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CAN YOU STILL FIND FUNDING?

by Simon Lord,
last updated 23/07/2009

Is inability to raise funding stopping people buying into good opportunities?

July 2009 - Despite the recession - or perhaps because of it - interest in franchising is increasing. Hits on the Franchise New Zealand website have been constantly increasing and demand for magazines has meant we have had to re-allocate stocks to meet demand. So it's all good news, right?

Well, no. Although interest is high, the number of new franchises opening has slowed - despite the fact that many franchises are reporting continued high demand from customers. So what is the reason?
A recent article in the US Franchise Times reported that ‘Franchise sales (in the US) are plummeting not because people aren't interested in opening units... but because they can't get loans.' As a result, US franchisors have introduced incentives for new franchisees such as reduced royalties or waived franchise fees, while some have taken the radical step of guaranteeing and servicing loans themselves, or even lending the money outright. Are we likely to see such initiatives introduced in New Zealand?

Money or Nerves?

The first question to be asked is: Do we really have the same financing problem here? Have banks really tightened up on lending criteria so that potentially good franchisees are suddenly unable to get funding, or are some franchise buyers blaming the credit market because they are too nervous to take the plunge until conditions improve?

According to a survey of 18 franchisors conducted in June 2009 by the Franchise Association of New Zealand, 55% of franchisors report that they have experienced higher levels of enquiry from potential franchisees in the last six months. Unfortunately, the same percentage also reports that their potential new franchisees are experiencing increased difficulties in obtaining funding. ‘The banks are saying that while they're being more cautious they will continue to lend to good prospects,' says Graham Billings, the Association's Executive Director. ‘What we don't know, of course, is whether the franchises experiencing difficulties were good prospects or not - especially in the light of increased enquiry levels.'

So have the banks actually made in harder to get funding? ‘I think that is what some franchisors would like to believe, but it's not true,' says Westpac's Daniel Cloete, one of the longest-serving specialist franchise bankers in New Zealand. ‘I've talked to colleagues from the other banks and we all agree on this. Yes, there are certainly cases where we have turned down applications from potential franchisees, but it's not because our underwriting standards have changed - it is because the current economy has moved the goalposts for some franchise propositions. If a business proposal from an intending franchisee makes economic sense then we will fund it, as we always have. There are a lot of positive factors in the market at the moment, including the availability of better rents and locations, lower funding costs and the fact that existing businesses are selling at lower multiples of their EBIT figures. These all help to reduce funding requirements.

‘But if a potential franchisee doesn't have the necessary level of equity to put into the business, they may need to look at a lower investment opportunity for now. And if a franchisor cannot present an opportunity that is going to make money in the current market, perhaps because the level of sales has dropped, it means that their business model simply doesn't work in the current environment - not that the banks don't want to fund,' he emphasises. ‘In fact, many franchises are doing very well and have no trouble in obtaining funding. Certainly, our lending in certain industries has increased dramatically and is continuing to grow.' There's certainly some evidence to support that: one experienced franchisor told us, ‘Funding is ticking along nicely. We are attracting people with cash and equity to borrow against and we haven't had a problem.'

Perhaps the truth lies more in the statement by one respondent to the survey, who said, ‘Potential franchisees are concerned at the prospect of going into business in these economic times. If they have the money, they are not keen to part with it.'

Perception vs Reality

According to the survey, 62% of franchisors report that they have had no difficulties in obtaining funding from their present lender, while 54% of respondents said that the interest rate on their business loan had fallen in the last six months, providing some relief against recessionary pressures.
But while the majority of franchisors may not be finding borrowing more difficult, there is still plenty of criticism flying around. ‘82% of respondents believe that banks and other financial institutions are not being open and genuine with their positions in regard to interest rates,' says Graham Billings of the Franchise Association. ‘That's the strongest negative that came through in the survey, but when you compare it with the statistics that say the majority of franchisors are not experiencing problems and business loan rates have fallen, there's a significant difference between perception and reality. It seems to be a communication issue.

‘I do think that one respondent has a fair point when he comments that, "The banks justify the lack of movement in business lending rates by citing increased business risk due to recession. However, most business owners have also got personal guarantees or personal property as security and the banks do not seem to take into consideration this additional security when setting their rates."'

Franchisor Funding

In the US, where lack of funding does seem to be a significant problem, the concept of internal funding has been attracting a lot of attention. ‘There are numerous ways companies can offer internal financing,' says the Franchise Times report. ‘They can provide limited guarantees, full guarantees, loan servicing, remarketing agreements, mezzanine financing or joint ventures. Franchisors can raise money themselves and set up a separate fund, or they can simply use their own available cash.' It goes on to say, ‘The risk of guaranteeing loans forces the franchisor to think differently about the type of owner entering the system. Because the franchises would be on the hook for the defaulted loan, they're scrutinising their prospects more carefully.'

On consideration, what this is saying is that when loans were easy to get, US franchisors were growing fast but now it's the franchisor's own money on the line, they are more concerned about their franchisees' chances of success! ‘Fortunately, the situation in New Zealand is a bit different in that good franchisors have always been very selective,' says Daniel. ‘And the default rate among franchisees that have been through our own evaluation process has been very low indeed.

‘Of course there are various situations where alternative funding is appropriate and we advise our customers accordingly. However, you have to be careful to ensure that any such solution doesn't merely transfer or escalate the risk. Franchisors might consider deferring franchise fees, but many are not in a position to do so - and if deferring fees robs them of the funds they need to provide proper franchise support, it is ultimately self-defeating. Similarly, if you load a greater proportion of the business's initial costs on to an ongoing basis, perhaps through higher fees, that is making a fundamental change to the business model that may not ultimately be sustainable. If a franchise is being resold, the outgoing franchisee might choose to leave some money in as vendor funding, but they are then accepting the risk involved in the way the incoming franchisee runs the business. Frankly, unless they have to sell then they would be better continuing to run it themselves until the right buyer comes along at the right price.

Nonetheless, current uncertainties are encouraging some franchisors to be creative, such as Snap-on Tools. The international franchise has launched a new finance programme called Gateway which gives individuals the opportunity to fund a start-up business with less need for external finance. ‘With the Gateway Programme, Snap-on provides the inventory needed to operate the franchise but retains ownership,' explains Snap-on's Nick Hudson. ‘The franchisee gradually builds equity in their inventory by paying a percentage of the money they collect every week. This is always a manageable amount and enables them to have everything on hand they need to grow their businesses.' Another interesting approach to growth comes from the Jumping J-Jays franchise, which gave away a $50,000 business package in Melbourne earlier this year. Just a publicity stunt? Maybe, but it's repeating the exercise in Canberra.

Conclusion

Whatever the funding situation, and whatever alternatives franchisors might come up with, the fundamentals of buying a franchise haven't changed: choose something that suits you, choose something you can afford and choose something you will enjoy. ‘Whatever the market, you need to look for a solid, profitable business built on a proven model,' says Daniel Cloete. ‘Any bank is going to look more closely than ever at the figures right now, but that protects you as well as them. If the figures stack up, you'll find the funding.'

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