McLending: The booming business of franchise financing

Much of the risk of franchise lending has also been eliminated by the federal Small Business Loans Act (SBLA), which guarantees 90% of the value of business-improvement loans up to $250,000. In particular, the SBLA makes it possible for banks to finance leaseholds for franchisees.

Canadian Banker magazine
January/February 1996

McLending: The booming business of franchise financing
From fast-food restaurants to muffler shops to clothing stores, franchise operations now account for 40% of all retail sales. And they’re an attractive, cost-effective market for banks.
Sheldon Gordon


Franchise Association head Richard Cunningham: "We don't get calls from members saying they can't get bank funding."


Charles Scrivener of CIBC: "It's getting more and more hairy to figure out where the market is going."


TD Bank's Denise Lepard: "Some U.S. franchise systems aren't that desirable from a Canadian point of view."

LAST YEAR WHEN ERIC Peterson, a 55-year-old educator in the northwest Saskatchewan town of Meadow Lake, wanted a new career, he explored franchise opportunities. Approaching Work World Enterprises, a Coquitlam, B.C. – based retailer of work and casual clothes, he was evaluated favourably and then referred to the Royal Bank branch in his community, which is managed by Glen Huber. Peterson received $225,000 in loans, and opened a 2,600-sq-ft store in April.

Work World, the franchisor, has 140 outlets in Canada and has been dealing with the Royal since 1984. “We used to finance franchisees independently,” says Wayne Graves, the company’s chief financial officer. “But the Royal came knocking on our door, and slowly we’ve become bigger and better business partners.”

In 1992, Joe Klossen, a youthful Calgary restaurateur who had opened several seafood restaurants under the name Joey’s Only, decided to franchise the concept. “We interviewed a few banks,” recalls Klossen’s vice-president, David Massey. “The Toronto Dominion sent three people to our office. They acted like true businessmen. They said, ‘We like what you’re doing, and we want to be involved with you.’” And they have been – as Joey’s Only has grown to 55 outlets across Canada.

From Bonavista to Vancouver Island, franchises are a booming market for commercial lenders. At a time when the banks are being pilloried in some quarters for scrimping on small business, their loan portfolios for franchisees are growing by 16% a year.

“The relationship is quite healthy,” says Richard Cunningham, president of the Canadian Franchise Association (CFA). “The best barometer of that is that we don’t get calls from our members saying they can’t get funding from the banks.”

To be sure, not all franchise business is small business. While the fee for a Joey’s Only or a Work World franchise is only $25,000, it costs $3 million to $5 million to buy into Burger King or Holiday Inn. Moreover, the bank usually expects the franchisee to provide 35% to 50% of the startup costs in the form of equity and to borrow the rest. So the pricier franchises tend to require a syndicate of investors that may be financed by the banks’ real-estate or corporate-lending divisions.

While franchises account for 40% of all retail sales, and there are an estimated 650 active systems in Canada, 20% of the franchisors do 80% of the business.

“The top 50 are the real powerhouses,” says Jim Holloway, senior manager, national franchising, at Bank of Montreal. “We’re focused on them.” BMO, however, is locked in a fierce battle with Royal Bank and CIBC for the largest slice of the franchise pie. Toronto Dominion Bank is also an important competitor.

In fact, says Holloway, “all the major franchisors have relationships with at least three banks, and some deal with all of us.” Having multiple relationships ensures that even if a franchisor’s lead banker doesn’t have a branch in, say, Meadow Lake, one of the other banks it deals with will be there to arrange financing for a new franchisee.

All the major lenders produce instructional material for less experienced franchisors to help their new franchisees approach a bank. Franchisees are free to approach whichever bank they wish, but they’re usually referred to – and borrow from – the lead banker of their system.

“The franchisors offer these programs as an additional service to the franchisee,” says Holloway. “The franchisor doesn’t have to find out who the account manager is in Corn Flakes, Alta. We find out for them.”

The major banks develop profiles of franchisors, so that when an account manager at a local branch is approached for a loan, head office sends off an information package explaining why the franchise is a viable business. “Each account manager knows what he can and cannot do,” says Holloway. “The terms are pre-negotiated – though not pre-approved – by the head offices of the franchisor and the bank. That protects the franchisee: the account manager can’t be a strong negotiator with an unsophisticated franchisee.”

Royal Bank refers new franchisors to independent consultants who help them develop a formal market strategy for franchising their concept. It also refers would-be franchisees to accountants and lawyers who specialize in franchises. These professionals help the newcomers crunch the numbers and understand the contracts.

“When we finance franchisees, we get them to sign a statement saying they consulted a professional advisor,” says Ben De Castro, senior manager, franchising markets. “That way, they can’t turn around later and claim the banker pushed them to borrow the money.”

What make franchise lending so attractive to the banks is that franchisees represent a proven formula for success. Over 90% of franchises survive for five years, compared to only 23% of independent startups.

“If you start an independent business,” says De Castro, “you’re working with your own experience, which may be inadequate, and with limited resources. With a franchise business, you have a proven track record. It starts off with adequate capital, it attracts a better operator into the business, and the training and support systems provided by the franchisor encourage success.”

And franchise lending is extremely cost-effective for banks. Once a bank has done one financing for a system, it doesn’t need to go out and take a look at each new franchise as it opens. “We don’t have to do a lot of legwork to get the information together,” says Denise Lepard, manager of franchise banking services for TD Bank.

Furthermore, the franchisors weed out most of the unsatisfactory candidates before they even approach the lender. “We look at the individual before they’re looked at by the bank,” says Massey of Joey’s Only restaurants. “We know what the bank requires. Only about 10% of the people we’ve referred haven’t gotten financing.”

Because terms are pre-arranged with the franchisor, the loan package is upfront to the applicant, says Roger Roy, franchising manager at The Bank of Nova Scotia. “So it doesn’t come as a surprise to them if they’re turned down. If they can’t get the money, they know why. There are normally criteria they have to meet which are set by the franchisor, not the bank. If they have any complaints, it’s against the franchisor, not the bank.”

Another plus for the banks is that respectable franchisors don’t just walk away from a franchise that runs into difficulty. They’ll send in people to help turn things around or, failing that, look for a new franchisee. In situations where the location is the problem, they’ll move the existing franchisee to a new site.

“On many occasions, bank managers will phone us and alert us to a franchisee’s problems,” says World World’s Graves. “We may go out there and take a closer look. That’s really helpful, because we’re sitting in an office in Vancouver and may miss something. A manager who knows his town and that business can give you some really great insights.”

Typically, franchisors will have 5% to 10% of their stores as under-performers. “To make franchising work,” says Charles Scrivener, general manager, national franchising services, at CIBC, “franchisors must be willing to take back a store in a distress situation. I’m not very good at flipping burgers. If the lights go off in a store, there’s not much intrinsic value.”

Many systems guarantee the banks a buy-back of inventory that would provide 85% of the depreciated book value. So the banks, by lending only up to 75% or 80% of that level, are assured of eventually recovering all their principal even in a worst-case scenario.

Much of the risk of franchise lending has also been eliminated by the federal Small Business Loans Act (SBLA), which guarantees 90% of the value of business-improvement loans up to $250,000. In particular, the SBLA makes it possible for banks to finance leaseholds for franchisees.

The vast majority of loans to franchisees are term loans against hard assets such as equipment (e.g. cash registers or computers) and leaseholds (e.g. paint, tiles, shelving and furniture). Leasehold improvements can be crucial in making a restaurant franchise aesthetically appealing. But, unlike equipment, they have no resale value. The banks would therefore insist on outside collateral for leasehold loans if it weren’t for the SBLA.

Even though the SBLA underwrites much of the risk, the banks are still careful about whom they finance. The ideal franchisee, says Scotiabank’s Roy, is one who “has good management abilities, a drive to succeed, a sound business plan and sufficient equity capital.” The banks prefer applicants who have a net worth of at least $150,000, understand the hard work involved, and like dealing with the public.

The banks also apply exacting standards to the franchisors they befriend. “We look at how long they’ve been in business and how long they’ve been actively franchising in order to get a feel for the management capability,” says Scrivener at CIBC.

“They should have had corporate stores for four years and franchises for at least two years,” he adds. “That at least demonstrates some sort of track record. We also look at the sector they’re in: is it a grocery or a hardware chain? And we look at their position vis-à-vis competitors. It’s getting more and more hairy to figure out where the market is going. What’s the consumer likely to want two or three years down the road?”

Certainly, financing is not a done deal in every sector of the franchise industry. The banks are “still reluctant with the food area,” says the CFA’s Cunningham, “and very conservative with new concepts coming on line – things that may have a corporate track record but just not a track record in franchising.” Nonetheless, he adds, all the major banks are members of the CFA and “very supportive of all our actions.”

In any list of the most attractive franchise industries, the automotive sector- with such specialties as tires, mufflers and transmissions – ranks first (see side bar). “Cost-conscious consumers are making every effort to extend the lives of their autos by doing more repairs to them,” says De Castro. “About 56% of all cars being sold are used cars. Many consumers can’t afford to put out the $18,000 to $25,000 required for a new mid-sized car.”

Automotive is followed by the home-improvements and home-services sector; service businesses such as dry-cleaning, printing and tax preparation rank third. Restaurants remain one of the largest franchise sectors, but prices have dropped, leaving aggregate sales flat. “Pizza and donut shops have proliferated to the point where these markets are saturated in a number of major centres,” says De Castro.

While fast-food outlets in general don’t top their wish list, lenders always cite McDonald’s Restaurants as the model franchise. “The banks haven’t lost a dollar on a McDonald’s,” says TD’s Lepard. And because their franchisees are such a low risk, all the banks vie to finance them. For McDonald’s franchisees, that kind of competition keeps the loan margins low. Certain other U.S. – based franchises, however, are a different story.

“Some U.S. systems aren’t that desirable from a Canadian point of view,” says Lepard. True, they may offer a recognized brand name, which is a definite asset in a competitive market. But U.S. franchisors often provide less support in training and promotion for foreign affiliates than for those located in the United States. “If they don’t offer strong infrastructure in Canada to support their system, then, no, they’re not a desirable business from our point of view,” insists Lepard.

“The worst thing you can see happening in franchising,” says Scrivener at CIBC, “is franchisors selling franchises just to get the fee. We’re interested in franchisors that are seeking a long and growing stream of royalty revenue.”

Best bets for future franchise growth
From a banking perspective, franchise customers are usually assessed on two fronts, says Royal Bank’s Ben De Castro: first, the industry sector’s responsiveness in terms of growth potential and ability to tap into consumer trends, and second, the quality of the franchise organization’s structure, management and financing. The latter consideration normally accounts for about 80% of the assessment. De Castro offers the following “subjective listing” of attractive franchise industry sectors.

1. Automotive (lubes, muffler, transmission, tires). Targets cost-conscious consumers wanting to make their cars last longer, especially in a soft economy. Also reflects current attitudes towards recycling.
2. Home improvements / home services (building products, paint and paper, hardware, security, lawn care, etc.). Focuses on “cocooning” and “burrowing” lifestyle trends. Addresses the desire for close relationships and the shift towards home entertainment. When the real-estate market is soft, home improvements soar.
3. Service businesses (printing, accounting/tax, dry-cleaning, mailbox, laundromats, shoe repair, temporary services). Explosive growth is expected to continue as businesses tap into the time-strapped consumer and the proliferation of small businesses, including home-based enterprises.
4. Food specialty (donuts, cookies, portioned and prepared foods). Taps into the need for people to reward themselves with small indulgences and for time-strapped consumers. Trend of ergonomics –people will pay for custom products.
5. Specialty retail (toys, books, drugs, photo, pets, dollar stores). Businesses that capture these trends do well: value, convenience, selection, service, desire for products and services that are fun, green, domestically made, icon-toppling.
6. Entertainment / recreation (video, music, electronics, travel, sports). Appeals to the indulgence and self-reward needs of a cocooning and aging population.
7. Personal grooming (hair case, cosmetics, diet). Reflects the trend towards healthy living, feeling better and “down aging” – think young, age slowly.
8. Education / training (schools, day care, mini programs, business training, including computer/software stores). Growth factors include need for increased management skill and productivity, automation, working women, home-based businesses and competitive markets.
9. Restaurants / quick service (family sit-down, fast food, take-out, delivery). Seems to have reached market saturation, and is in conflict with the shift to more home entertainment. But mid-priced, family style concepts and those with appeal to the over-40 crowd should do well.

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