Liquidity, or having funds on hand that can be quickly accessed, is essential to your franchise business growth, particularly in the first year. This is especially true if the brand you plan to franchise has a business model geared toward rapid expansion.

It's also a vital component of your ability to access franchise business loans.

"When we evaluate borrowers, besides the brand and experience, the franchisee's liquidity is probably the most important characteristic we look at," says Jon Kilpatrick, franchise finance specialist at ApplePie Capital.

Liquidity requirements

Liquidity requirements may differ based on the lender and loan product, but what a lender requires is only one component to consider in regards to your liquidity. You'll also want to ensure you have enough money on hand to cover the initial expenses that come with opening and ramping up a business.

"If early operators are relying on the franchise disclosure document (FDD), they'll see a range of costs required to open a unit," Jon says. "But that might not feature all the information. A lot of things can happen. Sometimes a contractor is more expensive. Sometimes a buildout takes longer than expected."

Imagine you estimate it will cost half a million dollars to open up your first franchise unit. You have $150,000 worth of liquidity, put down $100,000 as a down payment, and take out a loan for $400,000 to cover the rest. If costs in the initial months are more than $50,000, where will the extra money come from to cover them?

If your liquidity is used up, and your business is not yet profitable, obtaining another loan to handle cost overages will be difficult.

How you use your liquidity will impact your franchise business plans.

Using liquidity strategically

In order to support franchise growth and minimize risk, liquidity should be viewed strategically. The more liquidity you possess, the easier it will be to obtain financing and fund your growth. Some borrowers may attempt to self-finance, doing everything they can to avoid taking on debt. While this may appear to be a conservative approach, such a strategy can back franchisees into a corner that will hinder their growth.

"Some people are averse to debt, but if they use all their cash to open a unit, they've spent their whole nest egg and now could find themselves going from having a lot of cash to being in a cash crunch," Jon says. "We have found that liquidity shortages are the number one source of financial troubles for franchisees, so not strategically using debt and liquidity together is a business risk."

For example, if you have a total of $500,000 in cash and use it all to open your first unit without the assistance of financing, you will have no remaining liquidity and will have to wait until that first unit provides enough cash flow to open new units.

On the other hand, if you borrow $400,000, and use $100,000 for the down payment (and $100,000 for a liquidity cushion), you will have another $300,000 to be able to open two to three units and also have a cushion for contingencies.

The security of liquidity

Beyond the franchise growth advantages of liquidity, having funds on hand as a safety net is just good business sense.

"It's absolutely important for franchisees to have a rainy day fund set aside in the bank," Jon says. "Beyond rent, utilities, taxes, insurance, which all adds up quickly, you'll want some reassurance that you have the necessary funds to handle any sudden expenses."

One approach is to calculate three to six months of fixed charges (including rent, utilities, insurance, taxes and debt service) as a proxy for how much excess liquidity you need.

Liquidity also acts as necessary security if you plan to make franchising your primary source of income.

"Let's say someone left their job and plans to use their new franchise for income," Jon says. "We will look at their living costs relative to their savings and liquidity and allow for a period of transition to living off the franchise unit if we can see they have enough savings to cover their cost of living for an extended period of time. But if that person only has $100,000 of liquidity, and they are relying on the revenue of the business for their personal needs, it's much more difficult for us to feel comfortable they will have enough income to cover their living expenses."

Just remember that liquidity is vital to both borrowing eligibility and franchise growth. Used strategically in combination with franchise loans, it can offer greater security and open up the door to faster expansion.