Financing your franchise dream with a commercial loan

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And some underwriting pointers to my fellow lenders

One of the things that I do not like about underwriting loans for the middle market and large corporate market is that I do not get to see many of the small business loan requests from people starting out or in the process of building up their business. While I still get to see some small businesses in my practice, it is rare when a request with less than $5 Million in revenues crosses my desk. There is something about pulling for the underdog that appeals to me, and it is difficult to pull for companies whose revenues are the same as the budget for a medium sized city. While the banking profession has been demonized in recent history, I can assure you that all of us want nothing but success for our borrowers. After all, a successful borrower is a paying borrower.

Having said that, I would like to talk about franchise financing today. I think it is a topic that is misunderstood by both borrowers and lenders alike. This article might help clear some of those misunderstandings, and explain franchise loan underwriting. I am very familiar with the subject as a good friend of mine is a credit officer for a franchise specialized lender, and another friend of mine is the head underwriter for a competing non-bank lender that does dozens of franchise loans. I have in the past talked to the underwriter about different requests, and consulted on how to structure “out of the box” loan requests for franchise transactions.

Common misconceptions and missteps from prospective franchise owners and some lenders are:

Not all franchises are the same. Each concept has to be evaluated.

The fact that a concept is franchised does not in itself take away a lot of the risk associated with a loan request. Each franchise has different brand recognition, geographic reach & market penetration. On top of that, the way each franchisor deals with the franchisees makes a lot of difference on the bottom line and cash flow of the business. A  lender counts on that cash flow to repay the loan. The lender that thinks a franchise label makes a concept safer needs to remember that nothing beats your own due diligence.

This remind me of a Quiznos restaurant that used to be in a shopping center near work. I used to frequent this shopping center about once a month because it  has an Italian restaurant that makes a great lasagna special for lunch on Wednesdays. One of those days, I decided to have a sub instead of pasta so I went into the Quiznos. My experience was disappointing, the restaurant seemed so unkept that I was surprised any chain would let their franchisee keep it like that. Furthermore, the Quiznos was empty with only one other customer showing up during lunch. As someone that has thought about buying a sub shop franchise for investment purposes, the situation was sad.

The Quiznos went away, and was replaced with a Subway. The difference was like night and day. The Subway is very successful at the same location, and everytime I drive there during lunch there are people in line to buy subs. Parking has gotten so bad that the last time I went to the shopping center, the Subway is so busy that I turned around instead of dealing with parking.

Although anecdotal references are fine, there are actual numbers that support an argument for differentiating between franchisors when it comes to loan requests. Last year, the SBA released loan performance by franchise brand. The data reflects loans approved from 10/01/01 to 09/30/10, which were assigned to a franchise brand and subsequently disbursed. The dataset tracks over 500 franchise concepts, but for the purpose of this article I concentrated on sandwich shop chains that I am familiar with.




As you can see by the table above, the failure rate for Quiznos is about four times that of Subway. Other smaller chains show disappointing failure numbers, but the numbers for Quiznos are surprisingly bad for such a well known brand.

Both prospective franchisees and prospective lenders need to do their due diligence

One of the benefits of going with a franchise instead of your own concept is that there is  information available specially if you are willing to spend the time. In addition to the  Franchise Disclosure Document required by the FTC from all franchisors, there is a lot of information available from several sources. For example, a two-minute Google search pointed me in the direction of some lawsuits by franchisees against Quiznos about the requirement that franchisees buy their ingredients from a corporate related supplier. By contrast, Subway requires only that the franchisees buy from approved suppliers. If a loan request for a Quiznos had crossed my desk five years ago, I would want to understand how this practice might affect the profitability of the restaurants.

Doing due diligence means little if it does not make it into the underwriting

I think this is better explained in an example. According to an SBA audit, a total of 12 Huntington Learning Center franchises received SBA guaranteed loans from Banco Popular for the acquisition of their businesses in 2007. The loans ranged in amounts from $196,500 to $379,900. Banco Popular approved these loans based on first-year projections that showed that the franchises would generate revenues ranging from $483,000 to $650,025.

The problem was that Banco Popular had information that average revenue for franchises in operation for one or more years was $468,442 in 2005. The lender disregarded relevant and available data, which indicated that the franchises’ revenue projections were unreasonable. This was due, at least in part, to the lender’s perception that franchise loans required a lesser degree of due diligence because of the established business model of franchise systems.

 If you want to read more about this and related subjects, you can visit the following:

Audit Report on Banco Popular’s franchise underwriting at SBA.Gov (PDF file)

SBA Franchisee Failure Rates by Brand – – Where I got the SBA default rate data

You can also download a complete listing of all franchise loans default rates by clicking below:



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