Investing In Yourself, Part 1 of 2

Creative financing strategies to open (and re-open) franchise locations

All franchisors are considering how to maintain or increase market share in the new normal. Nobody can deny that the Great Recession has created more and better opportunities for those who can afford to exploit them, as well as a surplus of qualified operators, composed increasingly of women and minorities, without assets to operate. The number of opportunities appears to grossly overshadow any one franchisor's resources in terms of cash, personnel, and credit.

These circumstances often are precisely the motivation to pursue franchising as a method of expansion in the first place. The difference now is that prospects generally need a lot more assets and cash to qualify and fund the initial investment. Moreover, many successful franchisees who have exhausted their available credit and need a vehicle to fuel future growth are increasingly looking outside their brands to others that cost less, that are more bankable, and especially to those that offer financing. This perfect storm is causing some franchisors to consider financing, leasing, or partnerships as a strategy to maintain or acquire market share.

Five years ago, franchisors didn't need to offer financing because there was an abundance of credit; plenty of local, regional and national lenders; and enough financially qualified prospects to fuel growth. According to the IFA, franchising is expected to seek $10.1 billion in capital this year, while banks are expected to lend only $6.7 billion.

Today, to obtain desired growth rates or to prevent the loss of closed some franchisors are putting their money where their mouth is, and offering up credit enhancements, guarantees, captive financing programs, or operating lease programs for fixtures, and/or equipment (FF&E). Many franchisors are structuring franchise offers for a smaller platform or for highly efficient units, with higher productivity or lower initial investment, in order to make units more bankable. To induce franchisees to acquire closed or at-risk units, franchisors are making the most compromises in terms of up-front and ongoing fees. Some franchisors are financing, or in rarer cases even waiving, initial franchise fees to facilitate a change in control.

It doesn't actually surprise me that in a franchise universe so dominated by private equity that franchisors would be willing to invest in their own brand, as many have already made a considerable investment in expansion of company-owned units.

However, franchisor- or affiliate-offered financing requires disclosure in Item 10 of a franchisor's FDD, which may trigger early amendments in registration states and a materially larger disclosure document (because all the loan documents must be attached). Also, in our experience, franchisors that offer financing are very selective about the units they finance and often struggle with describing a uniform offer. Moreover, it appears that the parties are shortening the terms and thinking through the ultimate exit (with performance-based repurchase formulas, or participation in premiums realized through resales of reopened and rehabilitated units) and agreeing to objective criteria by which the operator can be removed for non-performance and other predictable consequences throughout the term of the relationship.

We don't mean to suggest that some or all of the foregoing strategies or techniques are novel or new. In fact, there are living and breathing examples of systems that have thrived on these techniques long before the economic downturn. And while some programs are specifically targeted to less financially qualified individuals, most exist to accomplish other business purposes, such as re-franchising company-owned units; reopening a franchisor's or a former competitor's closed units; entering into new markets or more desirable real estate; or merely attracting the best operators irrespective of cash or credit. Very few are designed to give people with no experience or bad credit free money or a free franchise; all are strategies to reduce the initial investment or to give the lender some defined recourse against the franchisor. In our experience, franchisors close a unit they have guaranteed or to which they have given a credit enhancement only as a last resort.

Real estate subleases in franchising were the prevailing practice until a decade or so ago, when we at least saw systems migrate to merely obtaining a collateral assignment of lease. In contrast, franchisors generally see a need to control the real estate in transactions in which they facilitate the financing. These are often pass-throughs, and franchisees often pay the contract lease terms directly to the landlord. The difference here is that in the most recent iterations franchisors are also facilitating financing of FF&E, structures, and sometimes even initial inventory.

According to Jay Bandy, president of Goliath Consulting Group, a consultancy, many high-end QSR franchisors, such as McDonald's, control the real estate and undertake to build the restaurant and then lease it to the franchisee with the development costs built into the lease. While the franchisee is still responsible for the FF&E, such an arrangement lowers the amount of available cash or financing the franchisee must have up front and opens opportunities for minorities or other skilled operators who may otherwise lack the required capitalization to become a franchisee. Likewise, many franchises located at non-traditional sites (airports, theme parks, stadiums, military bases, etc.) are controlled by the franchisor and occupied under a sublease or management agreement structure.

Chick-fil-A has long structured its franchise offering to make the franchise more accessible to prospective franchisees and, at least from a franchisee finance perspective, to make the franchise opportunity attractive even in a poor economic climate, such as the one we are experiencing now. The Chick-fil-A offering is made in the same spirit today as the original opportunity extended to potential franchisees decades ago by the chain's founder, S. Truett Cathy. Under Chick-fil-A's model, the franchised operator pays a small initial franchise fee that also serves as a working capital deposit and, in turn, Chick-fil-A provides a turnkey franchise opportunity, including a trademark license and leases of the real estate premises, restaurant structure, and related equipment. In addition to the lease payments, a franchisee pays Chick-fil-A a percentage of the restaurant's gross sales as a base service charge and an additional fee based on the restaurant's profits. The working capital deposit (minus any remaining charges and costs owed by the franchised operator in connection with the operation of the restaurant) is returned to the operator upon the termination, expiration, or non-renewal of the franchise. By funding the restaurant's development directly, Chick-fil-A can focus on selecting the best candidates as franchisees.

As an alternative to its traditional franchise offer, Saladworks recently began offering a limited number of operating leases to qualified franchisees to open new locations within a specific defined geography, through a related entity, "in an effort to create a vehicle for undercapitalized operators to get into the Saladworks system," says company President Paul Steck. Under the program, the franchisee executes a master lease agreement and pays a $40,000 initial deposit. The financing affiliate will lease the franchisee an initial package of restaurant equipment and furniture, leasehold improvements, signage, millworks, and miscellaneous office equipment.

In addition, a portion of the franchisee's deposit will cover the cost to initially lease the restaurant's POS system and the first three months of lease payments. In return, the franchisee pays the financing affiliate a percentage of the restaurant's gross sales on a weekly basis. The financing program distinguishes Saladworks from other franchise offers, and prospective franchisees can click through to the franchise leasing program right off their website. Steck reports that while Saladworks rolled out this program only recently, the company "already has four to five prospects lined up to close, and the program is generating many more leads."

According to its general counsel, Robert Sawyer, Friendly's "has, on occasion, put an individual with high operating skills but a low net worth into an existing restaurant under a BFL arrangement where the franchisee pays rent for the real estate and FF&E, plus a royalty and marketing fee under a month-to-month franchise agreement." The lease and franchise agreements are subject to an option to purchase at a price that includes longer-term possession under an assignment or sublease, title to the FF&E, and the initial franchise fee for a full-term franchise. "Generally, the franchisee improves operations and margins and funds the purchase out of operating revenues plus an improved P&L that is now more attractive to lenders," says Sawyer.

Next issue, Part 2: Friendly's, Firehouse Subs, Marco's Pizza, Quiznos, Fastsigns International, and Brightstar Healthcare tell how they're overcoming financing hurdles with leading-edge, innovative programs.

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