Franchisees defaulted on nearly $900 million in funding in 2001,
quadrupling figures from 2000, according to a study by financial
research firm Fitch Ratings. Regardless of who's to blame for
this staggering leap--the franchisee, franchisor or lender--the
impact on franchising is already evident, as lenders become
increasingly wary of providing franchisees with funds.
So will it be harder for you to get a franchise loan? Franchise
Zone spoke with Kevin Burke, managing director of Los Angeles
investment-banking firm Trinity Capital LLC and former senior
executive of Franchise Mortgage Acceptance Co., about what caused
this increase in loan defaults, and what the franchise industry can
do to help you.
Franchise Zone:Why are
loan defaults so high right now?
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Kevin Burke: For a couple of reasons. One is that some of
the predominant systems began to slow their rate of growth toward
the end of the '90s, and a lot of franchisees and entrepreneurs
bought stores with 100 percent financing in a high-growth market
and were highly leveraged. When the growth bubble burst and/or when
sales actually declined, they were ill prepared to meet their
obligations. This was further compounded by the fact that many of
them had inadequate liquidity when the transactions were initially
capitalized. Operators who relied on 100 percent debt financing
were not prepared to weather a storm of rising costs in labor and
utilities and soft sales growth.
How can franchisors help franchisees?
Some of the major franchisors have been very proactive in trying
to ensure the financial health of their franchisees--some of them
have offered loan assistance programs or agreed to provide facility
enhancement. There's a whole range of things a franchisor can
do. That doesn't mean the franchisor gets stuck with the bill;
it means they play the role of an interested party and sponsor in
the process, which includes steps to rectify some of the
over-leveraged franchisees.
What role should the over-leveraged franchisees play?
Franchisees should work with their franchisor and their lenders
and be disclosure-minded. The franchisor, franchisee and lender are
sort of like three legs on a table. Everybody has a significant
concentric alignment of interest and is compelled to seek a
consensual solution when somebody is critically over-leveraged and
possibly facing bankruptcy.
What can prospective franchisees do early in the research and
selection process, and also when they are applying for franchising,
to make sure they don't become delinquent on their
loans?
They have to make sure they aren't paying too much for a
store or stores, have a proper mixture of debt and equity in their
capital structure, put down a significant amount of equity to
eliminate the risk associated with the 100 percent debt financing
structure and have adequate liquidity and resources to deal with
seasonality, dips in sales, etc. They need to make sure their
projections include adequate reinvestment in their business and
capital expenditures.
Another thing they need is a good understanding of the actual
expense of facility enhancement, which takes place over the life of
the franchise agreement; a franchise agreement renewal fee, which
will be due in some number of years, and any franchisor-sponsored
initiatives that may be mandated from time to time to keep the
brand competitive. Those costs have to be factored into purchase
price, leverage and liquidity equations, so they can establish a
robust financial model that is as prosperous in its fifth, tenth
and fifteenth year as it is initially.
Will this growth in franchise loan defaults have a lasting
impact on franchising?
Yes. In the short run, it will make financing more expensive and
retard any growth of available financing. In the long run, it will
make lenders more thoughtful and cautious and probably require both
franchisors and franchisees to reflect on the economic model of
some concepts.