Tight credit is turning franchisors into lenders
V2K Window DÉcor had to do something. Franchise sales were plummeting, not because people weren't interested in opening units for the low-cost, home-based concept, but because they couldn't get loans.
So the company took the financing issue into its own hands - literally, by starting its own internal financing program.
Now the company gets prospects' credit information along with all the other information V2K gets in deciding who should get a franchise. "We were finding that people otherwise qualified can't get financing through traditional methods," said Paul Linenberg, the company's marketing director. "Demand is still out there, but the availability of credit is thin."
Incentives such as reduced royalties or waived franchise fees have been common as franchise sales have fallen amid the recession and the collapse in the credit markets. But a growing number of systems are taking an even more radical step by guaranteeing and servicing the loans or even lending the money outright.
Some companies feel they have little choice. Low interest rates for years encouraged a loose lending environment that fueled growth in the franchise sector. The credit crisis has put a stop to that environment, and while there is some evidence that the market is improving lending is unlikely to reach pre-recession levels anytime soon.
The lending tightness is especially difficult on franchises with smaller initial investments because banks are less likely to write smaller loans in the current environment. "The world has changed," said Tariq Farid, chief executive at Edible Arrangements. "It's gone from banks giving loans to anyone with a pulse to where they hardly give to anybody."
Tighter lending is slowing companies' growth and putting a substantial dent in revenues. To wit: V2K's revenue from franchise sales in the three months ending Dec. 31 fell nearly 80 percent. That difference, about $236,000, represented just about all of the company's total losses for the quarter.
As a result, franchises are now considering options they wouldn't have even thought of a few months ago so they can get units open - such as internal financing. "Everybody is feeling the same effects as we are," Linenberg said. "But we needed to do something innovative to change the dynamic."
Internal financing is hardly new. Companies such as ServiceMaster, Applebee's and Hardee's have had such programs in the past to ensure that their units can get the financing they need. Yet franchisors have generally been reluctant to develop such programs, in large part because they had no need to given the ready availability of credit, and because they feared the risks of financing.
Now that they have a need, franchisors have been looking into the plans with gusto. Dennis Monroe, attorney with the Minneapolis law firm of Krass Monroe, said that his firm has been "inundated" with requests from franchisors seeking to guarantee financing. "They're open to the options," Monroe said.
Monroe believes that franchisors were conservative over the years, which kept them from developing programs. Yet, he said, "They should have been doing this a long time ago, actually." He said franchisors with internal financing plans not only ensure financing but can get more control over what happens to their system - and he said that the risks of internal financing tend to be overstated. "I think it's just silly not to have been done in the past," he said. "They could have saved their systems a lot of heartache."
There are numerous ways companies can offer internal financing. They can provide limited guarantees, full guarantees, loan servicing, remarketing agreements, mezzanine financing or joint ventures. Franchisors can raise money themselves and set up a separate fund, or they can simply use their own available cash.
Franchisors who have internal financing programs note that they are a demonstration of the brand's faith in their system and the process they've set up for choosing and training franchisees. "We do it because we have that level of confidence in the franchisees we approve that they're going to perform under the franchise agreement, to the extent that we won't accumulate much of that debt," said Jim Deering, director of franchise development for Colortyme, which has guaranteed loans for franchisees, and serviced them, for several years.
The risk of guaranteeing loans forces the franchisor to think differently about the type of owner entering the system. Because the franchises would be on the hook for a defaulted loan, they're scrutinizing their prospects more heavily.
Farid's company is starting its own finance company, Farid Capital Corp., that will provide packages for existing owners looking to open a new location or upgrade their store, as well as leases on equipment for new franchisees. The company will guarantee and service the loans, and it has banks that will actually lend the money.
Farid said the program is causing the company to look much deeper at their prospects' finances. While before the company used to see if the prospect could get financing, it is now looking at whether the prospect should get financing - a big difference. "If we don't think it's the right transaction, we would be more adamant about it now," he said, "especially if they're looking to get financing from us." Farid added that the company should "be able to let them know if we don't think it's the right time or the right type of investment."
While internal financing would put companies on the hook for the loan should it default, those franchisors that have had such plans for years say that failures are minimal. "It's not a number big enough that I track every week," said Barrie "Bazzz" Young, president of franchising for Snap-On Tools, a mobile franchise that sells tools to auto mechanics and other technicians.
The company has had an internal financing program for years in which it will finance all but $25,000 of the initial investment, which runs from $149,848 to $278,444. The 89-year-old company has 3,445 franchises in the U.S. and roughly 4,800 worldwide. Young said the key to an internal financing program is to have strong franchisee support to ensure that their business runs well.
Here's another key when a franchisee gets into trouble: "We're proactive in helping them exit the business," Young said. "That limits the financial risk of them getting out of the business." He said the company would direct prospects to struggling franchises. "If you have a lot of people leave your business and lose a bunch of money, you're hardly likely to get a reputation to attract new ones," Young said.
Indeed, in many cases the franchise is in reality risking little. In V2K's case, the initial investment is generally low enough that the company ultimately has little to lose in the first place. In other cases, as Young noted, the company could work with a distressed franchisee to sell the business to another prospect that may be able to turn it around.
There are other risks, beyond default rates. Mostly, by deciding to guarantee and even service franchise loans, the franchisor is putting itself into the position of banker - which is generally much different than the company's core business, whether that involves selling blinds or marketing fruit gift bouquets.
That difference wasn't lost on Farid. "It's very much a departure," he said. "Are franchisors really good at financing? I don't think so. That's why we stayed away from it for 10 years."
But, he added, "There is a void that needed to be filled."
And despite the risks, franchises that have such programs say there are strong benefits. Colortyme, which will provide $380,000 to franchisees with good credit and $140,000 in cash, began its financing program to ensure that its owners could get the credit they need. The program also ensures that the bank that provides the financing - Wells Fargo Foothill - keeps the rate low. The company is able to offer its prospects the same rate as an SBA-guaranteed loan.
"It's been in place for a number of years now," Deering said. "That's put us in a good position this past year with the credit crunch. We haven't had to feel that same level of credit restriction that other franchises have."