The Evolution of Franchise Finance
Franchisees should have a sound understanding of their financial positions and match funding with long-term plans.
By Randy Jones
Prior to the financial crisis of 2007-2008, the primary sources of financing for franchisees were U.S. Small Business Administration-backed loans, conventional loans, and equipment financing. During the Great Recession, traditional financing was a long challenging process, and the outcome was very difficult to predict; even for existing franchisees. As a result, a number of online lenders and marketplaces emerged. These innovative funding sources are actively competing for their share of the franchise loan market.
Today, there is a substantial amount of money in the system and financing is not as challenging as it was a few years ago. Compared to the pre-financial crisis era, existing franchise owners have more options to fund their development, remodels, equipment or working capital. At this year’s International Franchise Association annual convention, it was quite noticeable that there was a wide variety of lenders offering different products.
To simplify the discussion, assume the transactions do not involve real estate.
SBA loans still offer long-term (up to 10 year) loans with down payments ranging from 10 to 20 percent of all project costs. Eligible project costs include hard costs, improvements, soft costs and operating capital. The programs have implemented quite a few changes to allow access to more people and to streamline the process. Some notable changes in the SBA programs are:
- A scoring model has been implemented for loans less than $350,000 to make the process more efficient.
- Procedures have been streamlined for lenders documenting loans, which in turn simplifies the process for the borrower.
- Fees for loans less than $150,000 were set to zero.
- Fees for loans to military veterans between $150,000 and $350,000 were set to zero, and for loans greater than $350,000 the SBA fee is half.
- The personal resource test for liquid assets has been modified; making more borrowers eligible.
- The amount of SBA loans a borrower can have outstanding was increased from $2 million to $5 million.
- Rules for determining whether an affiliate business should be counted toward the size standard have been adjusted. This not only increases the number of businesses that are eligible for SBA financing, but also reduces the amount of paperwork necessary to review a request.
- With the advocacy of the IFA there are a significant number of lenders that are participating in the Patriot Express program.
- In general, there are significantly more SBA lenders actively providing loans to the franchise community.
Loans through Franchise Finance Divisions of Commercial Banks
These loans are often described as conventional financing and offer a five to seven year term. They typically cover equipment and possibly all construction costs. There have been some notable changes in this sector as well:
- Most lenders in this space required three years’ time in business. They are now considering loans for franchisees with less.
- Consideration is now given for financing requests for second units. Traditionally, these lenders focused on loans for applicants that were already multi-unit operators.
- Projected revenue streams to assess repayment ability are now being considered.
- There are more lenders in this space. The result is a competitive rate environment and faster turnaround time on approvals to take the loan off the street.
- Development lines of credit are being offered for stronger franchisees looking for a multiple store approvals in advance.
Equipment loans are two to five year agreements and can be “application only.” The most notable changes are:
- The use of online portals to submit applications. Most of these portals have a built in scoring system that assesses the type of equipment, personal credit, business credit, and time in business and provides a credit decision in hours.
- Similar to the conventional lending discussion above, there is more competition in this space which is creating a competitive rate environment.
The lenders are receptive to financing construction and soft costs for delivery and installation of the equipment. A few years ago they only financed the cost of the equipment.
Alternative Funding Sources
These are technology based alternative lenders that offer online applications, fast decisions, and quick funding. Three models are emerging in online lending to small businesses. Since these are a relatively new options, the discussion will be focused on an overview of how these products work.
1. Short term working capital solutions and loans. Amounts can range from $2,500 to $250,000. Underwriting is based on an application and a review of three to six months merchant account and bank statements. The credit decision and the amount an applicant is qualified for is determined using risk scoring models based on industry specific data. These products are generally more expensive than bank loans and are most often used by businesses that do not qualify for regular bank loans. However, competition and innovation has led to downward pressure on rates. There are two main products in this category:
a. Merchant Cash Advance: This is not a loan; it is a purchase and sale of future payment card receivables. For example: A business sells $50,000 of future card sales in exchange for $40,000 lump sum. Repayment is daily based on a percentage of credit card sales, and the process stops automatically when a business delivers the total amount future credit card receipts that it’s sold. Because there is not a defined repayment period, it is very difficult to assess the interest rate. The timeframe for repayment is typically between six to 18 months.
b. Short Term Loans: These often get lumped in with merchant cash advance products simply because the information provided by the applicant is similar and many times they are offered by the same lender. The biggest difference is the amount of the payment is defined over a given amount of time, therefore, the interest rate is clearer. Depending on the lender, repayment can be daily, weekly, or bi-monthly with a term of 12 months to 36 months.
2. Peer-to‐peer platforms are connecting capital from institutional and retail investors with business borrowers through a marketplace. Borrowers submit an application on a platform which is reviewed by the marketplaces’ credit assessors. Once approved, businesses post their loan request for investors to review and bid. The auctions typically take seven days, and loan funds can be disbursed within 30 days of initial application. Loan amounts range from $25,000 up to $1 million depending on the marketplace provider. The term of the loan will range from one year to six years.
With so many products available, franchisees have to be careful to select the right one. Since most franchise lending is cash flow based, choosing a short term loan to fund long term assets can result in debt obligations that can hurt their ability to expand. By putting more equity into the project, franchisees can negate the impact of short term loans. However, they have to be careful not to deplete the majority of their liquid assets in doing so, as this will also impact development plans.
All of the aforementioned options have a place in franchise financing. F franchisees must have a very sound understanding of their current financial position and match the funding option that propels them toward their long term plans. As with most things in life, failing to plan for the finish usually results in trouble getting there.
Randy Jones is a partner with Funding Solutions. Find him at fransocial.franchise.org.