Loan Broker: "SBA Liar Loans a Problem"

Those in my firm saw what Banco Popular and other lenders were doing. We would decline a loan transaction, only to hear a few days later that Banco, or some other SBA-approved bank/lender did the deal. It was baffling to see these bad franchise risks receive loan approval. We saw hundreds of undercapitalized or unqualified franchisees put into business by other lenders that had no place being there.

Blue MauMau
September 23, 2011

Loan Broker: "SBA Liar Loans a Problem"
Bob Rodi

Bob%20Rodi%20FF.jpg

I cannot tell you how many times my lending brokerage had to stop bogus franchise loan applications that were provided to us. There was a lot of "coaching" and application "prep" going on by franchisors. Many franchise salespeople think lenders should be on a "need to know" basis. In other words, they tell the lender only what they think is necessary in order to get the application approved and their franchise sales finalized, even though there may be other pertinent information that should be disclosed.

The Small Business Administration guaranteed loans is part of a bigger systemic problem with the securitization market. Nobody holds their own paper. Almost everybody sells off transactions, without any recourse, and makes a huge commission in doing so. Underwriters do not have the proper “mindset”, given the rewards of the system and lack of risk. Both bank and non-bank SBA lenders can immediately sell off the paper to rip twelve points from the deal. That is a different mindset than a lender that is required to hold the paper in its own portfolio for the next ten years.

Lenders need to closely examine the franchisor and subject them to strict underwriting criteria. In my opinion, it is a mistake to rely on projections provided by the franchisor or the applicant without first calculating average unit volume (AUV, i.e. average store sales) with a simple method. I use royalty revenue, divide by the royalty percentage, which provides sales subject to royalty, and then divide by the number of units. I average the three years that are disclosed in the Franchise Disclosure Document (FDD) and I find that the result is pretty close to the system AUV. In fact it is often a better measure of AUV because the calculation spans three years and discounts a recent year that may have included explosive growth. It also includes all stores, not just selected stores that are included in most Item 19 disclosures.

In my experience, franchisees aren't completely innocent in misleading. They go along. Many of them trump up their numbers in an attempt to outsmart a lender. I am fond of asking a franchisee, whose projected revenue is two times higher than the best stores in the system, why they think they are going to do so much better as a startup than a franchisee that has been in business for several years. It is easy to tell by their answers that they did not expect the question because they thought, or were told by the franchisor, that their lenders wanted to see a high revenue number in order to approve them.

Those in my firm saw what Banco Popular and other lenders were doing. We would decline a loan transaction, only to hear a few days later that Banco, or some other SBA-approved bank/lender did the deal. It was baffling to see these bad franchise risks receive loan approval. We saw hundreds of undercapitalized or unqualified franchisees put into business by other lenders that had no place being there. I remember having conversations with franchise salespeople, where I asked why they would want to put a franchisee in business that had little or no chance to succeed. Since having a high failure rate would certainly make lenders far more cautious in the future, I could not understand the logic of their very short-term thinking of wanting the sale now, despite what the future might bring.

Some franchisors and franchise salespersons convinced themselves that the lending spigot would never turn off. They rationalized that as long as they could increase the number of locations, the failure rate would always remain in an acceptable range. In reality, many franchise systems already had dismally high failure rates that would have excluded them from consideration by a conservative cadre of lenders. Unfortunately, the SBA guarantee was seen as a way to get a loan funded if it proved too risky for a conventional loan. That is because banks or SBA lenders would have little or no downside in approving such risky loans. The result of not feeling the bite of risk was that applicants who had no business starting a franchise were getting loan approvals.

Now that credit criteria have considerably tightened, these types of franchise applicants have little opportunity for approval.

Because of the abuses pointed out in Blue MauMau's article Franchise Liar Loans Spread among Banks, I think the franchise industry will see slow growth for the foreseeable future. The industry will see strong franchise chains eat the weak — both franchisors and franchisees. There will be a much smaller pool of franchise applicants to recruit from, especially for startups. Since there is very little construction of new franchise buildouts, by next year, locations for expansion should be difficult to find, especially in the regions hit hardest by the recession. That, coupled with the fact that franchisees are going to be very careful about selecting the right location, will also cause growth to slow. This will result in franchisors becoming increasingly involved in the lending process as part of the "risk equation", especially if they want to obtain financing for their startup franchisees. This won't only be the smaller systems. We will see a lot of the bigger chains that partner with lenders. Franchise finance "captives" will begin to emerge with increasing frequency.

In short, the ability to offer financing will become a major point of differentiation between franchise systems, with those that can offer financing being the first choice among a smaller pool of qualified applicants.

It will be interesting to see what the banks do as the SBA continues to tighten its standards even further because of the abuses pointed out in the article. At the International Franchise Association summit in Washington, DC last April, the rhetoric from the banks about the availability of franchise credit did not sound promising. Additionally, with the costs imposed by the new reporting requirement and the continued tough stance taken by regulators, I expect bank lending to be a difficult environment despite the recent news about this bank or that bank increasing its franchise lending by some percentage over last year, a year that small business loans were harder to spot than Bigfoot.

Note by Don Sniegowski, editor of Blue MauMau: Mr. Rodi wrote the above column in an email to me. He has given Blue MauMau permission to publish it under his name. For years, Mr. Rodi has been a candid source of information for this journal on how he sees lending and finance trends in the franchise industry.

COMMENTS
As of August 18, 2012

1. Puerto Rico-based bank Banco
robert benwell
Puerto Rico-based bank Banco Popular was recently admonished for its approval of Small Business Association (SBA) loans to companies that it did not properly analyze for earnings and repayment potential. Now it appears the practice of issuing “liar loans” is not limited to Banco Popular…

2. Observations
michael webster
Bob writes: "The Small Business Administration guaranteed loans is part of a bigger systemic problem with the securitization market. Nobody holds their own paper." Yes, but underwriting standards were the problem when the demand for securitized mortgages outstripped supply and the result was the sale of synthetic cmos and liar loans. We have had securitization for almost 30 years, so it by itself is not a problem.

Bob writes: "Lenders need to closely examine the franchisor and subject them to strict underwriting criteria. In my opinion, it is a mistake to rely on projections provided by the franchisor or the applicant without first calculating average unit volume (AUV, i.e. average store sales) with a simple method. I use royalty revenue, divide by the royalty percentage, which provides sales subject to royalty, and then divide by the number of units. I average the three years that are disclosed in the Franchise Disclosure Document (FDD) and I find that the result is pretty close to the system AUV."

I agree with this, and the calculation - which I have argued for. The royalty revenue is sometimes not reported in the financials - sales, advertising and royalties all lumped in. That by itself should rule out a system for further consideration. When you use this calculated AUV, and check it against a similar calculation using the advertising royalty, you can also calculate the 3 year chances of a total loss of investment by looking at the Item 20 turnover. These two numbers should enable you to screen out worthless systems.

Bob writes: "The industry will see strong franchise chains eat the weak — both franchisors and franchisees. There will be a much smaller pool of franchise applicants to recruit from, especially for startups. Since there is very little construction of new franchise buildouts, by next year, locations for expansion should be difficult to find, especially in the regions hit hardest by the recession. That, coupled with the fact that franchisees are going to be very careful about selecting the right location, will also cause growth to slow. This will result in franchisors becoming increasingly involved in the lending process as part of the "risk equation", especially if they want to obtain financing for their startup franchisees. This won't only be the smaller systems. We will see a lot of the bigger chains that partner with lenders. Franchise finance "captives" will begin to emerge with increasing frequency. "

We have started to see franchisors offering some financial assistance, but I am not sure that this is a trend. Be interesting to revisit this prediction in 8-12 months.

3. AUV just the start
Granville_Bean
I'll agree that a prospective Zee should AT LEAST know the AUV. Howver, that's no guarantee. After all, half the units do less than AUV. NONE of our stores do anywhere close to systemwide AUV simply because they are all in small markets. But then we didn't expect them to do AUV.

There can be tremendous store to store variation among even well run stores. A Zee who we know, his lowest volume store does 1/3 the volume of his highest voume store. Same owner and rotating managers. The lowest voume store is on the outskirts of a small town and located "along the side of the road".

The highest volume store is on the busiest suburban commercial corner in the area's biggest city, on the route that connects the power center that has the Walmart and Home Depot, with the nearby indoor mall that has the major brand department stores and the cinema complex.

AUV is just the start, but at least it's a start.

4. AUV
Bob Rodi
The point is not so much that one should expect to hit AUV once operations commence but that it is only reasonble to assume that a location won't exceed the AUV by some unbelieveable amount. If your expectations are "average" and a location turns out to be a homerun then that's great. If the location is below AUV, the pain it causes may be somewhat mitigated because sales are only off by 20% of projections instead of 75% of projections. From the standpoint of a lender, having a handle on the chain wide AUV allows for a more objective evaluation of the transaction. We should know the actual rent, cam, average food costs, labor costs, etc. If the deal can handle those expenses and produce enough cash flow to repay DS, then a much better lending decision is likely to be made. Prudent underwriting dictates that we look for some fall back resources in case the operator comes up short. How short is the $64MM question. That is where the "art" of doing the deal comes in to play.

5. AUV and Averages
michael webster

Bob writes: "The point is not so much that one should expect to hit AUV once operations commence but that it is only reasonble to assume that a location won't exceed the AUV by some unbelieveable amount. "

This is probably hard for the optimistic first time franchisee - you are average, nothing more. And more many systems, paying 7 points or more for the trademark and average sales is a very bad deal.

http://www.bluemaumau.org/lender_says_sba_liar_loans_problem


Brought to you by WikidFranchise.org

Risks: Comments on article are interesting, False earnings claims, Fraudulently inflated franchisee revenue figures, Government guaranteed loan program very attractive to fraud, Government guaranteed loans, Government guaranteed loans used a great deal in franchising, Government guaranteed loans: program loses $1, franchisee families lose $10, Liar Loans, Lending duty, Loan-broker fraud, Moral Hazard: a party insulated from risk behaves differently than if the full risk were present, Taxpayers end up paying for private gain, The game is rigged, U.S. Small Business Administration, SBA, Why should we care? It's not our money., United States, 20110923 Loan broker

Unless otherwise stated, the content of this page is licensed under Creative Commons Attribution-ShareAlike 3.0 License