For franchisees, SBA loans have their pros and cons
Franchisees have numerous financing options, from equipment finance companies and banks to online fintech solutions. Yet borrowers are still exhibiting a healthy appetite for an old standby—SBA loans.
Small Business Administration loans were designed to assist startups and small businesses that don’t have the collateral or experience that most conventional capital sources, such as banks require. That’s where the SBA shines, says Alan Thomas, managing director of SBA banking at Cadence Bank. SBA financing is usually an ideal fit for startups with one or two locations, because it fills a financing gap for borrowers where conventional loans are not an option.
SBA loans also are attractive to borrowers who want a longer loan term and flexibility on how proceeds are used. For example, an SBA loan can finance soft costs, equipment costs and working capital that other equipment finance companies or other lenders may not be willing to finance. Loans can go up to $5 million, and the majority are financed as a 7(a) business loan. The SBA also offers loans through its 504 program, which are specific to the purchase of fixed assets such as real estate.
New franchisees often go the SBA route unless they already have an established banking or finance relationship, notes David Bloom, chief development and operating officer for sandwich concept Capriotti’s. Although there were some initial concerns about SBA reforms that went into effect in 2017, most agree that the changes have made the process easier and faster for franchisees to navigate.
“We have not been adversely affected by the rule changes. We have outstanding finance partners that are expert at navigating the process and supporting our franchise partners in obtaining their financing,” says Bloom.
A ‘new’ SBA franchise directory
Prior to 2017, a franchisor would have its franchise agreement and other documents reviewed by the SBA. If approved, then the franchisor would be listed on the SBA’s franchise registry. The previous process for capturing the franchise agreement and making sure it was SBA approved was lengthy and cumbersome, notes Margaret Ference, a senior vice president and SBA director at Huntington National Bank. It was up to the lender to review each and every agreement that was received by the would-be-borrower to make sure it was eligible for SBA lending.
If provisions within the franchise agreement were not eligible, the lender would have to work with both the SBA and the franchisor to create a unique addendum. That addendum process could take up to four weeks and delay a closing by as much as six months. Now lenders can easily review the franchise directory to determine if the franchisor itself is eligible, and it only requires a standard addendum be signed. “Overall, this has led to a much smoother closing process and a much faster closing process,” says Ference.
The new directory shifts the burden to brands to self-certify that they’re compliant with SBA rules. The downside of the change is more risk falls to the bank and the brand, notes Ron Feldman, chief development officer at finance provider ApplePie Capital.
If there is a default and non-compliance with SBA rules, then the SBA won’t honor the bank’s guarantee and there will be liability at the brand level for falsely self-certifying. “So, it went from having an assured process to a process where there are more shades of gray,” says Feldman.
Less than two years into the changes, it is still too early to tell what the longer-term implications of this might be. There haven’t been enough defaults and bad loans to provide enough data. “The issue is that we just don’t know yet,” adds Feldman.
Weighing pros & cons
SBA loans are designed as a steppingstone to help people get started in business. Most borrowers graduate out of those loans and transition to conventional financing well before the 10-year term is up.
“As franchisors, we like the SBA programs, but we have to be steadfast in our diligence process to ensure that franchisees are capable of both paying off the loans and still cash flowing the business,” says David Graham, CEO of Code Ninjas. “Without the right lease, loans and staff setup, it’s possible to get into a downward spiral where they are profitable if it weren’t for the loan payments.”
Borrowers also have to weigh the pros and cons of SBA loans as compared to other financing and go into the application process with eyes wide open on the potential pitfalls. “The SBA loan is a very painful process to go through, but once you have the loan, it is a relatively painless loan to service,” says Feldman. SBA loans are typically 10-year terms with no prepayment penalties and no restrictive operating covenants.
With complicated rules outlined in a roughly 400-page document, the process can be challenging for borrowers looking to move quickly to open a new location.
Another downside is in many cases a borrower has to pledge personal collateral, such as a lien on a home or other personal property.
The associated fees can also be a deterrent. For example, loans of more than $750,000 typically come with a 3.5 percent fee. In the past, the SBA has offered relief on fees for certain borrowers, including veteran-owned small businesses, as well as businesses located in rural areas. It’s not certain whether Congress will pass any fee relief for fiscal 2020.
Despite the pain points, SBA loans can be a great option for franchisees just getting started, or newer franchisees that are looking to finance growth. Franchisees in good brands have the ability to borrow between 70 percent and 85 percent of total project costs. One advantage is the loans are “patient capital,” meaning they’re structured with long amortizations and there is an ability to have a blended use of funds in one loan, such as to purchase equipment or to use as working capital, says Ference.
Selecting an SBA lender that’s a good fit for the borrower’s specific needs is paramount.
“One of the most important things that we stress is that as a small business that is just starting out, growing or in transition, that you really take the time to make sure your financial partner aligns with your purpose and your vision and plan,” says Ference. “It can sometimes be very easy to get access to capital, but it doesn’t necessarily mean it is the right fit for your strategy.”