Lenders tell how to fund renovations
A newly renovated Johnny Rockets pushes revenue to new heights, but franchisees need to find capital to fund the update.
The iconic French Laundry has just completed a $10-million renovation that has breathed new life into the 39-year-old restaurant with an ambitiously modern design.
Chef and owner Thomas Keller spared no expense recreating the fine dining restaurant with fritted glass, local basalt and wooden accents charred in the ancient Japanese shou sugi ban style. And to help with the cost, the restaurant sold off its temporary shipping-crate kitchen to the highest bidder.
At the same time, the Wendy’s in Shelby, North Carolina, shut down for two months for a major renovation and reimaging, as part of the brand’s wide-sweeping renovation efforts.
At first blush, these two restaurants couldn’t seem more different, but to compete in the current era of endless market share shifts, both needed more than a fresh coat of paint to stay competitive.
“There are two courses of thought. Some brands have a remodel program that you need to do for the brand just to keep sales flat,” said James Short, director of food franchise finance at BBVA Compass Bank. “Then there are some brands where the results are a lot better and it’s driving traffic and you’re getting a 15 percent bump.”
McDonald’s reports a 6 to 7 percent bump in revenue, Burger King has seen 10 to 15 percent bumps and Johnny Rockets’ down-to-the-studs renovations have driven a nearly 30 percent revenue bump.
It’s clear that reimaging plans are necessary to stay competitive; that’s why most FDDs include a renovation clause and timeline. And in markets where others haven’t remodeled, it can be a competitive edge. But it can be a sticking point for franchisees large and small.
Inside a renovated Johnny Rockets, out with the old, in with the modern.
Unlike the French Laundry, that North Carolina Wendy’s couldn’t sell off its temporary kitchen; it had to get some new financing to pay for the $450,000-$650,000 renovation.
Banks are still looking to get capital to work, but standard term loans and renovation loans are very different things. Getting access to fresh capital for a reimaging project isn’t always an easy conversation with banks. Banks like simple leverage, so the promise of future earnings is a tough story to tell sometimes.
“It’s a sunk cost. And in many ways it’s a company expenditure that a company has not had to deal with, and that can be tough,” said Derek Ladgenski, a partner at the Katten law firm specializing in M&A and corporate finance. “Companies need to find lenders out there who understand the cost, but also understand the upside of the reimaging or rebranding.”
So when an operator is ready to do some renovating, it might not be the same lender who helped with an original term loan.
And even for lenders well acquainted with the franchise space, there are some projections lenders will be looking for. Those brands that are just trying to stay even shouldn’t require major capital commitments. And brands just starting a reimaging program need to outline the performance possibilities.
“Let’s say you’re a pizza shop franchisor and you know that the hot little concept has been brick oven. If you’re reimaging to something more akin to that, you’re going to look for comps down the road not just in the brand but what it’s trying to get to,” said Ladgenski. “Look at Wendy’s. It’s a classier look for Wendy’s. It looks more like Smashburger, so pull your comps from there.”
In the franchise space, renovations aren’t generally a simple loan—especially among multi-unit operators embarking on big renovation projects across a longer timeline where a term loan would be unwieldy and cost-prohibitive for the borrower.
“A development line of credit is a much more nuanced instrument. It’s something that’s typically only used in the restaurant and franchise space,” said Ladgenski. “You can basically borrow over time, but they do what we call ‘term out’ over time. So you borrow as you go, maybe you’re allowed 10 bites at the apple to draw down dollars, and every year or so it goes to an amortization schedule as well.”
Oftentimes one of those larger projects will also mean refinancing existing debt to simplify what becomes a fairly complex financing setup. Getting everything under one lender also gives lenders some peace of mind around leverage.
“We work with the customer to understand what their capital needs are going to be for the next two to five years and create a model and projection to determine two things: how much of a development line they’re going to need and an expectation around what they’ll be able to use each year and stay within the financial covenant,” said Short, who generally works with larger operators.
For example, a lender might refinance an operation with a standard $20 million term loan with a $10 million development line that is available for three years. The operator can borrow from that pool throughout the year, paying only interest until the end of the year. At that point, it’s rolled into the original and they can continue to borrow development funds for another year.
Of course the red hot M&A environment complicates things further for both buyers and sellers. For buyers, many new acquisitions also come with reimaging commitments. For established operators, that’s not a big issue, but diversifying operations may find some issues.
“In a buyout you’ve got a lot of moving pieces. When you introduce a reimaging on top of that it becomes more difficult to anticipate what may be coming down the pike as opposed to someone who is operating their company well and just looking to find some financing for the reimaging,” said Ladgenski. “Not to say it could derail an acquisition, but it’s always more difficult to tell a complicated story to the investment banker and potential buyers.”
Short said buyers should be prepared to demonstrate their skills or get some expertise on the team if they’re jumping to a new segment. “As long as the operator has been able to forge a good relationship with the brand themselves, then we feel pretty good about QSR to QSR,” said Short. “What we need to understand more is if QSR is going to casual, then you need to understand bar and liquor sales, full menus. That’s where we would look to have that operating partner who has done some casual dining before.”
Operators pondering sale or retirement saddled with a remodeling commitment have a lot of thinking to do. On top of the many moving parts, adding a development line of credit to a business might just not make sense if an operator is thinking about being done.
“Say a family has worked for 10 years to build up 10 to 15 burger shops within a franchise system and they’re hit with a significant reimaging platform,” said Ladgenski. “Depending on how excited they are about the business” and what their personal plans are, “it may be a good time to exit.”
And for small operators with just a few locations, reimaging is still a tricky situation. But personality goes a long way.
“The smaller operators deal with their local community banks in a lot of cases because they’re in that community and know them. And in these local community banks, the personal guarantee goes a long way,” said Short.
“These smaller operators are still finding financing, but it’s based on Bob being the McDonald’s guy in town and the bank loving that.”