January Franchising World 2011
By Darrell Johnson, CFE
The credit crisis is mostly behind us. That’s the good news. But that doesn’t mean we are going back to the easy credit period of the last decade–far from it. We are now entering a multi-year period that can best be described as a competition for credit. Franchising in this next era will depend on understanding some new, as well as old banking rules.
The reality is that franchising is changing, in part because of economic factors and in part because of how lenders are changing their approach to lending. Economic factors can be best understood by looking at how public companies have responded to the downturn. During the good times, adding incremental revenue is less costly than it is now. A growing economy allows companies to increase revenues, in part, without a fight over market share. In a flat or contracting economy, gains in revenue come from some other company’s market share. Yet public company profits and stock prices have rebounded rather nicely in the past two years. That seeming contradiction is explained by how many companies have realized profit growth during the downturn–through efficiencies that come from expense reductions.
Adjusting to new economic factors occurs at two levels for franchise concepts: At the franchisee/unit level; and at the franchisor level. At the franchisee/unit level, we are seeing a period of operational focus, as well as revenue focus. There is a very simple reason for this increased focus–the margin for operational error is much less today than it was a few years ago. The rising economic tide allowed franchisees to make mistakes and still continue to grow. Today it’s much harder to stay above water because the margin for error is much less.
The best evidence of this change is the number of franchise systems that have begun utilizing unit benchmarking programs. Operations dashboards have entered the business lexicon. It’s hard to gain efficiencies without good information and franchising is seeing a big move toward benchmarking at the franchisee/unit level. Systems without such capabilities will be at a disadvantage as the slowly rebounding economy struggles for traction. We also are seeing a focus on investment efficiencies at the unit level. Footprint reductions, lower equipment costs, and greater uses of technology all are showing up in our tracking of yearly changes in franchise system information.
At the franchisor level, we are at the beginning of a period where franchisors start comparing operational efficiencies across brands and sectors. Franchisors have functions that are uniquely applied because of the franchising business model, such as development, training, field support and compliance. In this environment, a well-performing franchisee is more valuable because the amount of franchisor support costs is less than for an underperforming franchisee. In fact, most franchisors today do not know how much of a cost differential there is because these functions have not been benchmarked.
Like many public companies that are focusing on operational efficiencies, we will see further emphasis on such topics within the franchising community over the next few years. Our analysis of some franchisors show that their fully loaded costs to provide pre-opening training and site selection for each franchise unit is at least 25 percent higher than the initial fees received and the differential is recaptured over the first 18-30 months of normal operation of a new unit. The majority of units that fail happen in about the same time frame, which leads to additional franchisor costs, and pushes the average breakeven point out further.
The outcome of such comparative performance assessments will be changes to how franchisors operate. In the banking world, some business development commissions are being linked to loan performance. Will franchisors start seeing a closer working relationship between development and operations? Will operations begin to have benchmarks that link service costs to franchisee performance? New metrics will evolve from answers to these questions.
Competition for Credit
These actions have direct implications to the competition for credit. Lenders want one simple outcome: Their money back with agreed-upon interest. Any actions that franchisors and franchisees can take to increase the likelihood of that simple outcome will be viewed favorably in this era of competition for credit. Most borrowers view lenders in the context of a set of qualifying credit standards, such as net worth, liquidity, industry experience, credit score and so on. That’s just the qualification standard for lenders, who are getting far more sophisticated today.
Meeting the qualifications for credit and getting a loan commitment are two different actions. To get a commitment, lender loan committees are looking beyond the borrower and evaluating the brand that is behind them. Essentially, lenders are trying to determine which of the roughly 3,500 franchise brands are providing support that increases the likelihood lenders will get their money back.
A few years ago, when loan losses were at a minimum, all except the large, national franchise lenders were not looking very deeply into a brand’s performance. The national franchise lenders, of which there were only a handful, underwrote the brand and did a rather thorough analysis of franchisee and franchisor performance. For all other lenders the additional due diligence was mostly consigned to reviewing SBA loan loss statistics (which most lenders knew were not very accurate, but were easy to obtain), verifying that a brand was on the SBA Franchise Registry and, if the lender had some franchise experience, a cosmetic review of a brand’s Franchise Disclosure Document.
When the economy turned and concerns over loan portfolio performance (including housing and commercial real estate loans) rose, two things happened: First, most of the bigger, national franchise lenders essentially exited the market for various reasons largely unrelated to their franchise portfolio performance, taking away most of the experienced franchise lending capabilities. Second, the regional and local lenders started digging deeper to satisfy credit committee concerns before further lending without a good understanding of how franchising worked.
Most of the franchising community interpreted these changes as an unwillingness to lend. After the international financial crisis ended, it could be more appropriately understood in the context of inexperienced franchise lenders wanting greater assurance that a particular brand had good performance outcomes. Many regional and local lenders simply lack the knowledge of how to properly assess franchise credit risks. Since they have money available to lend, the burden of delivering such information has fallen on franchisors. That’s why it’s all about a competition for credit in the next few years.
We are now in a multi-year period where good unit, franchisor, and system performance matter more because it is those three credit risk categories that lenders are trying to assess. The economic factors that I discussed earlier and the credit risk factors that lenders are trying to understand are two sides of the same coin. Both are aimed at identifying better performance. After almost a decade of easy lending that was helped along by a rising economic tide that obscured underperforming brands, franchise brands that focused on good unit economics, strong system performance and solid franchisor support are going to be the capital access winners in the next few years. The rules of capitalism always prevail, even if they get side-tracked for various reasons once in awhile.
Lenders are from Missouri
We’re in an era where all lenders are from Missouri (the show me state) and all franchisors with good unit, system and franchisor performance measures will start being forthcoming with such information. Determining whether a borrower meets the evolving credit box is the easy part. What lenders also want to understand starts with assessing unit economics. To be clear, lenders want to see far more than is usually provided in an Item 19. While the absence of an Item 19 is not a good sign to lenders (does the franchisor not keep track of such data or does the franchisor not want to show it), having an Item 19 that only shows unit sales is a starting point, not the answer to the unit economics credit risk assessment. Lenders can be provided with additional information that is not in an FDD without creating regulatory issues. For franchisors with good unit economics, such information increasingly is being packaged as part of Bank Credit Reports.
System performance comes next. Lenders make credit decisions in large part by evaluating past history. What lenders really are trying to assess is how units and franchisees have fared in the past few years, including how many units have truly failed and for what reasons. Like unit economics, the FDD may be a starting point but it certainly isn’t all that helpful in answering this credit risk issue. And it may even be misinterpreted by a less experienced franchise lender. It’s a document that was designed for another purpose and has not been particularly helpful when it is used for credit risk assessment purposes. Instead of relying on a document that does not properly address credit risk, it is far better to assemble system performance information based on banking risk factors and in banking language (for instance, unit turnover and unit continuity are two very different concepts and the latter directly applies to credit analysis). Further, with the general understanding of the limitations of SBA performance data, being able to verify the actual loss outcomes is now more important.
Finally, how a franchisor performs is important to lenders in assessing the likelihood that they will get their loan dollars back on schedule. That starts with the franchisor’s own financial performance. Isn’t their own ability to manage their financial house a reflection of how well they are able to help franchisees manage their financial houses? Further, development, training, field support and compliance monitoring are as much a credit risk issue as they are a franchise function. Being able to assess the brands that perform these functions better has meaningful risk implications to lenders.
We are in a new period of capital access where the emphasis is on comparative performance. Franchisors that are able to prove to the lending community that their systems are better performers will have more capital available for both new unit development and resales. In fact, resales are becoming a more significant factor for many systems, as a baby boom generation transfers the reigns to the next generation and some of the franchisees that got into the game in the 2003-2007 economic expansion period find less interest in continuing in the slow growth decade we are in now. I suspect that many franchisors will start functions for resale that are added to or separately managed from their development and operations units.
The competition for credit will force changes in how franchise systems operate as better brands show the lending market that they are better credit risks. Doing so will require some new performance measures, franchisor functions will evolve, and independent validation of the results will be needed to convince those Missouri bankers. Change of this magnitude will be hard to adjust to and will be disruptive to businesses and people. It’s a form of creative destruction that has been witnessed in many other industries. And, while hard for the half of franchise systems operating below the average, it is necessary in an economy that rewards success. It will be good for franchising because the result will be stronger performers and a strengthened business model. It’s going to be an exciting next few years in franchising.
Darrell Johnson, CFE, is president and CEO of FRANdata Corporation. He can be reached at firstname.lastname@example.org or 703-740-4700.