Where's The Money? Finding The Funds To Grow In A Tight Lending Environment
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Where's The Money? Finding The Funds To Grow In A Tight Lending Environment

"How's risk management in the big bank world?" he asked the banker.
"I wish it were that," the banker replied. "It's more about risk elimination. We won't make a loan to anybody unless they don't need the money."

True story, says Bob Rodi. He asked the question. The banker was a former employee of his, who now works in a large national bank. The banker also told Rodi, who is president of franchise lender Mount Pleasant Capital Corp., that his bank wasn't making any loans right now unless they were secured by cash, CDs, or NYSE-listed stocks, or the applicant had a minimum of $150 million in sales.

Franchisees want money to grow, and bankers and other traditional sources of finance are running scared. This is driving franchise borrowers to consider alternative sources of funding.

"Money has been getting progressively tighter and tighter over the past 6 to 12 months," says John Rinaldi, president of Irwin Franchise Capital. Rinaldi calls the current situation a "double whammy": in addition to the greater cost of funds and higher interest rates, the credit markets have dictated that lenders be more conservative than before.

A year ago, franchisees could find 100 percent financing; today's lenders are requiring more and more equity with each passing month. Rinaldi says today he is seeing equity of 20 to 25 percent, even as high as 30 percent, required by some lenders.

He also says lenders today can be more picky as the number of lenders in the franchise space dwindles. "If there's greater demand and limited supply, lenders will be more selective and dictate better terms [for themselves] than when there were more lenders serving the sector," he says.

A year ago, franchisees with good credit and cash flow may have had 20 lenders willing to fund them, says Bernie Siegel, founder of Siegel Capital. Today there may be one or two.

Brian Colburn, managing director for franchise finance at Butler Capital Corp. [Ed. Note: Colburn left Butler and joined Mount Pleasant Capital shortly before press time], says his company will lend up to $2 million. And there are companies that will lend upwards of $5 million. But when it comes to finding funding in between, he says, "Guys from $2 million to $5 million will have the hardest time."

So-called second-tier lenders like Rodi and Colburn see this situation creating a lot of opportunities for lenders like themselves. In many cases today, says Rodi, his company is "first-tier" for an increasing number of borrowers.

Referring to Butler Capital, a larger lender than Mount Pleasant, Rodi says, "We now have a mutual customer who a year ago wouldn't have given us the time of day." The customer, a 100-unit operator with $230 million in sales, had done business with Butler before, but today is working with Rodi as well.

Multiunit operators with 25 stores and up are good candidates for obtaining funds, as long as the business is in positive territory, with cash flowing and debt handled, and is part of a system that's growing, says Irwin Franchise Capital's Rinaldi. "They can borrow. It's the smaller borrowers who are having trouble," he says. His own company's "sweet spot" is franchise restaurant loans up to $10 million, and Irwin will participate with other lenders in transactions.

"The credit markets have tightened significantly," says Rinaldi. Even when an individual franchisee is doing well, if they're part of a troubled system, their personal success may not be enough for a lender in today's environment.

Spreading The Pain

Although the capital markets have changed, "Our approach and model hasn't," says Trey Brown, senior managing director at GE Capital Solutions, Franchise Finance. Still, he says, "We certainly are a party to recalibration of the credit spreads."

"Most of the active lenders in franchise financing have increased rates 100 basis points from where they were before," says Rinaldi.

Colburn says would-be borrowers should not be as rate-sensitive as they might have been a year or more ago, when lenders were plentiful and lending standards more relaxed. Even at 100 more basis points, he says, "If the money is available, they should take it."

The perception, he says, is that the prime rate has dropped in the past year and a half, but as a direct lender he bases his rates on LIBOR and 5-year Treasury swaps. "We're not getting any more on the spread of the money than we used to," he says.

"The commercial rates, the cost of money, has little or no relationship to the rates they're seeing in the Wall Street Journal," Rodi explains. Rates have gone up because of perceived risk and from lenders continuing to cover losses from the subprime debacle. "Pay an extra 100 basis points if you have to expand, or sit on what you have and wait a couple of years—and there's always the option of refinancing at some future date."

Says Colburn, "When it comes to a rate objection, for example the rate is 9 percent and they're thinking 7.5, it comes down to a couple hundred dollars per month. If $200 is the determining factor, they shouldn't do it in the first place."

Adds Rodi, "They say, 'The SBA will do it for 9 percent,' and we'll do it for 10 percent. True, but I'm not taking your house."

Jolly Green Lender

Not surprisingly, says GE's Brown, today's financing/lending environment is part of the cycle correcting for what he called "a pretty hot market over the past three to four years. Overall, "access to liquidity has diminished," he says. "Institutional lenders have decreased dramatically," adding that while long-term players and national banks are still around, they are behaving differently.

However, says Brown, GE is making deals—and for franchisees with a demonstrated track record of growth and profitability, the right brand, and the right size, deals are available.

GE itself has been "optimistically acquisitive," he says, spending a total of about $6 billion to acquire the assets of Trustreet in early 2007, Merrill Lynch Capital early this year, and this May was in the closing stages of its acquisition of Citi Capital. "We like the synergies," says Brown.

With $14 billion in served assets, more than 5,000 clients, and 22,000 properties in its portfolio, GECC, FF is clearly in a class by itself. Brown said the company has "a very healthy portfolio with a lot of healthy operators" and will originate from $3 billion to $4 billion in new investments per year.

Although the average size of the company's deals has climbed from the $3 million to $4 million range up to $8 million to $10 million, smaller franchisees "shouldn't get lost in thinking they're too small. We're still financing single-unit operators." Brown says GE is still offering loans across the full spectrum of franchisor needs, from $150,000 to tens and even hundreds of millions.

For multiunit, multi-brand operators and area developers looking at opportunities to grow strategically, says Brown, "Well-managed, experienced operators with a foothold in brands they know should have no difficulty." The real challenge, he says, is for those new to a brand, or evaluating growth into a brand or segment they have not done before.

Beyond the money, Brown says GE can help strategically as well. "We're very actively portfolio managing our business. Operators should use that to their advantage in partnering with us, especially in cycles like this," he says. "As a vertically dedicated lender we can offer advice based on our portfolio."

GE's hefty experience can provide an additional edge to a borrower. "We've seen this business cycle before," he says. "We're big enough to matter in this space, and small enough to be very agile, responsive, and strategic in a market like today's."

Consider The Alternatives

There are advantages to working with full-service commercial direct lenders (despite the additional 100 basis mentioned above). These include obtaining funds faster than through a bank or the SBA (1–3 days versus 2–3 weeks or 2–3 months); longer terms (especially for equipment leasing) and flexible payment plans; and you don't have to mortgage your home or provide other personal guarantees. Most important when you need capital to grow, you can get funded.

"The major focus of my underwriting is on the actual franchise concept. I really become an expert on that franchise model," says Rodi. "I come up with a pro forma P&L of my own that I will compare to each franchisee as they come in. This has worked very well for us from the standpoint of constructing a good-performing portfolio."

Brown says no distinct patterns of change yet stand out in the types of financing GE is providing today compared with 6 or 12 months ago. "We need to see it play out more," he says. But clearly over 2006–2007, he says, sale-leasebacks were a hot commodity as private investors and shareholder activists sought to monetize real estate. "We still see a fair amount of sale-leasebacks," he says, though he expects it to peak or plateau.

"What is undeniable over the past nine months," he says, "is an increase in the number of draws on revolving lines of credit. If liquidity tightens and folks are pressured, they will draw down." Yet as some clients become more challenged for operating capital, they're choosing to hold onto their real estate as leverage, at least for now.
Any market or economic environment will always find optimists looking for money to grow, says Rinaldi. That's human nature. So are the bottom-feeders, who thrive in tough times by picking up assets at bargain-basement rates. Today, as the economy affects some franchisees, sectors, and regions more than others, and with some troubled franchise systems barely hanging on, he's seeing more acquisition opportunities for companies whose model is to buy on the cheap. For them, these could become boom times.

Time for Some Creativity!

Despite the general withering of traditional franchise lending sources for all but the biggest and the best, there are things franchisees, multiunit operators, and area developers can do to improve their prospects, says John Rinaldi, president of Irwin Franchise Capital, which specializes in lending to franchise restaurants.

  • Use your equity. Consider borrowing against the embedded equity in your current businesses. For example, he says, if you own several stores, obtained financing years ago, and have paid down the existing debt, you can "re-up" the loan amount or leverage the equity of the business. "If the equity that you own is significantly greater than the debt, try borrowing on that to assist in acquisitions or new unit growth," he says.
  • Consolidate debt/refinance. Another idea may be obvious, he says—considering that banks always are interested in attracting new depositors. If you don't have a good relationship with a larger bank, start one. Consistent and/or sizable deposits could make a bank more willing to make a new consolidation loan on reasonable terms—as opposed to having your debt spread out among five different institutions. "Lenders are hungry for deposits, so put your deposits there in consideration of fair loan terms," says Rinaldi.

"We look at the debt schedule of a borrower to see if it makes any sense to refinance at lower rates—rates are still historically low," he says. While it could be costly to refinance, the resulting cash flow available for the business may be worth it, he says, even with a prepayment penalty.

  • Consider variable rates. Long-term and short-term interest rates had been running essentially the same for some years, but today there is a distinct difference. "You may want to negotiate a shorter-term rate that floats," he says. "As long as you have the discipline to watch, find a lender who will give you the option to flip to a fixed rate." If rates start trending up, some lenders may give you the option to term out the remainder at a fixed rate, he says.


Investing in Yourself

If you could finance your next location without taking on additional debt, why wouldn't you? Why pay interest to a bank or other lender if you can use your own equity?

That's what Ellen Hui did. She is using the equity in her 401(k) account to help her open six new Extreme Pizzas in Santa Clara County, Calif. Hui, who already owns six Popeyes Chicken restaurants in San Francisco's East Bay, is using the money to build out and buy equipment for the new pizza restaurants. She paid Guidant Financial Group of Bellevue, Wash., $5,000 to set up this alternative funding structure.

"For me, it's a tight credit market, and this is a good way to use the assets that I have and get a better return for them," she says. Hui, a former banker, says the money is still tax-deferred and conforms to IRS regulations. She calls the fee "reasonable."
Today, with the setup fee behind her, Hui has the relative luxury of no principal and interest payments to make every month: there are none. All of her capital and cash flow can be used to fund growth. "You can borrow the money and pay a bank 6 percent," she says. Or you can use your own equity to grow your company interest-free. "You can even use it to buy investment properties," she says.

But, she cautions, to avoid the serious penalties and taxes that kick in if the plan violates IRS rules, "You have to make sure you have professional people helping you with this. I do know what I'm doing, and it's not for everybody," says Hui. "Retirement is a sacred cow, not for touching." At least not in normal times.

The Setup

Guidant's CEO, David Nelson, explains how it works. While the details of the process are complex, the steps are simple. The only requirement is to have a 401(k) with enough assets to fund the planned business:

  1. Form a new C Corporation
  2. Form a 401(k) for the new corporation
  3. Roll over funds (some or all) from your existing 401(k)
  4. Use those funds to purchase shares of the new C Corp and deposit them into the new company's bank account. (The new 401(k) holds the stock, as it would any investment.)
  5. Start writing checks.

"We bundle that together and handle it under one roof. We act as the facilitator," says Nelson. "You are paying for the professional services." In the past four years, he says, Guidant has helped redirect more than $1 billion into this alternative financing strategy.

"We've helped people invest in their own core competency," he says. "It's an opportunity to take the knowledge and skills they've learned in their corporate experience and put that in an asset they know and can control."

This strategy has been available since Congress passed ERISA in 1975, but has remained largely underutilized. "The credit crunch may be drawing more attention to what we provide," he says. "People are starting to realize the benefits of going with equity instead of debt."

Nelson makes a good argument for considering this route:

  • The $5,000 fee is within range of the cost of an SBA loan and having an attorney set up a new corporation.
  • It's fast—it takes 2 weeks, quicker than bank loans these days, and is light years ahead of the 60 to 90 days for an SBA loan (if you can get either of those).
  • No debt is incurred. All the money can be used for growth (or any legitimate business expense).
  • No credit check is required.
  • No collateral is required.
  • No monthly principal and interest payments.
  • Any gains in the 401(k) are tax-deferred, the same as they were before.

And, he says, "There is no approval process. They either have the money or they don't."
Both Nelson and Hui advise caution—both in the use of one's retirement funds and in the choice of provider. Says Nelson, "It is a fairly complicated process, particularly under the hood. The heavy lifting is handled by our organization, and should be by those who compete with us."

Funding Tips: A Six-Pack

Even in the worst of times, there still are actions—as well as inactions—a franchisee can take to reach their goals. Here are a half dozen from the experts we interviewed.

  • Full disclosure. When a franchisee is working with a lender, make sure there's full disclosure of all financial information—including the negative—that may be material to the transaction. "Bring it up out front, because the lender's going to bring it out anyway," says John Rinaldi at Irwin Franchise Capital. He says borrowers (franchisees) also should do a little prequalification of the prospective lender as well. "Be sure the lender you're working with is the right lender you need, one that understands your business."
  • Communicate. Over-communicate, in fact, says Trey Brown at GE Capital Solutions, Franchise Finance. He also says to over-manage and over-measure in ways you never have before. Lenders prize transparency. They don't like surprises. And the more they know, the more they can help you through a rough patch.
  • Listen to your lender. Striking up a new relationship or growing an existing one with a lender requires routine dialogue, says Brown. The lender wants to be close to their investment in real time, and can help to strategize, even when things are going well. "You can't have enough advocates in our end of the business," he says. "We have a lot of folks with deep, deep experience in the franchise space. Now is the time to take advantage of that."
  • Choose a good horse. A well-established concept in a growing system in an expanding market segment or region will find you plenty of friends in the lending community.
  • Have a plan. Especially if you plan on significant growth. Lenders want to know that you can manage at the next level. "Growth has to be controlled. Back it up with a plan that shows me how you're going to do it that makes sense," says Brian Colburn of Mount Pleasant Capital (but with Butler Capital when interviewed for this story). With the available cash and infrastructure you have today, how capable will you be for the next level of growth?
  • Slow down/retrench. For many multiunit franchisees and area developers, this is a good time to ease off the accelerator and focus on fine-tuning their vehicles; to go slower, conserve resources, and work on the basics to improve operational efficiencies, same-store sales, training, infrastructure, etc. If you've signed an agreement to open so many stores in a given period, see if you can renegotiate the timetable, rather than overextend yourself and jeopardize your success to date. Franchisors understand the market today.

"We have seen many potential borrowers say they're going to pay attention to existing operations, clean them up, and look for increased efficiencies," says Rinaldi. And when the taps begin to open once again, those operators will be poised for growth.

Published: August 7th, 2008

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