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SBA's List of Franchise Loan Performance, a Tip Sheet at the Races

First Hawaiian Bank, Honolulu
First Hawaiian Bank is an SBA Preferred Lender. Photo/Blue MauMau

WASHINGTON, D.C. (Blue MauMau) - The Small Business Administration's compilation of loan performance data of over 500 franchise brands gives banks, lenders and now, franchise investors, guidance on franchise financial risk. The SBA list that is meant to help its bankers and lenders is far from perfect but the banker's “tip sheet” can now help franchise buyers who in the past had very little financial tools to judge risk by franchise concept.

Buyers of franchise units have a difficult task of guessing what franchise brands are better investments than others. Very little comparative information is available. The Wall Street Journal summarized this buying conundrum best: “There's no sure way for would-be franchisees to gauge their likely success with a potential franchise,” reporter Richard Gibson wrote. “But like bettors at a racetrack, they do have a tip sheet they can use for guidance. It's the Small Business Administration's annual compilation of performance data on thousands of franchisee loans it has guaranteed.”

Bet on the long-shot? Photo/BMM

That tip sheet is a secret list circulated among loan officers of SBA preferred lenders, the banks and lenders who are given the greatest autonomy to decide the validity of loan applications. The list of over 500 franchise brands is used by lenders to identify what to expect for a return from money loaned to franchise owners.

And how do banks determine what brands are worthy of their money? Simple. By keeping track of who pays them back and who doesn't.

The SBA gives out a list of franchise brands that features the failure rate of franchise owning borrowers in paying back SBA-backed loans. It is a list of how many loans were dispersed, consisting of SBA 7(a) and 504 loans to small business buyers, and how many franchise owners were so poor that they couldn't even sell their store to pay back their SBA loan. In short, it help lenders judge the lending risk of various franchise systems.

Some three years ago, Blue MauMau began searching for a very secretive SBA list. Preferred lenders did not want to get the Small Business Administration upset at them for leaking the information. Over two years ago Blue MauMau tracked down the list and published it for its franchise owner readership. Others have now published the list, including the Wall Street Journal.

That list means that there are some winners and there are some losers – chains that have heavier odds in favor of their franchise owners being able to pay back their loans and those with less favorable odds.

Problems with the SBA list

Critics speak about its weaknesses, saying that SBA loans are loans to riskier borrowers who do not qualify for conventional loans.

“The answer may be in the fact that SBA loans have typically been turned down by traditional lenders prior to receiving the SBA guarantee,” said Dale Nabors, speaking at the time when he was president of FranSynergy, a sales broker of franchise concepts and provider of back-office business solutions. “The average SBA guaranteed loan recipient has injected a lower percentage of personal capital into the venture, resulting in a lower commitment to the venture.” Mr. Nabors has since become the CEO of franchise chain Cuppy's Coffee. He was not available for comment for an update to these old comments.

If true, those issues make the list even more interesting for others. They want to know how the weaker buyers compare from one chain to another. They have little interest in the buyers who can afford to pay themselves salaries and have adequate capital to float their businesses for years, even if their businesses do not generate enough cash by themselves to stay solvent.

“If these are riskier groups, I still want to know how come only 4% of Subway franchise owners default on their SBA loans compared to 37% for Blimpie,” says Paul Steinberg, a New York-based franchise attorney. Steinberg elaborates, “While there may be some selection bias which would tend to make SBA loans higher (or lower) risk in the aggregate, that should be irrelevant in an "apples-to-apples" comparison WITHIN either the SBA loan default rates or the non-SBA loan default rates. Given the consequences of defaulting on an SBA loan, a high default rate is a serious warning sign. It is true that a high default rate may be in part reflective of a franchisor who does not properly screen applicants, but it is certainly a red flag warranting further exploration by a prospective franchisee.”

Mark J. Weiss, CEO of LeaseWise, LLC, a provider of small business funding solutions, disagrees that SBA borrowers are more risky. He states, “I believe that a lot of the SBA loans are because of cash-flow considerations, not because they are bottom of the barrel scenarios.” He explains that SBA loans are variable rate mortgages with possible payments below a conventional loan.

Some consultants and experts argue that the many reasons behind high failure rates make the list less useful. Knowing that certain franchise brands fail does not tell you why they are failing in such high numbers. Craig Slavin, a franchise consultant and president of Franchise Navigator, elaborates on this point. “This shows business failures and loan defaults. However, the real problem might be in the franchise sales practices of the listed companies.” He reasons that someone might have the right make-up to really thrive in such high-failure systems.

But whatever the personal reasons for the failure to pay back the loan, the bank has to look at the overall, aggregate risk. Weiss stresses why such lists are important to bankers. 'Although there are 85%, 75% and 50% guarantees from the SBA on its loans, ultimately it is the bank that will still eat a loss if the deal fails,” he says. “These [SBA loans to franchise borrower] deals have to get past both the bank and the SBA.”

Besides riskiness, the list has critics who say the data is slanted.

Robert Coleman, an SBA analyst and publisher of the Coleman Report, a trade journal for lending institutions, thinks there are two limitations with the SBA data. For one, these failure rates do not include conventional loan failure rates. After all, banks don't release their proprietary data on conventional loan failures for franchises. Coleman states, “This is an SBA loan as opposed to universal lending figures for a franchise brand.”

The second limitation is one of completing the forms correctly. “The loan has to be coded [in the paperwork] as a franchise. Someone, somewhere has to put the franchise code in the loan,” says Coleman. “And we know that there are loans that haven't been picked up in the system.”

Coleman advises potential franchise buyers to look at brands with a significant number of loan disbursements. “If you have loans where they have ten or twelve [loan disbursements], it's a small universe. That's going to throw the numbers [loan failure rates] out of whack.”

It should also be noted that of the ten worst performing brands that had the highest failure rates in the 2005 list, over 50 percent of those franchise chains eventually merged, were acquired or virtually disappeared.

Do lenders find the SBA list of franchise brands by failure rate useful?

No matter if some franchise salespeople and insiders do not like the list, there are a number of professional bankers who do. Coleman thinks the list is quite useful. “Lenders aren't relying exclusively on the [SBA failure rate] list, but they are using the list. It's a source of data, absolutely,” he concludes. “Even with all the flaws, the lenders still use it because it does give them a sense of franchise performance. They aren't solely looking at those numbers. They are inputting other factors. BUT most of the lenders I talk to do use it. I'm not familiar with one lender who would just throw it away. They all use it to a certain extent.”

The Wall Street Journal reports that Wells Fargo & Co., a major SBA lender, says it uses the data to help spot negative trends and reduce future loan losses, as well as to prospect for business. "We select new franchisers to target for sales opportunities based on the strength of their performance," says Thomas W. Burke, senior vice president. "High delinquencies will cause us to avoid a particular franchiser."

That is not universally the case. Scott Burns, senior vice president, SBA department of National City Bank, says from his perspective, “The data in this report is not deemed reliable. We use other due diligence sources to make our decisions on franchises.”

Nabors advises franchise prospects not to eliminate a franchise concept just because it is listed with a high failure rate. He advises, “when you see a table like this, you don’t eliminate the concept(s) from consideration, but you ask yourself WHY are they on the list, and WHAT does it mean?”

Coleman says that busy and risk-averse bankers have a different take on the issue.
“The franchisor better have one heck of a story to explain why they have a 30% failure rate for a lender to consider lending to their potential franchisees. In the past, they would just underwrite the franchisee. But now they want to approve the franchisor before they talk with the franchisee. Lenders want all the disclosures, including the financial statements. A lot of lenders I talk to, unless they are comfortable with the franchisor, they won't do the deal.”

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Related reading:

Next in the series:

  • Worst Franchisors by Failure to Pay Back SBA-backed Franchise Loans, 2007
  • Best Franchisors by Failure to Pay Back SBA-backed Franchise Loans, 2007
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