Where's the Money?: It's There For The Savvy

What's the outlook for franchise finance in 2006? Area Developer asked several industry veterans for their take on who's financing area developers and operators today.

"The short answer is everybody does a little bit of area developer financing," says Rick Anderson, general manager of franchising at Franchise Finance in Little Rock, Ark., who has been in the franchise lending business since 1988.

"Everybody" includes SBA lenders, brokers, commercial lenders, specialized lenders, banks, mezzanine lenders, and venture capital and private equity investors. And depending on a variety of factors (size, track record, finances, geography, brand, segment), there are more than enough sources for financing multiple unit growth--as long as you know how to present your case, and who to present it to.

"With an area developer, there's a big difference depending on who the developer is," says Bernie Siegel, president of Siegel Financial Services in Bala Cynwyd, Penn. "If they're already in the business, either in that system or in a related type system, obviously they're going to qualify for better kinds of financing, more conventional financing. However, there are multi-unit area developers who will need to use SBA lending for their first unit or two, even if they have decent resources. It might just be that they have no direct experience with that franchise system or in that industry."

Siegel, who lends through his company Siegel Capital, has been in the business since 1983. "We work with franchisees, and although we're not the lender, we package, place, and set up the loans for them," he says. "I hate to use the word because we do so much more, but think of us as the broker."

So why would anyone want to hire Siegel, or any other broker, when they could do it themselves? Easy, says Siegel. "We have the expertise and the contacts to know who will do what, where somebody fits, and how to structure their loans--particularly when they're multi-unit people--to make sure that when they go to finance units two, three, and four that they haven't shot themselves in the foot, and prevented themselves from being able to satisfy the cash-in needs or other needs of lenders so they can finance future units."

Siegel's experience gives him a sense of what lenders want, allowing him to shorten the approval process. "One of the things we do is put together the business plan in a way that the lenders want to see, and then allow the lenders, candidly, to say yes," says Siegel. "I've found many, many times when a prospective franchisee sends me a business plan they've done, it's either so aggressive that it's not believable, or more usually, it's so conservative that if the lender saw that projection, he would say 'Why should I lend this guy any money? He doesn't think he's going to make any money.' You have to balance what you do to meet what the lenders really want to see."

For example, Siegel says, someone may come to him about the ABC franchise, and he's done 20 of them in the past year. "We know what the lenders expect and what the lenders will and will not finance in that transaction. So we just save everybody a lot of time for a very nominal fee."

There's also the future to consider. "Let's say someone wants to open up five Dunkin' Donuts shops," says Siegel, who once owned nine himself. "We give them options on how to structure them so they know that they're going to be able to finance not only unit one, but all the way through unit five."

Outsourcing the deal-making also allows franchisees to spend their own time where it's needed most. "When someone is building 15 or 20 restaurants over a 5-year period, they have a lot of things to do. When you're doing an area development deal you might have two to five locations in progress at any one time. People like that don't have the time to go shopping around and finding the best deal, or who understands their needs best," says Siegel. "They'll go to a professional to help them do that."

Know where you're headed

While there is almost always a match for every franchisee with good credit, a proven concept, and a solid business plan, knowing where to go and how to present your case to potential funding sources can make a big difference--not only in getting approval, but also in gaining more favorable terms that coincide with future goals.

Before borrowing that first dollar or opening that first unit, know where you'd like your franchise to take you in life. In other words, plan your exit strategy, advises Jeff Rosenfeld, managing partner of Kessev Finance in Minneapolis. "Steve Covey has this thought about beginning with the end in mind. That's what area developers and all franchisees have to do, because so much of the value will be in the liquidity event when you sell."

It's imperative to set up your financing to provide the flexibility to take the cash flow from one unit and use it to finance a second, says Rosenfeld, who describes Kessev as a franchise finance boutique with three major thrusts: raising capital, buying or selling companies, and improving valuation.

One of his former clients, who had 70 units when he came to Rosenfeld, is a prime example of what not to do. "Every unit was as though he were putting up the first one because of the way he had financed himself," he says. "A lot of people in the not-too-distant past--and in fact it's still being done now--will use a local bank in each spot they're putting up a new unit. The way they're financed is they're pledging all the assets to that bank." When that franchisee goes to finance unit two at a second bank, the lender sees everything pledged to the first bank and will not give much credit to the cash flow from unit one.

"One of the things you would do as a strategy would be to say, 'All right, every time I do a transaction, I'm going to make sure that I can refinance out. So when I do the second store, I'll also refinance the existing debt.' It's a bigger deal, which is usually easier to do, and then you would get credit for the first store," says Rosenfeld. "Most people love a recap because they're financing something that already exists, rather than financing something new."

Poorly planned financing could come back to bite you down the road when it's time to sell. An operator with 10 units to sell looks a lot better to a buyer when they would not only get the cash flow, but also be able to recapitalize those new units into their existing organization. "Typically, bigger is always better," says Rosenfeld. "If I'm a 10-unit operator and I buy a 10-unit operator, I have more options with 20 But if I'm buying you and you shut me out of being able to recap you as part of my existing 10, you're not as attractive."

That's why he recommends franchisees approach financing from the start by considering beginning, middle, and end. "If you do it wrong, it is not easy to fix. If you have yourself locked into 20-year mortgages and you're trying to do a financing, and all your assets are tied up, each with an individual lender, and you have horrendous prepayment penalties, you're stuck."

More money for franchising

In late 2005, El Pollo Loco was sold by one private equity firm to another when Trimaran Capital Partners bought the brand from American Securities Capital Partners for a reported $400 million (see Area Developer, Issue IV, 2005, p. 15). While this deal was at the franchisor level, it holds promise for multi-unit developers.

"What's happened from my perspective is these private equity funds have raised so much money that they're looking for places to invest in," says Joe Stein, chief financial officer at El Pollo Loco. "Traditionally, where they would have invested in franchisors, they now are looking at some larger franchisees that have either developed out an area, or are continuing to develop territories but are looking for additional financing. Both of those could be of potential interest to these private equity groups."

This is a relatively new phenomenon, he says, and franchisees must be a certain size to gain the attention of these private equity firms. "It's not going to work for smaller franchise or area developers, but for the larger ones that's a potential source of capital that didn't exist before."

A surplus of money looking for investment opportunities should come as good news for multi-unit franchisees of all sizes. But it also can lead to some problems, as some developers bite off more than they can chew--or as consumer tastes or other external events turn against them.

There's more, but wait

"Franchise Finance is an independent finance company, licensed and bonded," says Rick Anderson, general manager, franchising from his office in Little Rock. "We have our own bank lines that we borrow from and we loan out money ourselves, and that's mostly on the conventional side."

Anderson says the company does much of its initial lending to franchisees thinking about just one location. "But after they do that, they almost always want to do a second and a third," he says. That's where success may lead to problems, and where the voice of experience can offer much-needed perspective. Anderson provides that--to protect both the franchisee's and his own investment.

"The biggest tendency always has been, and probably always will be, wanting to grow too fast," he says. "Sometimes area developers want to open maybe two or three stores in a year. In the financing world today, that's pretty fast. We would probably prefer one a year, no more than one every six months." While this urge to expand quickly is easy to understand, it's not always a good idea.

"The risk that you run--and we've been doing this since 1988--is if you grow too fast, there's a big difference between managing one store, and then two, and then three," he says. The problem, of course, is that multiple stores require their own sets of managerial and operational skills--as well as the ability to weather unforeseen market storms. "If you hit a blip along the way and one of the stores doesn't work out, then you've got a cash drainer," he says. When finances are stretched thin, one bad store can sink an entire operation.

Anderson says there are two aspects to his work with area developers: 1) they are doing the stores themselves and are growing; and 2) they have the rights to sell the franchise and could sub-franchise. "Those are also called area developers in our world," says Anderson. "We do both of those."

He's also a preferred SBA lender. "On the SBA side, the volume is so great you can't have a big enough bank line to cover it forever. We will underwrite it first, but then we will eventually sell the SBA loan off, either in the secondary market or to somebody that buys them. That way we can turn our money," he says.

His third business is build-out loans, or 90-day interim bridge loans. "A lot of the loans do not include They want you to do your own build-out. We have our own money that we use for that."

Anderson says most banks will not lend to franchisees doing their first store, or the terms and conditions are very difficult. That's where companies like his come in. "Many times, a private finance company that specializes in franchising will end up doing their first, second, and maybe their third locations." Once a franchisee has operated in the black for a year or two, the bankers will view them more favorably. Area developers with good ratios and a few profitable he says, can bypass him and go directly to their local bank.

Siegel agrees. For someone to qualify as an area developer, he says, they must be much more significant individuals or groups. "They're going to have financial resources, but they're also going to have track records. For people like that, there are conventional lenders-whether it's local banks or some national banks that are very focused in on franchising that will lend to them."

The Banker

"We generally tell people that once you've outgrown your SBA lender, come to us," says Ken Blum, senior vice president at Sovereign Bank in Worcester, Mass. "Our niche is the franchisee who has their first couple of stores open and are now looking to grow."

Blum, who heads Sovereign's franchise lending group, has a team of 12 franchise lending specialists throughout the Northeast who target franchised concepts only. "The majority of our focus deals with franchisees, but my group also handles franchisors," says Blum.

There are no hard-and-fast rules when it comes to franchise lending, says Blum. "Every bank has its own guidelines. We like to do business with the top three concepts in a niche, but we pretty narrowly define each niche." For example, within Mexican or sub-segments could include QSR or A brand's penetration in a certain area could also constitute a sub-segment. "We would look at that further. It may not be in the top niche nationally, but it could be in a geographic region." As it begins its nationwide growth plan, a brand like El Pollo Loco could span several sub-segments: Mexican, chicken, QSR, and regional, for example.

Blum, who's been in the business for 20 years, says Sovereign's franchise lending unit began with loans to Dunkin' Donuts franchisees in the Northeast and grew along with the brand. "Dunkin' Donuts is the biggest brand we do business with. We could be the largest lender in their system," says Blum. Today the bank lends to franchisees nationwide. Sovereign does have an SBA platform, but it's not the group's primary focus.

"There are only a handful of banks I'm aware of that have a franchise lending group," he says. "As a rule, it's not a natural evolution for a bank to want to lend money to a franchised concept, let alone any restaurant concept," says Blum. In banking, he says, the first thing they teach is collateral. Restaurant equipment usually isn't worth much as collateral, and since franchisors won't allow the bank to take assignment of the franchise, there's no collateral there either.

So when it comes to franchising, Blum says, "Bankers don't understand it, so they pass. That's why you see the likes of GE, which is not a regulated bank, as well as a lot of finance companies," he says, who have lower risk thresholds. "You're banking on the predictability and sustainability of cash flows." To mitigate risk, Sovereign's franchise lending team takes an extra step in its evaluation of potential clients.

"We meet everybody we do business with," says Blum. This may take longer and be more expensive on the front end, but it's much more economical over the long haul. Before each loan is made, someone from his team will hop a plane, meet with the management, evaluate the sites, and take the measure of existing operations: Are the employees well-groomed, the store and parking lot clean? How is the interaction between employees and management? "All the things you can't see on an application," says Blum.

Of all the factors they consider, in the end it comes down to the operator. "As much as we value cash flow, if we don't have a high regard for management, we don't have a deal," says Blum. He uses a horse racing analogy, with the horse being the concept, the management the jockey, and the location the track. "In horse racing, the right horse has to be racing on the right track with the right jockey. I think a good jockey can overcome a mediocre horse or the wrong track."

Blum says his group at Sovereign is unique, in that they will make deals from three up to 100 stores. "We have a credit appetite that's pretty large." Most banks have legal and house lending limits, he says. Sovereign will hold up to $35 million on a deal, more than enough for most franchisees. "If we exceed those, we can bring in some friendly competitors. We haven't had anybody outgrow us."

The Commercial Lender

"We are not an SBA lender, we are a commercial lender," says Doug Nielsen, president of Highline Capital Corp. in Boulder, Colo. "Our primary focus is working with franchise concept brands that are successful and growing." His financing strategy is primarily reviewing, analyzing, and approving brands. "The only time we'll provide financing is if we have an approved franchise concept."

Franchising is a strong focus for Highline, and although it amounts to only 20 percent of his business, Nielsen says he's "pretty heavily invested" in terms of dollars. "We're looking at both single-unit owners as well as area developers, where they'll have multi-units, even possibly multi-brands," he says. He views multi-unit and multi-brand franchising as "a very exciting segment."

Most of Highline's franchise customers are inline stores, located in a box mall or strip mall, where they have a lease and the landlord builds to suit. "We lend primarily against leaseholds, that is build-out and equipment," he says, which includes such necessities as POS systems and signage. "We do not lend against the or building." The majority of his clients are in the sector, though he will consider other inline concepts such as or haircutting.

So where does Nielsen see Highline's place in the lending spectrum? "We find ourselves very similar to the banks," he says, noting that most of the banks he sees in the franchise lending marketplace are SBA lender banks, though there are some commercial lending banks as well.

The Broker/Seller

When it comes to franchise lending, Jim Fitzgerald, founder and president of The FranchiseGuys in Rocklin, Calif., wears two different hats. Both involve evaluating potential franchisees and helping them achieve their goals. "I'm on the very front end as broker with basic recommendations, and ultimately let them and the company decide how they would be involved. Or I can represent the company, and work more directly with structuring their actual package."

Or both. In early 2006, Fitzgerald found himself working on a regional deal to sell a territory for one of the companies he represents--and simultaneously speaking with a different set of people interested in either a multi-unit or an area development package within that territory. "That's an example of something that has all those dynamics involved."

Fitzgerald considers the educational aspect of his job an important part of his work with area developers. Many of the people he sees who are interested in buying a region don't necessarily have a strong financing or franchising background. "They're going to trust the franchisor and the knowledge of their advisors on how they can acquire the territory with their current financial capabilities, and what's the best way to package it," he says.

Second, "It's one thing for an area developer to say, 'How am I going to finance my investment?' but there's another part that says 'How am I going make financing available and educate the people who may be investing in single and multiple units within my area development territory?' There's a dual need for them to be educated for their own purpose to get financing, but then to turn around and to have enough knowledge to help the other people who want to invest in their market get financing as well."

Helping franchisees acquire a good knowledge base about how they will find and help franchisees get financing gives them a comfort level that makes the venture seem far more viable than just the concept of getting royalty overrides, he says. One final piece of advice from Fitzgerald: "If they don't understand what goes through the mind of a single store owner, they're not going to be a very good area developer."

The Big Kahuna

With more than $12 billion in assets, 6,000 customers, and 21,000 locations, "We're the biggest presence in the market in terms of lending to franchisees," says Dave Russell, executive vice president of sales at GE Commercial Finance, Franchise Finance (GEFF) in Scottsdale, Ariz. The $12 billion, he adds, is predominantly to franchisees.

GEFF, he says, is divided into three broad sales teams. His group is responsible for about 70 concepts nationwide, about a third of the total. The other two teams work with the hospitality, storage, and the automotive aftermarket segments, while his deals exclusively with restaurants.

"There was a time when the restaurant industry was viewed as a more risky credit than a lot of lenders were willing to get into. That perception has changed over the past, say, two to three years. Now you see more of that than you used to," says Russell. "We've seen close to 14 consecutive years of real growth in the restaurant industry, and over the past two to three years the growth has been a nice, stable trend. So the industry looks healthier. You have a lot of capital out there that is looking for places to invest. I think a combination of those two things has caused that to happen," says Russell.

A move to larger deals is another shift Russell has observed. "Almost all of the systems we deal with have some type of program where they're trying to up their average stores-per-operator numbers. You see a trend in the industry to move away from the single-unit person and to a little bit more consolidation," he says. "In talking to different people in the systems, I think what they're going for is efficiencies of scale. With a multi-unit operator, the overhead is spread over more units."

Franchise systems in the restaurant segment today, he says, are seeking to attract operators with prior experience in QSR or casual dining operations who can put together a multi-unit development plan. "They either have deep pockets or investors with them who will help them with that, and who are more capable of running a larger, more sophisticated organization. That type of operator will tend to look a little bit stronger on the credit side. In terms of financing, it's a positive move from our perspective."

While the focus may be turning to larger deals, smaller ones are still within GEFF's lending net. "We can finance either type of operator. Each deal stands on its own, so we'll look at each under its own merits. There are benefits to either model for the system," says Russell. "We've been doing this for over 20 years. We've been able to weather through several cycles and make a long-term commitment to this industry." And, along with all the other types of lenders, continue to meet the industry's ever-changing needs at every level."

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