The Lending Gap is Diminishing

Finance & Legal

Here’s a look behind the lending matrix and how franchisors can help franchisees with financing.

By Kate Zhang

      Small-business lending is up, but not for all franchisees. This is due both to a continued increase in lenders’ willingness to lend and to the improved financing assistance provided by franchisors during the financing process. FRANdata recently completed the sixth volume of the Small Business Lending Matrix for the International Franchise Association Educational Foundation, an annual study that examines the current lending environment, projections on capital demand and the result on jobs and economic output due to the estimated lending shortfall in franchise financing in 2014. The worst of the recession is long behind us. The franchise business climate is improving for the fifth consecutive year. We are glad to see the lending community coming out of hibernation, and continuing this trend in 2014. However, challenges to access to capital extend well into the recovery. The demand for unit transactions and lending capital is at its highest level since 2008. Consequently, access to capital remains a challenge. Despite the fact that lenders are able to meet all borrowing needs, banks are still not willing to make sufficient funds available. Our study projects a lending shortfall for the sixth consecutive year at $1.3 billion in 2014. However, the silver lining is that the gap has declined dramatically from 9.7 percent in 2013 to a projected 4.4 percent. This means lenders are making funds available at a faster pace than the growth in unit transaction demand. This is the first time such a trend is observed since the onset of the recession. Here are some study highlights.

Increased Transaction Demand

Benefiting from an economy that is finally on track to a full recovery, new as well as existing franchisees are increasingly able and willing to invest in unit transactions. Franchisees’ willingness is mostly driven by a more optimistic view of the economy. The faster than average rebound among small-business owners is also an encouraging sign for entrepreneurs. Their strengthened financial position, fueled by rising stock and real estate values, gives franchisees better ability to start a new venture. The demand for acquiring new and existing units is a dynamic one. New unit development is a more attractive option for existing franchisees as they are more susceptible to the overall market conditions. The demand for new unit transactions will continue to surpass that for existing ones. Over the past years, the backlog of existing unit transactions has cleared out. The prices for such units are no longer suppressed, but at the same level as those for a new unit. We have observed that some franchise units are even selling at a premium because of the availability of better performance history. For 2014, FRANdata projects a total demand for more than 73,800 unit transactions, including 49,800 for new and 24,000 for existing units. This represents a 12.4 percent increase in demand over 2013 and an 18.8 percent increase over 2012. A total of $29.4 billion in lending will be needed to meet this increased demand.

Improved Lending Environment

The year 2013 was a great one for small-business lending. The U.S. Small Business Administration supported more than $29.6 billion in loans, the third highest level, only slightly behind the $30 billion made available in the record years 2011 and 2012. In addition, banks are sitting on an ever larger cash pile of close to $1.9 trillion in domestic deposits, which has been accumulating at a 6.2 percent annual rate since 2009. The prospects for small businesses in search of capital are even brighter in 2014. The banking system is strengthening and stabilizing, as is evident from fewer institution failures and their improving financial position year over year. Consequently, their willingness to lend is significantly enhanced, although it still lags behind pre-recession levels. Due to trillions of dollars left on the sideline, non-SBA loans made by larger banks are on the rise. While national banks are under pressure to put cash to work, creditworthy borrowers who are attracted by low interest rates are switching from alternative lenders to larger institutions. Increasingly, small-business owners are opting for non-SBA loans as they require less paperwork and can be processed faster. For 2014, we project that conventional lenders will make available $22.1 billion to franchisees, a 21.1 percent increase from 2013. At the same time, lender willingness to provide SBA-guaranteed lending is projected to improve by 5.8 percent to an estimated $6 billion.

A Reduced Gap, But a Gap Nonetheless

To fulfill the demand for unit transactions in 2014, lenders will need to make $29.4 billion available. However, financial institutions are only projected to lend $28.1 billion, resulting in a $1.3 billion, or 4.4 percent, shortfall. The nexus between sufficient capital and its effect on the economic recovery is critical. Thanks to the proven business model and established support, franchise businesses historically have shown tremendous resilience to economic cyclicality more so than non-franchise businesses. Because franchising represents an opportunity for entrepreneurs to change careers or expand their businesses, it has helped spur the pace of economic growth and recovery from the recession. If demand for the 73,800 projected unit transactions was met, the economy could create or maintain close to 1.1 million jobs and $144.3 billion in economic output. Conversely, the $1.3 billion gap will cost the economy 46,600 jobs and $6.3 billion in annual output. Clearly, banks are making more loans available. However, not all loans and borrowers are created equal. Based on close to 100,000 loans disbursed by the SBA over the past three years, the interest rate varies from 1 percent to 11.5 percent. As a result, a business perceived as riskier that takes out a $400,000 loan over a 10-year period can expect to pay $254,000 more in interest than another business that poses less risk for a lender. Given this loan environment, franchisors should ask, “How can I help my franchisees secure a loan or better loan terms?”

First, Present a Transparent System to Lenders

Lender willingness to extend a loan diminishes as a system’s credit risk becomes less transparent. Franchisors need to be involved and assist franchisees to ensure lenders will get their money back at the end of the term. Understanding the top line revenues allows franchisors to drive revenue. However, this is not enough. Lenders want to go beyond the top line and understand a business’ financial and operational capabilities. This requires the franchisor to get behind each business’ operating efficiency, actively manage the supply chain, and to be able to identify struggling units early to prevent store closures. Franchisors need to be able to demonstrate that they know what is going on within the system and close the loop with information flowing back to the franchisor. The ability to access franchisee performance information and carry out analysis reassures lenders that the system is healthy.

Second, Strengthen Relationships With Lenders and Publicize Your Brand

While banks are putting idle capital to use, finding qualified borrowers is paramount for them. Franchisees whose franchisors have the ability to statistically and quantitatively present a solid performance history will stand out and receive loans with a lower interest rate. The underwriting process helps lenders assess the specialty of the brand, how the business model works, past turnover or real business failures and how loans have been serviced in the past. The Franchise Registry is the first place many lenders turn to as it hosts essential underwriting documents such as franchise disclosure documents, addenda, SBA eligibility  and Bank Credit Reports. The registry also has 5,000 lender members that franchisors can contact. In addition, tools such as the Bank Credit Report facilitate a lender’s underwriting process and due diligence as it examines a concept on three levels: unit, system and franchisor performance in the context of other brands and the relevant sector. A brand’s inclusion on the registry and having additional underwriting tools ready for review gives lenders confidence and speeds up the process.

Third, Maintain Performance and Leverage Business Advantage

The past does not predict the future, but historical data sometimes is the only information on which lenders can rely. That is why it is important for franchisors to build a track record of great system performance with a pool of successful operators. A strong support structure is essential to ensure a system’s success. The first step involves setting measurable and realistic key performance indicators. Once these KPIs are in place, franchisors can get a snapshot of each business’ performance and spot problems before they magnify. Doing so also allows the franchisor to provide field support efficiently and strategically by allocating more resources to where they are needed. A solid support structure repays the franchisor with enhanced royalty revenues and fewer unit failures or compliance issues, which can be costly when they result in closures. From a franchisee standpoint, strong unit economics not only increases the bottom line, it also enables franchisees to continue servicing existing loans, a positive indicator to lenders when the next franchisee borrower comes through the door. Investing in such a franchisee support structure will result in better performance and better return on investment for franchisors, franchisees and lenders. Kate Zhang,is a senior research analyst at FRANdata, the only research and consulting company that exclusively studies franchising.  Find her at fransocial.franchise.org.