my old 401(k) into this new 401(k) plan. And then the new 401(k) plan is going to invest in my C corporation by purchasing stock in the corporation.

So now the $200,000 that was in my retirement account is now equity in my business. It's not a loan—there's no debt service. It's an investment. The retirement account owns stock in the company. I own the retirement account. So effectively, I own the company, but it's through this retirement account structure.

The benefits are: no early withdrawal penalty, no current year taxes, no debt service. The downside is there are some ongoing compliance costs. You have to maintain the C corporation status, you have to maintain the 401(k) plan, there are annual audits and filings that need to be done. So it's more complex than just taking money out of your retirement account and paying taxes and penalties on it.

Alan: Okay. And what are those ongoing costs typically?

Kent: So the setup costs are usually around $5,000 to $6,000. And then the ongoing annual compliance costs are typically around $2,000 to $3,000 per year. Some companies charge more, some charge less, but that's a typical range.

Alan: Okay. And you mentioned this is for a C corporation. What if someone wants to be an LLC or an S corp?

Kent: So the ROBS structure requires a C corporation because the retirement plan is investing in the stock of the company. And for various tax and regulatory reasons, it has to be a C corp. Now, after you've been in business for a few years and you want to convert to an S corp or an LLC, you can do that. But you have to do it in a very specific way to make sure you don't trigger any tax consequences. So you'd work with a tax advisor and possibly the ROBS provider to help you through that transition.

Alan: Okay. And is there a minimum amount that makes sense for a ROBS?

Kent: Yeah, typically you want at least $50,000 to $60,000 in your retirement account to make it worthwhile. Because you're paying $5,000 to $6,000 to set it up, and then you've got ongoing costs. So if you only have $30,000 in your retirement account, it probably doesn't make sense to do a ROBS. You'd be better off just taking the distribution, paying the taxes and penalties, and using that money.

Alan: Right. Okay. So what's another strategy for accessing retirement funds?

Kent: Another strategy is a Solo 401(k) loan. This is for someone who's going to be self-employed or who's forming a business where they're going to be the only employee, or maybe it's a husband and wife team. They can set up what's called a Solo 401(k) plan.

When you set that up, you check off the box that allows loans in that plan. And so a client who's looking for a lower investment—maybe they need $50,000 cash—they can form an LLC, make the S corp tax election, sponsor a Solo 401(k) plan, and then borrow $50,000 out of that, just like most corporate 401(k)s allow you to borrow money. You can borrow up to $50,000 or 50% of the account balance, whichever is lower.

So now I've got my $50,000 cash. It's a loan from the 401(k), so it has to be repaid. The debt service is a little higher with this approach compared to a ROBS—it's about $1,000 a month if you borrow the full $50,000. But the advantages are: it's much faster to set up, it's less expensive—you can get it set up all in one afternoon—and you're rolling over into that, and that's all you need to launch your business.

Now, what if it's a couple, married couple, husband and wife, and they both have $100,000 in an old retirement plan? They can each roll it to the new Solo 401(k), they can each borrow $50,000, because they're both employees with their own accounts. So maybe $100,000 is the total that we need to launch a business.

We have opportunities for the right person, in the right circumstances, there are opportunities under $100,000 that we work with. And maybe we don't need an SBA loan. Maybe we don't need a full ROBS plan. Maybe I'm out of work, but my spouse is still an attorney making $250,000 a year and does qualify from her income only to open a $300,000 line of credit on our million-dollar home with only a $200,000 mortgage.

So there's a situation where the client is in charge of all of the lending. It's all of their own money, and so they don't need to go SBA, they don't need to do the fancy ROBS plan. We're just going to do the Solo 401(k) plan.

But you know what? Even though they're not looking for a lender, do you know what they should do, Alan?

Alan: What's that, Kent?

Kent: They should do their own business plan. They should do their projections. They should loan themselves the money until they've proven to themselves, "This is how it gets paid back. This is how we're going to pay ourselves back."

Alan: That's right. What's the plan? How am I going to pay myself back?

Kent: Yeah. I'd say it's 50/50 people who are going to self-fund like that—50/50 whether they do the business plan or they're just taking off in the fog without any radar. And I'm not sure I want to be on that plane.

So even if you're going to self-fund and it might be the best strategy for different people, they still ought to have a business plan. They ought to know their KPIs. They ought to close their books every week or every month, every quarter. Even if they can just write a check, they ought to prove to themselves before they write the check—what are the economic prospects of this business and what are the things that I need to do to make those economic prospects come true?

Alan: Makes total sense. Whichever way you go, there should be a plan, and it should be done ahead of time. Know your numbers.

Kent: Know your numbers.

Alan: I love it. Kent, this has been a very enlightening conversation. I sure appreciate it. I've learned a lot. I know our listeners have learned a lot as well. Appreciate you being on here, and congrats on being a franchise champion.

Kent: I'll take that. I'll take that. Yeah, I cherish every day I get to talk with Alan—it's a good day. So thank you for the invite.

And hey, if you need advice, Alan is your man. He's done it with his own money, and he has all the resources to help somebody be successful.

Alan: I appreciate that, Kent. And this is why I connect clients with you for advice on funding. Because clearly, you are an expert in this field, and lots of experience and just know how to get it done, how to get people funded. So thank you.