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Loose Lending

Two watchdogs fault SBA for liberal loans to troubled systems


Default and charge-off rates are two data points to ponder when buying, or lending to, a franchise. Four systems, one unnamed, are cited in two recent reports, and not in a good way.

The Small Business Administration’s primary task is to make loans to businesses that can’t get them from conventional banks. But at least according to a pair of government watchdogs, the agency has been too liberal with those loans in some franchise systems

Both the U.S. Government Accountability Office and the SBA’s Office of Inspector General took the agency to task recently for approving loans to franchise systems with poor records of defaults. 

In theory, the results could make the SBA a bit more squeamish when it approves franchise loans, at least to riskier systems. But most doubt the reports will have much of an impact. “Honestly, looking at this stuff, I would have to say no,” said John Gordon, a restaurant and franchise consultant out of San Diego. 

The reports do highlight some of the risks involved in franchise lending. And they demonstrate the need for prospective franchisees to do their research before they buy into a system.

Both reports examined loans made within specific franchise systems—covering four total—and all of them had lengthy track records of high default and charge-off rates, meaning numerous loans within those systems failed and ultimately qualified for an SBA guarantee payment. 

According to the OIG report, the SBA “had not implemented a program or process to effectively monitor risk in its loan portfolio.” Nor did it develop a policy to ensure risks were addressed. The report analyzed three “high volume franchises” with historical default rates of at least 46 percent. 

Those franchises: Planet Beach, which had a default rate of 61 percent from 2002 to 2009, and a charge-off rate of 21 percent. Another was Petland, which had a 60 percent default rate in that period and a 23 percent charge-off rate. The third was Cold Stone Creamery, which had a 46 percent default rate and an 18 percent charge-off rate. A charge-off rate is a loss rate, meaning that 18 percent of Cold Stone loans during that period didn’t get repaid.

By comparison, similarly sized franchises had average default rates of 26 percent and loss rates of 7 percent, according to the OIG. Over that period, these three franchise systems received nearly 1,000 loans at a total value of $199 million, and ultimately led to $39 million in charge-offs. 

According to the OIG, the SBA “did not analyze risk at the franchise level for its portfolio” and, as a result, continued lending money to those franchises despite those default rates. Loans were made to each of those systems in 2012 despite the defaults.

None of the three franchisors commented on the report in response to Franchise Times’  requests via email and phone. 

Watch revenue projections

The GAO, for its report, reviewed loans to what it would only call a “select franchise” from 2000 through 2011. Over that time, 54 lenders made 170 loans to this system of $38.4 million. Of those, 74 defaulted, and the SBA ultimately made guarantee payments of around $11 million. But four lenders had a particularly high volume of loans to this system, with 88 loan packages, and 55 of those loans defaulted. In other words, high-volume lenders were far more likely to make loans that eventually defaulted. 

The GAO investigated the lending practices in part because of allegations that a single loan agent intentionally exaggerated the first-year revenue of the franchise to assure the borrowers would receive the loan. The agency could not prove fraud, but it did find revenue projections were more than twice the actual revenue for 19 of 24 franchisees reviewed that received loans through this officer. 

“Loan brokers made up the numbers, which had no basis in reality, and lenders didn’t look at the numbers,” said Bob Coleman, publisher of The Coleman Report, a newsletter about SBA lending. “You had a franchise that showed they were doing for a first-year startup 1.5 times the sales of existing franchises. It didn’t make sense. And the lenders just made sure those projections worked. There’s just a need for more due diligence all around.

“It’s a warning sign to lenders to be careful of the loan brokers you work with,” he said. 

Can you make money?

The GAO report also demonstrated how difficult it could be for those startup franchisees to get good information on how much money their business will make in its first year. 

The agency interviewed operators from the system, most of which defaulted on loans. One franchisee cited unexpected expenses and insufficient working capital, and also noted difficulty meeting revenue estimates and a limited access to business-planning information. That operator ultimately filed for bankruptcy. 

Franchisors may or may not include an earnings claim in their franchise disclosure document, but when they do there is no requirement the claim explain how much the franchisee will make in the business’s crucial first year—when numerous businesses fail. Instead, the numbers come from stores open at least a year, or at least 18 months.

But most loan applications require first-year revenue projections. So, many franchisees told the GAO they use the earnings claims for those projections. The problem? The first-year revenue is usually much lower than revenue for established locations used in earnings claims. According to the GAO, average unit volumes are 1.43 times a franchise’s first-year revenue, on average. 

Franchisees instead should seek out other sources of information to get that first-year revenue projection, such as existing franchisees. 

The SBA has vowed to take steps to fix the issues with risky loans. According to the OIG, the agency last year drafted a plan to address risk across its lending program, which would analyze the portfolio by lender, industry, program, franchise and other areas. It also started an office to manage risk. Both actions, the OIG said, are the “first steps” to establishing a program to monitor risk.

Likewise, the GAO said the agency is taking steps to address the issues found in its report, and to improve oversight over potentially rogue loan agents. 

Then again, many of these issues are not new. A previous GAO report said the SBA “accepts greater risks than necessary” in part by not requiring franchisors to share in the guarantee. The date of that report? April 11, 1980. 


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