I cannot tell you how many times my lending brokerage had to stop bogus franchise loan applications that were provided to us. There was a lot of "coaching" and application "prep" going on by franchisors.  Many franchise salespeople think lenders should be on a "need to know" basis.  In other words, they tell the lender only what they think is necessary in order to get the application approved and their franchise sales finalized, even though there may be other pertinent information that should be disclosed.

The Small Business Administration guaranteed loans is part of a bigger systemic problem with the securitization market. Nobody holds their own paper. Almost everybody sells off transactions, without any recourse, and makes a huge commission in doing so. Underwriters do not have the proper “mindset”, given the rewards of the system and lack of risk. Both bank and non-bank SBA lenders can immediately sell off the paper to rip twelve points from the deal. That is a different mindset than a lender that is required to hold the paper in its own portfolio for the next ten years.

Lenders need to closely examine the franchisor and subject them to strict underwriting criteria. In my opinion, it is a mistake to rely on projections provided by the franchisor or the applicant without first calculating average unit volume (AUV, i.e. average store sales) with a simple method. I use royalty revenue, divide by the royalty percentage, which provides sales subject to royalty, and then divide by the number of units.  I average the three years that are disclosed in the Franchise Disclosure Document (FDD) and I find that the result is pretty close to the system AUV.  In fact it is often a better measure of AUV because the calculation spans three years and discounts a recent year that may have included explosive growth.  It also includes all stores, not just selected stores that are included in most Item 19 disclosures.

In my experience, franchisees aren't completely innocent in misleading. They go along. Many of them trump up their numbers in an attempt to outsmart a lender. I am fond of asking a franchisee, whose projected revenue is two times higher than the best stores in the system, why they think they are going to do so much better as a startup than a franchisee that has been in business for several years.  It is easy to tell by their answers that they did not expect the question because they thought, or were told by the franchisor, that their lenders wanted to see a high revenue number in order to approve them.

Those in my firm saw what Banco Popular and other lenders were doing. We would decline a loan transaction, only to hear a few days later that Banco, or some other SBA-approved bank/lender did the deal.  It was baffling to see these bad franchise risks receive loan approval.  We saw hundreds of undercapitalized or unqualified franchisees put into business by other lenders that had no place being there. I remember having conversations with franchise salespeople, where I asked why they would want to put a franchisee in business that had little or no chance to succeed.  Since having a high failure rate would certainly make lenders far more cautious in the future, I could not understand the logic of their very short-term thinking of wanting the sale now, despite what the future might bring.

Some franchisors and franchise salespersons convinced themselves that the lending spigot would never turn off.  They rationalized that as long as they could increase the number of locations, the failure rate would always remain in an acceptable range.  In reality, many franchise systems already had dismally high failure rates that would have excluded them from consideration by a conservative cadre of lenders.  Unfortunately, the SBA guarantee was seen as a way to get a loan funded if it proved too risky for a conventional loan. That is because banks or SBA lenders would have little or no downside in approving such risky loans. The result of not feeling the bite of risk was that applicants who had no business starting a franchise were getting loan approvals. 

Now that credit criteria have considerably tightened, these types of franchise applicants have little opportunity for approval.

Because of the abuses pointed out in Blue MauMau's article Franchise Liar Loans Spread among Banks, I think the franchise industry will see slow growth for the foreseeable future. The industry will see strong franchise chains eat the weak — both franchisors and franchisees. There will be a much smaller pool of franchise applicants to recruit from, especially for startups. Since there is very little construction of new franchise buildouts, by next year, locations for expansion should be difficult to find, especially in the regions hit hardest by the recession. That, coupled with the fact that franchisees are going to be very careful about selecting the right location, will also cause growth to slow.  This will result in franchisors becoming increasingly involved in the lending process as part of the "risk equation", especially if they want to obtain financing for their startup franchisees.  This won't only be the smaller systems.  We will see a lot of the bigger chains that partner with lenders. Franchise finance "captives" will begin to emerge with increasing frequency. 

In short, the ability to offer financing will become a major point of differentiation between franchise systems, with those that can offer financing being the first choice among a smaller pool of qualified applicants.

It will be interesting to see what the banks do as the SBA continues to tighten its standards even further because of the abuses pointed out in the article. At the International Franchise Association summit in Washington, DC last April, the rhetoric from the banks about the availability of franchise credit did not sound promising.  Additionally, with the costs imposed by the new reporting requirement and the continued tough stance taken by regulators, I expect bank lending to be a difficult environment despite the recent news about this bank or that bank increasing its franchise lending by some percentage over last year, a year that small business loans were harder to spot than Bigfoot.

Note by Don Sniegowski, editor of Blue MauMau: Mr. Rodi wrote the above column in an email to me. He has given Blue MauMau permission to publish it under his name. For years, Mr. Rodi has been a candid source of information for this journal on how he sees lending and finance trends in the franchise industry.