April 2010 Franchising World 
 
Regional and national lenders are still active in the franchise arena; however, they are evaluating both the franchisor and franchisee. 
 
By Jerry Jones and Randy Jones 
   
Financing for franchisees continues to be an obstacle to the growth of franchise brands. Conventional lenders have pulled out of franchise lending unless the concept meets very stringent criteria. The International Franchise Association has gone to great lengths to educate Congress and the U.S. Small Business Administration on the impact franchising has on the economy and job creation. It appears the advocacy has gotten the ear of the SBA, as Karen Mills, the administrator of the SBA, made an appearance at the IFA’s annual convention in February. Mills announced a proposal that offers community banks more incentive to be more involved in SBA programs.
  
Regional and national lenders are still active in the franchise arena; however, they are evaluating both   the franchisor and franchisee. Local banks may not have knowledge of a particular concept, and they must be educated on the strengths of the brand. Therefore, whether a franchise prospect is seeking financing through a local, regional, or a national lender, the ability of a franchisor to properly service the franchisee will be evaluated. In the past, franchisors simply provided a franchise disclosure document for this purpose. Today, franchisors will be better served by providing supplemental information. What information will help? Thinking like a bank will answer this question.  
  
How has the economy impacted franchise units? 
Current data on key analytics of the brand demonstrates to lenders that franchisors are paying attention. What data   is collected to monitor the health of stores? Has action been taken to reduce operating costs for the franchisee? Are franchisees financial statements submitted on a regular basis? Do unit economics demonstrate profitability? If the answers are positive, boast about them. If they are negative, what changes have been made to prevent further declines?  
  
A franchisee is struggling…now what? 
What assistance is provided to a struggling unit? If the franchisee has given up altogether, does the franchisor assume operations? Further, does the franchisor have an action plan to assist lenders with potential losses? Assistance does not need to be guaranteeing a loan, and programs such as unit/ asset resale offerings have proven to be helpful.  
  
Has the franchisor increased the quality of franchise prospects they are seeking? 
Franchisors spend significant amounts of money on lead generation and on development teams converting leads. If lead criterion is not modified to match current lending trends, then franchisors are wasting resources on prospects that may not come to fruition. Additionally, due to potentially slower ramp up periods, a prospect with more staying power might be less of a risk to the franchise system.  
  
What is the new credit criterion? 
   • Experience: SBA lenders want more applicable experience than in the past. Franchisors should be prepared to discuss training programs, and the type of franchisee that has been successful within the system.

   • Down payment: 20 percent to 30 percent equity is the new 10 percent to 20 percent.

   • Collateral: Requirements vary greatly by institution; however, it is safe to say that collateral will be required, especially if it is the franchisee’s first unit. Home values are discounted when calculating collateral values. Therefore, the equity available on the personal financial statement will not be the same as the collateral value the lender is considering. With home values varying widely, a Web site such as  www.zillow.com can be a good resource to test if the listed value is in the acceptable range.

   • Personal credit: SBA lenders allow the prospect to provide explanations for past credit derogatory remarks. It is highly recommended to provide these explanations up front.  

   • Liquidity: Three to six months of personal debt obligations available after injection for a personal reserve is recommended.

   • Income outside of the new business: For new franchisees, lenders want to know that personal expenses can be covered by outside employment. Therefore, an income strategy should be implemented prior to seeking financing.

   • Debt-to-income ratios: For existing and new franchisees, lenders will want to see that a prospective borrower is not over-extended.

None of these factors have greater importance over the other. Strengths in one area can overcome weaknesses in another. Additionally, the criterion varies   greatly from lender to lender. To focus development efforts on quality leads, it is important for franchisors to understand these criteria, or use the expertise of a franchise finance consultant to guide them through the maze.  
  
What points should a franchisor address on its balance sheet? 
During these unstable economic times, financing sources will be reviewing the franchisor’s balance sheets to make a judgment of whether the system will be able to complete its mission of serving its franchisees. For that reason, it is important to educate lenders about the franchisor’s ability to survive. This process may require additional education about the unique nature of accounting for franchises.

   • Are liquid assets sufficient to cover expenses with the possibility of declining revenues?

   • Have royalty collections been negatively impacted due franchisees inability to pay?

   • How are deferred revenues handled? Revenues for franchise fees which have not been earned (generally meaning the franchisee is not operational) are normally treated as current liabilities. This is required for proper franchise accounting. For emerging and poorly-capitalized systems, this treatment can substantially erode the working capital position which is important to lenders.

   • It is imperative for the franchisor to explain to the lender the exposure of potential refunds of the franchise fees. What is the refund policy? Historically, what percentages of fees have been returned? A high percentage of refunds may demonstrate that the system emphasizes unit sales, as opposed to opening stores.  

   • The success of a franchisee and franchisor is dependent on the ability to efficiently open stores. Consider preparing a chart that tracks the time from when a franchise fee is collected until the store opens. This is a key barometer for the operating efficiencies of the system. Further, it is a start in explaining the amount of deferred revenues.

   • Taking all of these factors into consideration, does the balance sheet currently show that a franchisor has the ability to reimburse franchisees for any potential fee refunds?

   • Are the financial ratios similar to or better than other franchisors in your segment? Include a computation of working capital with and without deferred revenue, debt to equity ratios, and other relevant tests to highlight your systems financial strengths.

   • In the franchise industry, there are various ways for making distributions to owners, partners or parent companies. They are required to be detailed in the Statement of Stockholders Equity. Because many of these transactions may be deemed by lenders as depleting the system’s working capital, be prepared to provide explanations.    

What points should a franchisor address on its income statement?
Lenders will be reviewing Statements of Income to determine if the franchisor has been and will continue to be able to support the franchisees. Profitability is important to the growth and stability of the system. Lenders are more interested in past performance and not as interested in the future. Points of emphasis are:

   • Answers for the differences in year-toyear operating results, both good and bad.

   • If franchise unit sales have been slow, does the system require franchise fees to maintain profitability? Also, what is the impact of potentially reduced royalty revenues? Is there a plan for supporting franchisees if revenues are reduced?

   • Product development and system improvements should be an ongoing function of the franchisor. Are the profits sufficient to continue to enhance the health of the system?  

What does the FDD really say? 
The FDD is a required franchisor document. It is in a prescribed format and does not permit leeway for any explanations. As a result, there are areas in the FDD that need expanded discussions. If the franchisor does not provide more detail, lenders will assume the FDD as being “gospel.”
  
Franchisors should not assume that the FDD is their friend in the lending environment. A story needs to be told to the lenders. Specific areas come to mind:

   • Item 7: Estimated Initial Investment
Franchisees that experience cost overruns may be under-capitalized, and in the long run, may end up an unfavorable statistic in FDD Item 20. What systems are in place to determine that initial project budgets are realistic and being met? Has the franchisor developed ways to reduce start-up costs?

   • Item 19: Financial Performance Representations  
The debate continues with respect to earnings claims. Much of the discussion is legal in nature. In the lending environment, a “mature” system with statistically meaningful data, could gain an advantage by making financial representations. If nothing else it can validate the assumptions in the franchisee’s financial forecasts required by lenders. Also, it provides transparency for the lender.
  
For new franchisors, where meaningful information is not readily available, it is easily explainable why representations are not offered.
  
From a franchise development perspective, is the system losing sales because competitors are providing financial performance representations?  
  
   • Item 20: Outlets and Franchisee Information
This area is closely scrutinized by lenders. It is the scoreboard of franchisee entrances and exits from the system. A franchisor might benefit from expounding upon the raw numbers as presented. 
  
Does Item 20 suggest an aggressive growth plan? Is there financial strength to support it?
  
Lenders are uncomfortable with apparent unrest in the system. Abnormally high transfers and exits from the system raise questions about franchisee satisfaction.
  
It is important that the franchisor knows the details of these changes. Who exited the system? Why did they leave? Did a franchisee with multiple units leave the system? Is the exit rate normal for the industry and the system? "

   • Miscellaneous FDD Items
Franchisors should explain any areas that can raise questions about the operation of the system. As an example, commentaries should be made regarding the status of specific legal actions. Detailed comments of any bankruptcies should be made. 
  
Expanded biographies should be considered for key operating officers. Profiles in the current FDD generally do not explain the successes of those individuals.  
  
Are there resources available to franchisors to guide them through the lender education process? 
Franchisors will need to play a key role in assisting franchisees with obtaining loans. Lenders are not only looking at the strength of the franchise applicants, but also at the franchisor’s financial ability to support those in the system.
  
The following is a partial list of available tools and resources to further prepare for educating the lending community:
   • Bank credit report: Reviews the franchisor’s credit worthiness and compares concepts within the industry.
   • Industry reports, such as IBIS World, which discuss industry trends.
   • Consultants with lending experience who can carry the system’s story to the financing markets and guide prospects through the lending process.
   • SBA Registry. Small lenders will not lend to franchisees if the system is not on the Registry.
   • FDD will be reviewed by all lenders. Franchisors should prepare expanded explanations for areas which better explain the data reported in the FDD.
   • IFA Benchmarking Study when available.
   • Coleman Report regarding the SBA activity. Be aware that data may be inaccurate and prepare what is believed to be the correct information.

Jerry Jones and Randy Jones are partners in Funding Solutions, LLC. They assist franchisors and franchisees with obtaining financing. They can be reached at 734-207-0800 or  jjones@funding-solutions.biz   and  rjones@funding-solutions.biz  .  

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