The good news for franchising is the economy is coming back. Hit hard by the 2008 economic recession, franchise indices show an uptick in new franchise concepts and pent up demand for franchises among buyers. FranData, an independent franchise industry research firm, estimates that in 2013, banks will loan $23.9 billion to franchise businesses, the highest level since 2009. A quarter of these loans will come from the SBA's loan programs, which guarantee as much as 80 percent of the loan principal for a bank, with the rest conventional bank loans. But even with this improved outlook for franchising, FranData estimates a nearly 10 percent lending shortfall in 2013. There is simply far greater demand for franchise financing than there is money to lend.1
Lender reluctance is a significant obstacle to new franchise sales (franchisor-to-franchisee) and re-sales (franchisee-to-franchisee) which, in turn, presents a huge challenge for franchisors trying to grow a franchise system. While experienced franchise operators with a solid track record continue to find money to expand their franchise holdings (they present relatively low risk to a bank credit committee), the story is very different for new entrants—“start up” franchisees buying their first franchise. And start-up franchisors with unproven concepts are especially challenged in helping their franchisees find money to open the doors of the first franchise units.
What can franchisors, especially start-up franchisors, do to bridge the financing gap?
Get listed on the SBA Franchise Registry
The SBA Franchise Registry is a national online listing of franchise systems whose franchisees receive expedited processing of loan applications when applying for financial assistance from the SBA. A listing on the SBA Franchise Registry means the franchisor’s franchise disclosure document (“FDD”) and franchise agreements have been pre-approved as meeting SBA minimum lending standards. Pre-approval shortens the SBA loan process as franchisees buying a SBA Registry franchise do not have to wait for their lender to review the franchisor’s FDD and franchise agreement anew. Franchisors: it is easy to get a franchise program listed on the SBA Franchise Registry.
“Sell” your franchisees’ lenders on your franchise system
Franchisors, even start-up concepts, should have experience operating their business concept before offering franchises and should have financial data from their own operations to share with a franchisee’s lender. While franchise sales laws forbid franchisors from suggesting or implying to prospective franchisees a specific level or range of income, sales, or profits from owning the franchise (without disclosing the information in their FDD), franchise sales laws permit franchisors to share actual and projected results with the franchisee’s lender, “for the lender’s eyes only.” Even if franchisors opt not to make financial performance representations in their FDD (which the law leaves optional), franchisors should be willing to share with their franchisees’ lenders the results of “company-owned” units that serve as the franchise program’s prototype. Lenders remain highly risk adverse and will want to see any available performance history on which to base a loan decision. Franchisors should be ready to help their franchisees tell the franchise system’s story by providing performance and system statistics directly to the franchisee’s lender.
Select franchisees carefully
Franchisors, especially start-ups eager to jump-start the franchise program, may not be especially discerning in selecting franchisees initially. But franchisors who can demonstrate to their franchisees’ lenders that franchisee candidates must pass a rigorous selection process will have greater success helping their franchisees find financing. Franchisors should share their selection criteria and methodology with lenders. Reassuring a lender in the language that lenders speak (e.g., FICO scores) that a franchisee loan applicant has passed through a solid selection process can favorably influence a credit committee.
Mine your data
Franchise agreements routinely require franchisees to report their operating results to franchisors, but franchisors can be lax in collecting the information—or don’t know what to do with the data. Franchisee-unit data, including feedback from field inspections and compliance audits, should be considered an important franchisor asset that should be mined and studied to discern system-wide and individual operating strengths, weaknesses, and patterns. The data can be highly useful to franchisors in developing competitive strategies, detecting struggling units, and formulating a profile of an ideal operator to aid the franchisee selection process. Franchisee-unit data also allows franchisors to benchmark their own franchise system against peer brands, which can be extremely helpful not only in attracting top franchisee candidates, but franchisee lenders.
If you can’t provide capital directly to franchisees, know who’s lending to your franchisees
Marco’s Pizza rescued itself from decades of sluggish franchise growth when, in 2009, it committed itself to an aggressive franchisee financing program that included a captive leasing program, direct loans to qualified franchisees, and guarantying bank loans to Marco franchisees. Franchisors who provide direct financing (e.g., equipment financing, direct loans) and indirect financing (loan guarantee pools) demonstrate to lenders their willingness to put their own skin in the game. Of course, franchisors-turn-lenders are entitled to, and should be, especially choosy in selecting franchisees, but this, as noted, has positive benefits by reinforcing lender confidence in franchisee loan candidates. But even when direct and indirect financing is not an option for a franchisor, franchisors should track franchisee lending sources and outcomes in their franchise system. Developing a strong relationship with one or two banks that know the franchisor’s system well can streamline the loan process for new franchisees. Franchisors should be prepared to discuss past lending failures and the corrective steps in operations and the franchisee selection process that they have taken to avoid repeating past mistakes. Franchisors should put in place early warning systems to detect financially-troubled franchisees, be proactive in helping troubled franchisees identify and implement corrections, and get involved in the lender workout process (instead of turning a blind eye on a franchisee’s financial woes). These steps will help lenders feel more confident about their lending decisions.
Advice for franchisors
By the time your franchisee’s loan application is before a lender, you’ll have undoubtedly invested substantial time, company resources, and a few thousand dollars romancing the candidate, processing the candidate’s application, conducting background checks, and possibly beginning the site selection process and training the candidate (depending on your onboarding process). It is in your best interest to be proactive in helping your franchisee overcome the financing gap.
1These estimates were made before budget sequestration took effect on March 1, 2013. The SBA’s budget is slated to be cut by the mandated 5%, or by an estimated $900 Million, only worsening the franchise lending gap.
Davis Wright Tremaine is pleased to offer franchisors and franchisees advice on all areas pertinent to their franchise business and growth strategies. For questions about this Advisory, please contact Rochelle Spandorf, a partner in the firm’s Los Angeles office and a California State Bar Certified Specialist in Franchise and Distribution Law.