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Understanding the changing dynamics facing capital providers is more important now as growing uncertainties and risks combine to put pressure on continued franchise capital access.

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By Darrell Johnson, CFE, and Elizabeth Taylor
 
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The franchise business model depends on outside capital. In most cases, that means debt financing from various types of lenders. Historically, those lenders, mostly banks, provided conventional and SBA-guaranteed capital. Over the past few years, we have witnessed the entry and growth of alternative lenders, such as those that utilize internet platforms as a loan sourcing mechanism. The International Franchise Association’s Small Business Lending Matrix Report shows the expansion in the flow of capital and the source proportions as follows:

Normally, the entry of an additional type of supply would lead to at least a continuation in historical growth. However, that is not the case, starting in 2015. The flattening slope of total capital demanded and supplied (preliminary 2016 data supports a continuing slowdown in expansion) in part reflects the era of easy access to business loans of the past few years is winding down. Business lenders typically are committing to a payback period of at least three and often 10 or more years, which frequently straddle economic cycles. Hence, lenders tend to become more conservative in their clients’ financial projections and resulting cash flow analysis ahead of actual downturns in the economy.   

Three Big Uncertainties

Lenders are in constant battle with two adversaries: uncertainty and risk. As we move into 2017, lenders face three big uncertainties: the economic cycle, the regulatory implications of the Trump Administration, and Small Business Administration rule changes. Lenders’ battle to assess risk is a constant. Risk in a lending sense is a relative issue — how one borrower, one franchise brand, and one industry, and one sector compare to other borrowers, franchise brands, industries and sectors.  First, let’s look at uncertainty.

 
  1. The Economic Cycle: We are in the third longest recovery in U.S. history. Only the 1961 to 1969 and 1991 to 2001 periods were longer. It certainly could go on beyond 2017, due in large part to this expansion also being the weakest pace of growth since World War II, thereby not creating any overheated sectors. However, the odds are increasingly working against continued expansion as we are double the duration of expansions in the past 100 years. Lenders become more conservative heading into downturns to avoid loan portfolio problems. 
  2. The Regulatory Implications: The past eight years have been difficult for banks as the significant expansion of regulations has forced more conservative lending practices, increased lending and compliance costs, and pushed many smaller banks into mergers. Banks will continue to move cautiously into new lending programs and will emphasize deeper due diligence and greater loan documentation.
  3. SBA Rule Changes: SBA-guaranteed lending to franchising provides a vital source of higher risk capital. Effective January 1, SBA has a new franchise affiliation process involving lenders and franchisors that introduces a new level of uncertainty to SBA lenders. The new SBA process both simplifies and complicates franchisee access to SBA-guaranteed lending. Simplification comes in the form of a single standard addendum that will address all franchise-specific affiliation issues. Franchisors will make one of four decisions: sign the new addendum for all franchisee requests, sign it for some but not other requests, not sign the new addendum, or sign the new addendum but require additional documentation. Lenders won’t easily be able to determine how franchisors will proceed absent a centralized information source.
But Wait, There’s More

A new uncertainty is created since SBA will no longer review any franchise documentation, not just franchise agreements. There are business affiliation and credit issues arising from franchise operations manuals and other franchisor-required documentation that SBA previously reviewed on behalf of lenders as part of the franchise affiliation review. Now that falls on lenders to assess on their own. Most lenders are not experienced in addressing business affiliation and other issues in a franchise context. Many of those assessments undoubtedly will require franchisor involvement, something clearly more easily solved in a centralized way rather than with one-off lender/franchisor interaction.  

The average franchisee agreement is about 40 pages, which is the document the new SBA rule has eliminated from further review. The associated documentation that lenders will now be responsible for understanding relative to business and other affiliation issues range from 300 to 800 pages. Fortunately for franchisors, the Franchise Registry was originally designed and, even with lots of other lender services added in the past 18 years, still continues to address lender uncertainties around all these issues. However, until new processes are understood and refined (for example, will SBA accept electronic signatures on the new standard agreement?), uncertainties exist for lenders and that will lead to less capital to franchising than otherwise would be realized.  

Which Risks Matter?

Addressing uncertainties provides the framework with which to assess risks lenders have to also address. Risk is a relative issue for lenders. At any point in time some borrowers, sectors and franchise systems are lower risk than other borrowers, sectors and franchise systems. The question a lender must figure out in a constantly changing and uncertain world is “which ones are which?”  

Lenders are pretty good at assessing borrower and sector risks. Since the last recession, a lot of progress has been made to help lenders assess franchise system risks. That is important as the franchise business model has been associated with higher risk lending without solid evidence. For instance, SBA recently added franchise loan concentration as a separate lender portfolio risk category. The FUND risk scoring model for franchise systems, similar in concept to the FICO risk scoring model for borrowers, has been designed to show the relative credit risk performance of a franchise system across an entire economic cycle. Essentially, it shows how the likelihood changes for a lender to get its money back from a borrower depending on which franchise system the small-business borrower chooses.  

This sort of analysis is also necessary for lender efficiency purposes as the traditional bank business loan origination model changes. Alternative lenders, led by website-based platform originators, are putting increasing pressure on traditional lender cost structures. Their entry has begun to disrupt the way traditional face-to-face loans are originated and serviced, leading to the need for credit scoring models. SBA recognized this and introduced a credit scoring model of its own that allows SBA lenders to more efficiently originate loans under $350,000. The same efficiency is needed for franchise brand risk assessments, which is what FUND analysis does.  

Understanding these changing dynamics facing capital providers is more important in 2017 as growing uncertainties and risks combine to put pressure on continued franchise capital access. As the points above should make clear, better credit-related information and better communication around franchise system performance to lenders will be necessary, a role that at least the better performing brands should embrace. 

 
 
Darrell Johnson, CFE, is CEO of FRANdata and a frequent speaker and contributing columnist. Elizabeth Taylor is Chief Legal Officer and Chief of Staff for the International Franchise Association.
 
 
 

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