How Do Lenders Decide What You Can Afford?

It’s rare these days that anyone would simply pay cash to buy a new business. Like many long-term investments, the upfront cost is out of reach for most people — and even when it’s not, there can be some very sound reasons to retain a good portion of your capital, whether it’s to pursue other investments, fund business growth, or simply keep as a safety net.

This usually means that when you ask yourself “Is this franchise in my price range?”, you’re not going to be the only one asking. Your lender will be asking much the same thing — although they may be coming at it from a slightly different angle.

For a borrower it probably seems like the simplest of questions: How much will you lend me? But for a lender, that’s actually quite tricky — there are just so many variables. Instead, most lenders will say: Show me how much you need, and what for, and I’ll tell you yes or no.

So how do you bridge the gap? While there are a lot of things a lender might consider when making a lending decision, there are two key questions that cut to the heart of affordability.

1. How much skin do you have in the game?

“Skin in the game” is about how much of your own money you’re contributing to the setup or purchase of the business. If it were something as simple as a car being financed, it would be your deposit or trade-in value.

Using some of your own funds isn’t just about reducing the loan amount. For a lender, there’s a very significant difference between a $100,000 loan to someone who has saved up and is putting in $50,000 of their own money, and the same sized loan to someone with only $10,000 to contribute.

Regardless of the loan size, most lenders will want to see you put in at least 20% — and quite possibly more, depending on what the borrowed funds will be used for.

There are some exceptions. If you’re asset-rich but cash-poor, a lender may consider a larger loan without a big cash contribution. Likewise, if the borrowed funds are going toward something that offers strong security (such as a vehicle or quality equipment). But as a general rule, your lender is going to want to see that you’re taking some genuine risk with your own money — not just theirs.

Key takeaway: As a starting point, expect to contribute at least 20% of your own funds. The more skin you have in the game, the stronger your application looks — and the more options you’ll have when it comes to finance.

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2. Does it service?

“Servicing” is the other big affordability measure. From a lender’s perspective, the question of whether you can afford a particular franchise — or anything at all — is wrapped up in what lenders broadly call “servicing.”

In banks and finance companies across the country, the question being asked in some form is always: Can they afford to pay all their bills and repay our loan?

This might seem like the simplest of calculations — income minus expenses equals profit, right? Sure, but there are a lot of “what ifs” and “maybes” that go into that question.

For a new business, almost every component of your financial forecast will be an assumption — your best guess at what things will cost. You might not have chosen premises yet, so rent will be an assumption. You might not have hired staff yet — what if you have to pay more to get the people you need? And what about income? Hopefully you know how many customers you need and what it will cost you, but it’s all still your best guess.

Your lender might test your assumptions against other similar businesses, maybe even against other franchises in the network, but your future as a franchise owner is still somewhat uncertain.

Generally, your lender is going to want to see that your business will generate enough income to pay its bills (including taxes) and have enough left over to make your loan repayments. Remember also that if you’re going to be working in the business, the lender will want to see that you can draw a living wage — whether through profits or as an employee.

Tip: If you’re retaining other external sources of income, don’t forget to highlight this when applying for finance.

The bottom line: Every lender is ultimately asking one question: Can this business pay all its bills, repay our loan, and still put food on the table? The clearer you can answer that question with realistic numbers, the stronger your application will be.

Tools to help you prepare

There are various tools available to help you understand how all these pieces fit together and present them clearly to your lender.

A good financial forecast template is a great place to start — we provide one for free — or your prospective franchisor may have their own, tailored to their particular network.

Another useful tool is a cost and funding scenario, which sets out all the different types of expenses likely to be incurred in setting up a business, and more importantly, where all the money will come from to pay for them.

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The bottom line

While all the tools, forecasts, and rules of thumb can give you some idea of whether you can afford a particular business, it’s your passion, energy, and “fit” that will make the difference between survive and thrive.

Start by looking for the right business for you — then talk to a specialist about what it will take to bring it all together. You might be pleasantly surprised.