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Equipping Franchisees for the Financing Race

Despite increases in lending activity, small business is not yet out of the woods. 

Several franchise-related indices continue to point toward positive developments, but lender willingness remains an obstacle to economic growth. In March 2013, the International Franchise Association’s Franchise Business Index showed that demand for franchise growth remains strong and the index reported that franchise lending rose 2.92 percent month to month. In early April, the fifth volume of the Small Business Lending Matrix, which FRANdata prepared for the IFA Educational Foundation, also projected lending to small businesses to increase in 2013 to levels not reached since the recession.

As the graph demonstrates, banks are indeed projected to provide more lending capital as demand continues to rise. In addition, anecdotal evidence suggests that small businesses find themselves in a position where lenders compete again to provide loans.

So, all’s well that ends well? Not really. Although banks are happy to lend more than is needed to the lower end on the risk curve, in praxis this means they remain focused on credit risk. They make capital available just to a select few, but not to a broader group of small businesses. As the Lending Matrix points out, franchisee willingness and ability to invest in a franchise unit is up. However, the willingness of lenders to provide financing is not increasing fast enough to catch up with the growth in demand − and that hinders economic growth.

What is in the way of increasing lender willingness? The economy is improving, personal savings rates are up, 401(k) accounts are up and housing prices are slowly recovering. All these are important factors improving loan applicants’ ability to provide equity and collateral. Since that does not appear to move the needle enough, it is important to understand the following: lenders’ still very high risk aversion stems from a financial crisis that pushed them to become very conservative in their lending decisions. To avoid any costly mistakes − read risk − lenders tightened the credit box and have not eased lending practices significantly. As the graph shows, financing went into hibernation mode in 2009 and has yet to fully wake up.

At the same time, certain borrowers do not experience any challenges in finding willing lenders. They are mostly experienced operators that represent relatively low risk as viewed by bank credit committees. That begs the question of how new franchisees can make a lender willing to lend and what franchisors can do to help their franchisees when they seek a loan. After all, having spent time and resources on finding, qualifying and training franchisees, franchisors are now stakeholders with an investment. They stand to lose thousands of dollars for each franchisee that lenders do not qualify for a loan.

Essentially, franchisors need to prove that they have a lower risk than other systems. Some strategic steps are surprisingly simple. Keep in mind that franchisors and lenders are basically looking for the same franchisees, namely the ones who pose little risk. Franchisors seek franchisees who will successfully operate the business and generate a return in the form of royalty payments. Lenders want assurance that they get their money back, plus interest. To show that a system represents less risk than another and to help franchisees secure the required loans on the best possible terms, franchisors can follow these steps:

1. Get listed on the Franchise Registry. 

The Franchise Registry has been designed with lenders to connect them to every franchise. It provides the information, services and support that facilitate thousands of franchise loans each year. The site allows U.S. Small Business Administration lenders to find the eligibility documentation they need. It provides SBA and conventional lenders with underwriting information in the form of bank credit reports, franchise disclosure documents and other information about franchise systems and franchisees to make credit decisions.

2. Show lenders that you know what is going on in your system. 

This goes beyond your ability to know your franchisees’ top line revenues. Collect information from franchisees that helps you understand their financial and operational performance capabilities. This information can come directly from franchisees or feedback from field support staff and it can come from your compliance programs.

Implement a process to identify struggling units early instead of waiting for that panic call. And if you do all this, make sure you are not simply collecting data, but analyze them to turn them into information and actionable items. Keep your franchisees in the loop, too, and show how they stack up against their peers in your system. And while you are at it, benchmark your own system against the performance of peer brands.

3. Think about your prospective franchisee selection criteria and how to explain them to a lender.

Is this process simply based on a FICO score (the Fair Isaac Corporation, which is an organization that computes and publishes credit scores for consumers and creditors to view), a net worth/liquidity figure and touchy/feely “good fit for the system” criteria? Show lenders that your franchisees go through a solid selection process to identify the ideal future operator.

For instance, some brands look for solid business and industry experience. Others are only interested in business experience and prefer candidates not to have any prior industry experience. In any case, lenders need to understand why. If franchisors can show that the financial selection criteria are based on a solid methodology and are designed to take several factors into consideration, the franchisee’s case is stronger. As a result, lenders will be reassured that the loan applicant has already been thoroughly vetted.

4. Think of ways you can become a provider of capital. 

Increasingly franchisors find ways to provide either direct or indirect financing support to their franchisees. Direct financing programs include equipment financing and direct lending. Indirect financing may include loan guarantee pools. Offering such options shows that franchisors have skin in the game. And if they do, why shouldn’t the lenders?

5. In preparation for such a step, learn how your current franchisees financed their operations. 

Track lending in your system and even more importantly, track lending outcomes. Point out to lenders that still rely on SBA loan performance data that this information often does not tell the real story, if not an entirely misleading one. This can be demonstrated with the following chart which is based on a sample of 100 franchise brands.

Learn from past loan failures (SBA-guaranteed or not) and get involved in the lender workout process. That way, you can reassure lenders that even if they end up with a troubled loan, you will get involved instead of turning your back on the operations. This is a risk-mitigating factor that will help lenders more accurately assess their own exposure.

Coming Full Circle

Remember that franchisors and lenders are looking for the same type of franchisee. The franchisees, on the other hand, are looking for some guarantee that the brand they are investigating for investment is backed up by a system that will enable them to succeed. They are shopping around and are perhaps less wedded to a particular brand than to a whole sector or type of business. The more sophisticated they are, the more they will base investment decisions on a system’s performance.

Franchisors increasingly understand this and their pitch to prospects has evolved from a “brand promise” to a “franchisor support promise.” So why not add something like a “finance promise” into the mix. If a combination of the above can increase lender willingness, franchisees should expect better financing terms and therefore lower costs of operation.

To demonstrate how lender risk perception impacts a franchisee’s loan terms and the bottom line, we created a simple model. Using our assumption from the Small Business Lending Matrix, the initial investment for a franchise business averages $635,200. A typical franchisee will provide 35 percent of the capital needed in equity for a 10-year loan. While borrowers perceived to have the lowest credit risk may get the prime rate, lenders will charge an additional spread to borrowers they think pose more credit risk to mitigate the risk for potential default. With the current prime rate at 3.25 percent, three scenarios with the spread of 75, 175 and 275 basis points were created.

Let’s assume an average franchise business generates $800,000 in revenues and retains 18 percent in EBITDA and flat-lined revenue projections for 10 years, no additional capital expenditures, no depreciation and amortization expenses, and the underlying drivers hold constant into perpetuity. Based on these assumptions, the interest expenses vary between 1.6 percent and 3 percent in the first year, which means a riskier candidate pays almost twice as much in interest alone than another otherwise equally qualified candidate. Over a 10-year loan term, the franchisee with a higher spread of 275 bps is effectively paying $65,900 more in interest than those lending at the prime rate. In terms of return on equity − calculated as earnings before taxes, with the initial equity backed out, over the initial equity − the franchisee with better covenants can achieve a return of 5.2x, compared to 4.9x for a candidate perceived to be riskier. These interest expenses do affect a business’s profitability greatly and cannot be ignored as an expense item.

The effect on returns is amplified when a franchisee provides less (or more) than the assumed 35 percent in equity. To illustrate, we created a sensitivity analysis to examine the effect on ROE for 20 percent, 30 percent and 45 percent in equity. A franchisee with better covenants and lower equity (zero spread and 20 percent equity) can achieve almost three times the ROE, 9.5x versus 3.6x, than a less qualified candidate (275 spread and 45 percent equity). This results from just the different interest payments alone.

Lending remains a challenge to all borrowers except the least risky ones. Our five steps can impact how lenders view the risks associated with providing capital to franchisees. Anything that improves a franchisee’s loan covenant, improves their bottom line.

Kate Zhang is an analyst and the lead analyst of the Small Business Lending Matrix and Peter Schwarzer is research director For FRANdata.  Zhang can be reached at 703-740-4703 or kzhang@frandata.com and Schwarzer can be reached at 703-470-4706 or pschwarzer@frandata.com.

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