Franchisees Kept Out of Earnings Forecasts for Their Own Loans

WASHINGTON - With a quiet wink and a nod, many franchisors and lending brokers pass around financial information to a franchise investor's bank while keeping the franchise investor in the dark.Everyone seems to know except the person who has the most at stake in the loan, the franchise buyer. And yet, lending brokers often say that they are the agents for franchise owners and not the franchisor.

One franchise lending broker, who is well known in the industry but wants to remain unnamed, declares, “One of the oldest tricks in the book in franchising is the back of the napkin deal where the franchisor says 'Okay, we cannot give you an earnings claim. But we will help you put together a business plan for you to take to the SBA.'

"Because the SBA requires a business plan. It must be documented with a three-year financial forecast.

"The franchisor frequently will supply numbers with a big disclaimer saying these are not indicative. We cannot say anything. These are purely for business plan purposes.”

Toronto-based franchise attorney Michael Webster thinks this is a problem. Webster has been involved in legal agreements south of the Canadian border for years, and Ontario franchise law is based on the U.S. Federal Trade Commission's franchise rule. He states, “While scribbling deceptive earnings claims on the backs of napkins by franchisor salespersons does still occur on occasion, the franchisor, SBA packagers and banks have evidently come up with a more sophisticated version of the earnings fraud. The SBA packager gives out an earnings projection to the bank, avoiding the item 19 requirements of reasonableness, but never shows the earnings projection to their client until the SBA loan has been approved.”

Too Little Too Late, Or Not At All

Take the example of Elinor “Pinky” Legaspi, a franchise owner. Her now-collapsed franchise chain declared in its 2007 franchise disclosure document that it refuses to give potential earnings figures to franchise buyers. Cuppy's Franchise Disclosure Document of 2007 clearly states that they will not provide earnings projections.

Item 19: “We do not furnish or authorize our salespersons to furnish any oral or written information concerning the actual or potential sales, costs, income or profits of a Cuppy's franchise. Actual results vary from unit to unit and we cannot estimate the results of any particular franchise.

"We specifically instruct our sales personnel, agents, employees, and officers that they are not permitted to make such claims or statements as to earnings, sales or profits, or prospects or chances of success, nor are they authorized to represent or estimate dollar figures as to a franchisee's operation. We will not be bound by allegations of any unauthorized representations as to earnings, sales, profits or chances of success.”

But investors reasonably desire to understand future earnings scenarios of their investment. That includes banks. So franchisors typically prepare pro forma (financial forecast) statements with exact earnings projections for the franchisee's lending agent and for their bank.

Below is a pro forma profit & loss statement. Cuppy's Coffee and Funding Solutions, the franchisee's agent, prepared it without sharing the information at the time with the franchise candidate, Ms. Legaspi.

Figure: Three-Year Profit & Loss Statement prepared by Cuppy's Coffee and Funding Solutions for a franchisee to obtain a bank loan

The financial projections compiled in June 2008 show a rosy three year picture for 2009, 2010 and 2011. Compare that to the reality of 2007 and 2008, where Cuppy's franchisees were either unable to survive as a franchise or they went independent. The coffee chain imploded.

What's going on?

And then there is the additional problem of not being able to see the financial projections until it is way too late for it to do much good for an investing decision.

Only after franchise owner Claudia Robbins had signed the franchise agreement, signed a loan agreement with her lending agent, and then asked for the business plan did she see the financial estimates that Cuppy's had prepared for her lending broker on how much her shop would make. "Those numbers clearly came from Cuppy's," she declares. But by the time her lending broker, Funding Solutions LLC, showed her the earnings figures for her shop, it was too late to pull out.

"When I saw the numbers after closing, I gagged," Robbins emphatically states.

Those numbers were shown after she "closed" or signed the franchise agreement and bank loan agreement. She was on a road from which there was no pulling out.

Lest there be any doubt who her lending agent works for, Franchise Solutions emphasizes that its relationship is with the franchisee, not the franchisor or bank. The lending agent for the franchise buyer posted an article on June 1 that specified who its client was:

“. . . the lending institution works directly with our client, the franchisee, regarding distribution of the loan proceeds.

"If we find that a franchise system is not operating within a standard that will not serve the franchisee’s best interest, we will withdraw offering our consulting services to prospective franchisees for that franchise system.”

Ms. Robbins observes that Funding Solutions was constantly visiting Cuppy's Coffee and their finance department.

“The lenders that I work with would not accept that,” states a lending broker. “If there was something that came from the franchisor, they would not accept it. The lenders that I dealt with would not do a deal unless they had pre-approved a franchisor. And they have lots of requirements. They must be in the business for at least five years. There could be no prior bankruptcies. They [the franchisor] had to have multiple years of increasing retained earnings.”

Regarding the earnings projections given on her Cuppy's franchise to the bank, Pinky Legaspi says, "Those numbers had no relation to reality."

PInky and Claudia did eventually see their earnings projections — after their loans closed. But many franchise buyers never even see the earnings projections given to their lenders. Many have no idea that such a thing exists in connection with their loans.

Bogus Cash Flows Projections

The question is why the seeming collusion between lending broker, bank, Small Business Administration and franchisor.

“You have a back-door earnings claim. Not only are financial forecasts being provided to banks to induce the loan, but lenders and loan brokers are often contractually prohibited from sharing these earnings projections with borrowers," says New York franchise attorney Paul Steinberg.

Steinberg stresses how this system is like the housing liar loans, where bogus income and assets were put into sub-prime home loan applications without a care.

"The risk is passed on so no one cares. And the franchise owner isn't in a position to know or do anything about it," says Steinberg. He adds, "The actual person who is the real  party in interest is the franchisee/borrower who will lose their home if the loan is not paid. In this case, the 'real party in interest' is prohibited from knowing about these bogus numbers by the franchisors, who forbid the lenders and brokers to share them with the loan recipient."

“If the financial forecasts were accurate, a lot of these loans would never be made," declares Steinberg. "If the bank, broker or the government were on the hook for losses, you would never see these loans. It is like the housing liar loans."

A franchise owner in a 300-unit franchise system states, “My lending consultant told me that the only way the SBA will guarantee a loan is if you put a number down that fits their requirements, and that they knew what those ratios were.”

He borrowed $300,000 and finds that almost all of his fellow franchise owners are not able to make money.

His lending broker worked with him, telling him what numbers needed to be inserted in order for him to qualify. He says, "I remember that my lending consultant called to tell me that they had to change some of my expenses in order for me to qualify for an SBA-loan with a lender."

"When I was preparing for the loan, my loan consultant, who I was referred to by my franchisor, gave me all the gross sales figures and asked me to fill in my monthly expenses.  I was told by the franchisor that the consultant has worked with a number of their franchisees and that they are very familiar with the franchise system and have all the numbers and business plans to help get the loan. The consultant confirmed they worked with many other franchisees within my system and they validated the sales figures.  After filling out the expenses and returning the information to my consultant, I was told my net profit numbers were too low so the consultant changed some information to raise the net profit number." 

The franchise owner continues, "I have since come to learn that the SBA requires a profit to be shown on your financial forecasts for your first, second and third years in business. Not just any profit, but a number high enough to meet the ratios required by the SBA and the banks — which is why my consultant was playing with the numbers. Those gross sales numbers that were "validated" turned out to be twice as high as what the average first year franchisee grosses in their first year within our franchise system. Essentially, the consultant "backed into" the numbers by first knowing the amount of loan needed, about $300,000, and then figuring out what gross revenues are needed to get to the proper net required numbers. If we had used the real gross numbers as opposed to the inflated, fraudulent numbers, I would never, no one would ever, get approved.  I had no idea what was going on until it was too late."

The franchisee adds, "I discovered later that the lender didn't seem to care if the numbers reflected reality because as long as home prices were going up, the SBA could get their money back from closing on the homes of the borrowers.”

A Solution

Steinberg asks this fundamental question, “Why doesn't the SBA insist that the financial information given by franchisors to the banks also be given to loan applicants, that is to say the actual franchise buyer? Buyers would be in a good position to verify whether the financial scenarios for their future store were bogus or not.”

The New York attorney stresses, "This is likely to be a developing problem. The reason we haven't heard about this is because home values and the stock market were roaring. When borrowers got into trouble, they could get a housing loan. There was plenty of money. Now with the collapse of asset values, when people get into trouble they don't have the wiggle room. As Warren Buffet says, 'It's only when the tide goes out that you see who has been swimming naked.'”

Steinberg asks, "Now that they are in so much trouble, will the lenders and Small Business Administration wise up to the franchisors that have their number?"

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Related Reading:

• Bank Rankings of Franchises Not for Buyers
• SBA's List of Franchise Loan Performance, a Tip Sheet at the Races
• Exposed by Not Having Earnings Claims? Then Have Salespersons Write Records

Articles relating to Cuppy's Coffee franchise system:

• Part 1 of the 2 part series: Franchisees Learn from Cuppy's Broken Coffee Chain
• Funding Solutions, LLC Responds to Franchisee Accusations
• Regarding fraudulent conveyance of Java Jo’z to Cuppy’s, In-House Attorney Attempts To Set Record Straight
• Cuppy's Coffee & John Dozier: What Franchise Times Won't Tell You
• Cuppy's Speaks Out on Accusations, SBT, AAFD and More
• Official Response of SBT
• Cuppy's Coffee Goes to Court: SBT Sues Elite Mfg.
• Loan Broker Cuts Ties with Cuppy's Coffee
• AAFD Terminates Accreditation of Cuppy's Coffee Franchise Agreement
• Cuppy's Coffee CEO Attends Court, Confronted by Franchisees