A Lender's Advice on Purchasing a Franchise
Read the UFOC As If You Were an Investor Looking to Buy a Stock And Ask These Questions...
There are a number of Franchise Expos coming up. When attending such meetings, remember that exhibitors pay big bucks to get customers. Do not attend something like this and be surprised when the exhibitors try to sell you something. The assumption is that if you aren't looking for a franchise you would not be attending.
There are many who ask how to select the right franchise. While I would not denegrate the value of a so called "ground floor" opportunity, as one who has completed hundreds of millions of dollars in franchise loans and assisted with opening over 2500 locations I would offer one simple rule to all of the fine advice that has already been offered here. That is, read the UFOC as if you were an investor looking to buy a stock.
As you do so, ask the following unemotional questions.
Would you invest more money in a franchise location than the franchisor has invested in their entire business? Consider the capitalizion of the franchisor. They make a lot of representations in the UFOC.
Does the franchisor have the money available to keep their promises to you?
One of the most highly touted advantages of buying a franchise is that you are buying a "proven system". Just how "proven" is the system? Has it been proven in 5 locations, 50 locations or 500 locations?
How long has the franchisor been in business? If it is under 5 years we would not consider lending money to their franchisees because until a franchise has passed the 5 year mark the % of franchise system failures is very high.
Does the system have a "brand name"? That is a big part of what you are paying for. Understand that if you are opening in a new area for the franchise, you will be largely on your own in building the brand. There will be no regional advertising fund. If you love the opportunity then understand that your costs in that type of opportunity are going to be much higher than in an area where the franchise is well known. Negotiate with the franchisor and see if they will commit to building the brand in a new area. If they will not, my advice would be to look elsewhere.
Look at their revenues. Is the franchise system deriving revenues from royalties or is the bulk of their revenues coming from the sale of franchise agreements and/or area development agreements?
Look at the outlet list. How many stores have they opened over the last 3 years? How many do they intend to open in the coming year? If you see a large number there, you should investigate whether or not the franchise system has the resources to support the kind of growth it is reporting.
How many stores have closed or transferred? In a mature system a high number of transfers is not uncommon. In a relatively young and growing franchise a high number of transfers is a major red flag.
If the system does not provide an earning claim do your own. Here's how. Take the average royalty revenue over the past 3 years, divide that by the royalty %. That will give you the average sales sales subject to royalty. Divide that by average number of units over the same time period. If the number of units has doubled or tripled in the most recent year then throw that year out and use the first two years. As the existing franchisees what they are paying for rent. Look at the rent as a % of revenue. Calculate FCCR (fixed charge coverage ratio) FCCR=EBITDA +Rent divided by Rent + Debt Service. You should be looking for a potential ratio of 1.3:1. This means that you should have $.30 of revenue for every $1.00 of fixed costs. Below 1.3:1 franchise delinquency nearly triples and you run the risk of not having the cash flow margin to weather tougher times.
Look at management. Has there been high turnover in top management positions? Why has this occurred? Has the franchise been sold recently? New owners have a tendency to change and tune the system. This will definitely affect your investment because you do not want to buy into a franchise while they are "experimenting" with a new direction for the concept.
With respect to franchise consultants that work for various franchise systems, simply remember how they are getting paid. In most cases they receive up to 50% of the franchise fee to talk you into signing an agreement. Well established franchise systems do not have to pay those kinds of fees to franchise consultants. That may be worth it for you if you find the right opportunity but knowing that may be a point of negotiation for you with the consultants.
Lastly and most importantly, do your best to remove emotion from the situation.
Don't get caught up in the fact that you are going to "be your own boss" or get rich with multiple units. Be very careful committing to multi-unit development contracts and make sure that you have the liquidity and net worth to open multiple units before you advance the money for 3 or more franchise fees upfront. Look at the development schedule and make sure that you have either the equity, or that you can raise the debt to comply or it will cost you money for extensions. Franchising can be very lucrative if you understand what you are getting into. If you add these items to your due dilligence then you increase your chances of success exponentially. If you feel yourself getting emotional just remember that you are committing your family resources to take a major risk. Understand the risks going in and you increase your chances of getting the reward that you are looking for.
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About me: I have been lending money to franchisees for over 15 years. My company offers conventional financing, 84 month, excellent fixed interest rates, no collateral required except the assets of the franchise location (no second on the applicant's home). I am not saying this to do a commercial but simply to underscore the fact that, as an unsecured lender, the performance of the Franchisor is of paramount importance. I currently have a portfolio of approximately $52MM in franchise loans and we do not have a 30 day delinquency. I attribute this to selecting the right franchise systems through which we offer our product but also the fact that the best franchises, in general, attract those with the best demographic profiles. We use both behavioral and demographiccensus based algorithms to qualify and pre-screen applicants. The average FICO score of our applicants is approximately 730 and the average tangible net worth is $300K. Our average loan exposure is approximately $190K.
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