Editorial

Financing for Franchisees: The Franchisor’s Role

One of the most common problems in the Franchise sales process is helping the prospective franchisee secure financing for their new investment. As a franchisor, should you offer financing to your franchisees? Or should you just not get involved? How much help is too much? And when should a franchisor say enough is enough?

Options for Franchisee Finance
In addressing this issue, a franchisor should first realize that there are myriad options for franchisee financing assistance. These range from a relatively low level of involvement (such as assistance in the development of a business plan or becoming registered on the SBA’s franchise Registry) to a high level of involvement (such as providing direct financing to franchisees).

In the middle of these more extreme options, the franchisor can establish preferred relationships with lenders, provide limited guarantees to facilitate franchisee loans, or provide other credit enhancements that will allow the lender additional comfort in working with a specific franchise company.

The level of involvement that a franchisor should have in the finance process should be based on several factors: size of investment, nature of the assets financed, the profile of the targeted franchisee, the ability of the business model to carry financing, the financial strength of the franchisor, and the relative demand for the franchise in question.

Since significant involvement on the finance side involves some degree of risk, the first question that should be addressed by the franchisor is to what extent is franchisor involvement necessary to meet development goals.

In essence, if you are not having any difficulty in selling franchises, a minimalist approach will certainly suffice. Provide outlines for business plans and register at the Franchise Registry, but do not put any of your hard won assets at risk.

It is a New Business
While the franchisor thinking of “getting more involved” in the franchise finance process may initially look at the advantages of providing financing to franchisees (“Just think of how many more Franchises we will sell!”), the downside can be considerable.

Yes, providing financing assistance can increase the number of prospective franchisees who might otherwise qualify for your franchise, but these same franchisees will likely be the worst credit risks with the highest likelihood of loan default. And there is certainly an argument that we should allow Charles Darwin to sort our prospects for us. Any time that a franchisor is taking on any incremental exposure in the lending process, the default rate on these franchise loans should be of substantial concern, and should not be overlooked.

Likewise, it is important to understand that a franchisor who provides limited guarantees, credit enhancements, or directly lends money to its franchisees will encumber its balance sheet with contingent liabilities which may, in turn, make it much more difficult for the franchisor to obtain a loan should the need arise. Such a posture may make it difficult or impossible to build that new building, finance additional corporate growth, or acquire that competitor. In essence, this financing can eliminate the very leverage that you were trying to create when you turned to a franchised growth strategy in the first place.

Moreover, it is worth noting that most franchisors are distinctly unqualified to get into the lending business. First and foremost, they are not in the lending business – which is ultimately a business of assessing risk and assigning a fee to that risk. And equally important, the franchisor that gets into the direct lending business has a built-in conflict of interest that could easily cloud his or her judgment.

Even if a franchisor can overcome the difficulties of mastering this new business, many will not qualify from a financial perspective. In order to provide a meaningful guarantee of any type, the franchisor will need to first evaluate their own creditworthiness – as each such guarantee will encumber their assets, and a fast growing franchisor can rapidly outstrip their balance sheet. And, if those guarantees come due because of loan defaults, that debt can easily consume an organization.

Get Paid for Your Risk
If you do choose to provide some form of credit enhancement or otherwise assume risk on behalf of your franchisees, the prudent franchisor will treat this credit enhancement like any other part of the value proposition – and turn it into a profit center.

It is not enough to benefit from the existence of incremental franchisees. The economic benefit you receive from those fees and royalties represents your return for the value proposition that you have created by being a good franchisor.

Over time, even the best finance program is likely to see some defaults, and thus the franchisor should seek to offset those defaults by realizing interest on those loans – enough to offset administrative costs, forecast defaults, and still provide some profit.

The bottom line is that the finance business is a new business for most franchisors, and as such has many inherent risks. While financing also may hold some advantages, most franchisors are better off allowing the Laws of Natural Selection do their work.