The Relationship Paradigm of Lender, Franchisor, and Franchisee

The current "credit crisis" should not have to be a major obstacle for franchisors and franchisees seeking to expand their businesses. To reach an effective solution, it is necessary to examine the relationship paradigm between the lender, franchisor, and franchisee with a goal toward creating greater awareness and understanding of the objectives of all involved.

Among the interests represented in every franchise lending transaction (franchisor, franchisee, and bank), there are certain common approaches. For one, each entity conducts an assessment of the deal terms and monetary performance and examines the potential returns. Essentially, the lender, franchisor, and franchisee are each attempting to determine whether they will assume the risk of working with the other parties.

While the parties are focused on conducting this analysis, they sometimes miss what is most needed to close the deal: communication and an understanding of each other's business and core values. The franchisor and franchisee each have certain non-negotiable requirements necessary for the successful operation of their business, which can vary based on, among other things, the industry or chosen venue. Similarly, lenders expect a certain return on their investment and desire to mitigate risk. If the parties are unable to communicate these core values, viable deals may fall through.

For example, some lenders lack knowledge and experience specific to the franchisor, or may not understand the franchisee's market segment to know what return they can expect. To address this lack of lender awareness, franchisors need to help their franchisees by providing potential lenders with information on the system's future vision, growth trends, business plan, and current unit performance in various venues and markets. Likewise, franchisees should emphasize to lenders how specific industry knowledge and experience are reflected in their profile and financial statements. It is this communication, combined with the overall economic recovery, that will ultimately change the current lending environment.

Nowhere is the need for communication more evident than with non-traditional venues such as airports, military bases, and college campuses, which can be a primary outlet for franchisors seeking expansion. With these venues, there are often greater requirements for operating, different and sometimes increased operating costs, and varying customer traffic patterns as compared with traditional outlets, which could lead to a misunderstanding in evaluating their creditworthiness.

Franchise systems looking to expand in non-traditional venues might receive significant pushback from banks that may view the transaction as an unnecessary risk. For example, lenders typically want to see a history of development and instant growth, whereas many non-traditional developers are start-ups. Airport franchisees in particular may experience difficulty in obtaining financing because of the RFP process, which requires candidates to bid on an opportunity with development targeted for a year or two later, a time frame that may be too long for some lenders. This disconnect in the non-traditional arena further highlights the need for communication.

Franchisees must also be involved in the dialogue. Franchisees have many viewpoints on the current lending environment based on their own particular experience, which may or may not be common with other franchisors or franchisees. Perception is reality, and there is a perception that larger banks are unwilling to lend in smaller franchise transactions. Therefore, franchisees are increasingly turning to smaller banks and the SBA for their lending needs. For example, although larger banks may be more familiar with a particular industry, they sometimes have less-efficient processes, creating a perception among franchisees that smaller banks are able to process loan applications more quickly, even considering the extra time it takes to become familiar with the applicant's business and market segment.

Some franchisors attempt to alleviate this problem by providing franchisees with a list of preferred lenders. However, this is not a complete solution because it is ultimately up to the banks to decide which applicants to approve, an issue that comes down to the strength of the individual applicant, which is why it is important for the franchisor to get involved in the communication.

The examples above highlight the potential for franchise deals to break down when there is a lack of understanding. If the lack of credit access is to be resolved, the relationship among the lenders, franchisors, and franchisees needs to improve. Each party should assist the others in aligning expectations, understanding needs, informing each other on the franchisor and the franchisee potential, and owning responsibility for the desired outcome: increased growth and revenue for the franchisor, franchisee, and the bank.

Joyce Mazero is a Partner and head of the Franchise and Distribution Practice Group of Haynes and Boone LLP and can be reached at joyce.mazero@haynesboone.com.

Emma Ricaurte Harker is an Associate in the Franchise and Distribution Practice Group of Haynes and Boone and can be reached at emma.harker@haynesboone.com.