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Money Hunt

'Everything will follow' if franchisees are profitable, experts say


Jonathan Benjamin of Corner Bakery, left; Mike Rozman, CEO of the franchise-lending site BoeFly; and IFA’s Beth Solomon took their discussion to the halls.

How do you get lending for your franchise system? Get more active. Provide more information. And make sure that your operators make money.

“Franchising is easy,” said Ron Feldman, CEO of Wilmington, Delaware-based Franchise America Finance. “You just have to make sure the franchisees make money.” This was the overarching lesson of Franchise Times’ Franchise Finance Conference at the Encore Resort in Las Vegas last month. Franchisee performance is tantamount to the credit decision. Systems with franchisees who make money will be able to expand since their franchisees will be more likely to get loans. Those with franchisees who don’t make money will struggle in the credit department.

The overall lending market is improving, although loans backed by the Small Business Administration are down from their peaks in late 2010. While lenders are doing more loans, they’re still chasing higher-quality borrowers from stronger systems. The challenge for franchises, therefore, is to ensure franchisees are profitable. Franchisors should also encourage successful operators to build new units, and they should carefully document their successes. And then the loans will come.

“Forget the lenders,” said Mike Rozman, CEO of the New York-based franchise-lending site BoeFly. “Make sure your franchisees are profitable. If that occurs, everything else will follow.”

Information age

The key element in the lending decision is information. Traditionally, that information has been provided in the Franchise Disclosure Document, through the Item 19 Financial Performance Representation. But not all franchisors make such a representation, and most franchisors don’t indicate how much cash flow a franchise can generate—which is what lenders are looking for. “The FDD is not your friend,” said Feldman, who believes Item 19s without cash-flow information are not worth doing.

Many speakers recommended franchisors provide simple summaries of their system’s credit-worthiness to lenders, which they can do without violating federal disclosure laws. Several recommended the Bank Credit Report sold by FRANdata, including Julie Huston, president of SBA lending at Minneapolis-based U.S. Bancorp. Greg Esgar, CFO at Scottsdale, Arizona-based Massage Envy, called it “the best money I could spend every year.”

Lenders will obtain this information regardless, so it’s best for franchisors to provide it. Rozman recommended lenders contact 10 franchisees if the franchisor doesn’t provide financial data. Bob Rodi, CEO of Warrendale, Pennsylvania-based Mount Pleasant Capital, said he estimates his own number if it’s not on the profit-and-loss statement. “If I can’t get good information from the franchisor, I make up my own,” he said. “I take the revenue royalty from the FDD, divide by the royalty percentage, and come up with my own average-unit volume.”

That information is out of the franchisor’s control, creating potential inaccuracies. By compiling this information and providing it to lenders, systems can ensure banks have the right data. Feldman said franchisors should collect profit-and-loss data from franchisees—while also helping them judge their own efforts by providing systemwide benchmarks for them to follow. He said Goddard Schools, for example, publishes all of its franchisees’ financials monthly. “That makes every franchisee act better,” Feldman added.

Tracking defaults

It’s also important for systems to track their rate of loan defaults. Franchises have a poor record on SBA defaults—for the SBA overall, the default rate was 9 percent at its highest point; for franchises, the default rate was 17 percent, almost double.

Franchises have long questioned the accuracy of this information. Darrell Johnson, CEO of the Arlington, Virginia-based franchise information firm FRANdata, said his company analyzed SBA loans in a system with a 23 percent failure rate according to the SBA. Yet four of the 118 loans attributed to the system were not part of it. Plus FRANdata found 40 additional SBA loans in that franchise’s system that did not fail, and yet were not attributed to the franchise by the SBA. Adding those numbers cut the company’s failure rate in half, to 12 percent.

Feldman said systems should collect all information on how franchisees financed their business every time a new unit opens, and keep track of their performance on the loan. They can use this information to correct any inaccuracies in the SBA data.

Another piece of information franchises should track carefully is turnover. System turnover of 5 percent or more is considered a red flag, but many terminations are mischaracterized. For instance, Feldman said, some units that are never opened are considered terminated. Franchises should clarify this data.

Of course, it helps to avoid closures altogether. Marco’s Pizza, based in Toledo, Ohio, gives its corporate staff an increased bonus every year if no store closes. Staff didn’t receive the bonus last year—the system closed two stores. “We were not happy” about the closures,  said Chief Financial Officer Ken Switzer, but he believes the emphasis on keeping stores open helps keep the closure numbers low.

In recent years, Marco’s has tried everything to improve its franchisees’ access to capital. “We don’t leave any stone unturned,” Switzer said. The company uses several programs to encourage franchisees to seek financing. It has a financing program through Feldman’s company, Franchise America Finance. It also helps guarantee a part of franchisee loans, and as a last resort has a captive-lending company to make loans directly to franchisees.

Franchisor participation in the financing game is a must these days. “It’s not ‘if’ you’re going to participate in your franchisee community financing,’” said Dennis Monroe, an attorney with the Minneapolis law firm, Monroe Moxness Berg. “It’s how.”

A growing number of franchisors have hired staff to talk with lenders and to keep track of the financing markets. “A franchisor in today’s market who isn’t able to source financing for a 15- to 20-unit guy isn’t doing his job,” said Jim Ellis of New York-based CapitalSpring.

Some systems have programs with Franchise America Finance, which preapproves top franchise systems for a certain amount of financing. That includes the sandwich shop Togo’s, which has only recently ramped up efforts to grow and at the conference announced a $15-million lending package.

Choosing well

Perhaps the best way to ensure franchisees are financed is to pick the right franchisees. Esgar of Massage Envy said his system requires franchisees to hit certain operational and financing targets to be eligible to get access to the $15 million in financing from Franchise America Finance. “We weren’t going to just give this money to anybody,” Esgar said. “We had to make sure they were growth ready.”

Experience remains a big consideration for many lenders. “I know there are concepts out there that have franchisees with less experience that are successful,” U.S. Bancorp’s Huston said. “But that’s not the rule. We’ve had more fail than be successful.” Those that do succeed with inexperienced franchisees, Feldman said, should “shout it from the rooftops.”

Another consideration is working capital, or another source of income. For instance, a person with a higher credit score and higher net worth isn’t necessarily a better borrower if his or her spouse doesn’t work. Credit score “is only a guide,” Feldman said.

Some also suggested that franchises should change their royalty and fee structures to encourage more development among the top systems. Monroe said systems should consider tying royalties to profits, rather than gross sales, to encourage financing.

Feldman said development incentives to the top operators could also help. Plus, many of those developers have financing as it is. “You already know they’re good performers,” Feldman said.


Juicy development deals? Why one banker would rather pass

Julie Huston, president of SBA lending at U.S. Bancorp, raised a few eyebrows when she looked out at an audience heavy with franchisors, and said, “Development agreements,” and then shook her head. “Don’t like ‘em.”

Some systems love development deals, especially big ones, on the theory that a sophisticated operator can make an entire market hum along nicely.

Yet in recent years many developers have failed to meet development deadlines, which can be a real problem for franchisors. Failed development agreements can weaken key markets, preventing a brand from gaining enough of a market presence to advertise and build name recognition.

Huston went beyond that. She said operators with development agreements focus not on getting the first unit up and running, but on where to build the next one. Early units frequently struggle as a result. The number of casualties is “too many to name,” she said.

“We’ve seen so many failures as lenders because of those,” Huston said. “That’s why I don’t like them.”

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Wingstop tries, tries again with innovative financing plans

Two of the most unique franchisee financing plans discussed at the Franchise Finance Conference ultimately failed. Richardson, Texas-based Wingstop has had a problem with some of its single-unit operators: They lacked the equity to build a second or third restaurant. And the company’s stores tend to start out slowly, making bank financing tough. So Wingstop proposed putting in the equity itself, covering costs other than furniture, fixtures, equipment and building improvements. “Not a single operator took us up on it,” said Wes Jablonski, chief franchise relations officer at the 500-unit chain. The problem? They’d make less money with the second store.

Wingstop tried another effort when a three-unit operator in Florida couldn’t get financing for a fourth. The company called with a proposal to buy 20 percent interest in its existing stores, which would have provided the financing for that fourth store. “We thought it was a great deal,” Jablonski said. “But the franchisee treated me like I was asking her for $350,000.”

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Opening teams that stick around help prevelosings

If you want to keep units from closing, make sure they open well. That was one lesson from Phil Friedman, current CEO of Charlotte, North Carolina-based Salsarita’s and the former chairman of the McAlister’s Deli chain.

Friedman noticed shortly after arriving at McAlister’s in Ridgeland, Mississippi, that the company’s new-store-openings team visited a new store for only a week at a time. The stores’ performance, and then their sales, suffered after the team left. Many closed, and multi-unit developers frequently didn’t move on to their next store.

McAlister’s changed its approach. It took its best operators and developed a training program and formed teams to help with openings. By 2008, operators opened 30 new stores, and all of them were successful. “You have to stay there, to make sure people are trained and can execute it after you leave,” Friedman said.

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‘Run a tight ship’ is lender’s best advice for operators

Here’s a good tip for existing operators that want financing: Throw away your own trash. This story comes from David Stiles, senior vice president at Los Angeles-based Trinity Capital, who was on a tour of one of the franchisee’s restaurants with a lender and the store’s owner. The operator wanted a loan for another unit.

The group walked along the parking lot, and came across a discarded bag on the curb, not far from a trash can. The franchisee walked right past the trash as if he didn’t see it. The lender picked it up and threw it away.

Suffice it to say, Stiles said, the loan didn’t get done. “How do you get the attention of a lender?” he said. “Call them. Be organized. Run a tight ship. Educate and share information. Gain their respect and comfort.”

And pick up the trash.

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Marco’s targets a bigger bottom line, store by store

How does Marco’s Pizza finance its franchisees? It whips out the credit cards, of course.
Not directly. The Ohio-based franchisor has a team that works to find ways to improve franchisees’ profitability by $30,000 a year. That could include cost reductions, improvements to the business model or reduced discounting.

The team recently targeted credit-card fees. CFO Ken Switzer said credit-card costs have been increasing, and as the company looked for ways to save money, it asked its credit-card processor for an account review. Switzer now believes the review could yield each franchisee a $1,000-per-store savings per year.

Such savings add up, and the increased profitability is a boon for Marco’s, which is trying to improve on its already solid 2-to-1 sales-to-investment ratio.

Marco’s has been growing, Switzer says. Last year it added 61 units, and now has 278. This year, it plans to add 90 to 102 new restaurants.

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