Times have changed for sure. Almost everyone is affected by the credit crunch. This can range from customers who are having trouble paying bills, to declining customer counts, to personal experience with loan approval issues. The mindset of the lending community changes drastically during crunch time. Even lenders who may not be directly affected are going to act in a more conservative manner. Those who had direct involvement in the sub-prime mortgage or commercial lending segments may drastically alter, or even stop altogether, their new loan origination activities.
This “insider’s guide” should provide the reader with some insight and no nonsense answers to financing questions. This is written from the standpoint of the underwriter and will provide you with information that you need to know to get a transaction approved and funded. What you find here will provide you with some necessary steps that you will have to take to get a solid loan approval. Not everything you read will be “what you want to hear”. Instead, it will be a realistic representation of the issues that all lenders are dealing with. Good or bad, the current market issues have changed the credit environment. This doesn’t mean that you can’t get a loan. It simply means that you probably won’t get the kind of terms that you wanted or think you many deserve. If you, as the franchisee, really want to be in business you will have to do an honest evaluation of what it will take. If it requires more equity or higher rates to get your business open now, then as a business person you have to view that as the “opportunity cost” associated with moving ahead in the current environment. If you do not want to move ahead then you will also have to evaluate the “cost” associated with waiting for, what you feel, are ideal conditions. Either way, this short guide is designed to help you through that process.
Defining Your Needs:
The current market conditions dictate that you understand that lenders are going to be inclined to provide as little debt as possible. The higher the debt you require, the higher the “perceived risk” that will be associated with your transaction. This may dictate that you will have to put in more equity than originally planned.
If you are a brand new franchisee you need to understand that any business start-up is going to be viewed as a high risk proposition. You should carefully define your needs using a “sources and uses” of funds document. This will detail your equity injection, any tenant allowance you are getting from your landlord and any other source of funds that you intend to use in your business. You will be asked to show proof of liquidity. If your liquidity is borrowed from home equity the repayment of “borrowed equity” will be calculated into your overall debt service for the location. If you are using all of the equity in your real property and you have little else in the way of unencumbered liquid assets your loan will be classified as high risk. This is because you will have no “cushion” should your business plan not work perfectly. The current market place is far too uncertain to work without a safety net.
If you are currently a multi-unit operator and you own locations that are debt free you may be required to use those locations as collateral for an expansion loan. If there is existing debt but your current locations have a solid “enterprise value” you may be required to refinance those remaining balances. This is because a lender, who is interested in funding your expansion, may see less risk in a larger loan spread over several units rather than a smaller loan tied to one unit.
As with anything, there is an upside and a downside to this from the standpoint of the borrower. The downside is that you may need to tie up additional assets to continue your expansion. The upside is that your current locations, especially if they are mature, may get you more than 100% financing and allow you to leverage those locations for some less expensive working capital that can be put to use in your existing operation.
A lender will actually view this as a lower risk scenario because their exposure is spread over multiple locations and the loan to value on each location is well within an acceptable range, so much so, that you may be set up for additional borrowing should the need arise.
You should also be realistic about the rates that you are willing to pay. If you are working with a lender that will use other collateral in addition to your franchise locations, then you can and should expect a lower rate. Depending on the value of your “other collateral” the lender may be looking at a transaction that is totally secured and not even dependent on the performance of your franchise locations should they need to be repaid in the event of a default on your part. If, however, you have a transaction that requires no additional collateral other than your franchise locations, you should expect to pay a somewhat higher rate. In the later case a lender is totally dependent on the “going concern” to be repaid. There is inherently more risk in this type of transaction so expect to pay a higher rate. The decision on which way is best for your business has to be approached from the standpoint of the “opportunity cost” associated with paying a higher rate to leverage your business collateral rather than your personal assets.
Having this thought out prior to meeting with lenders will make your financing discussions far more meaningful. You will not waste time with lenders who simply cannot meet your needs, nor you theirs. In this market most lenders will be following their underwriting guidelines very strictly. Engineering exceptions to these guidelines will not be productive. Understand what it is you need, convey that succinctly to the lender and do not take it personally if the transaction isn’t a fit for a particular lender, even if you have done business with them before.
Preparing your package:
Your lending package should be prepared and ready to hand to a lender when you learn that your transaction may be a fit for them. Your transaction should include the items listed below. There are very few exceptions to this and if you are not prepared, or do not want to provide this information, then you should tell the lender this right up front. In this way you will give the lender the opportunity to say “No” to you at that time instead of becoming embroiled in a long process that will result in additional information requests. Remember that there are two types of lenders. Those that will emphasize collateral such as Real Estate, cash, CDs, stocks, etc. to secure your loan and those that will emphasize cash flow and “enterprise value” as the primary source of repayment with much less emphasis on your home and personal assets as collateral.
A good lender presentation should be packaged as follows:
If your application is for a start up you should package your loan as follows:
- Application with bank references, contacts, and lending\trade references for all principals
- Sources and uses of funds detailing the amount of equity you will inject, and the amount you expect to borrow, any land lord or other allowances, gifts etc, that will be sources of funds. Detail on any other funds that you will borrow aside from the loan request.
- Copies of bank statements, brokerage statements, etc. that will verify the amount and location of your liquid assets.
- A Personal Financial Statement on all principals of the business.
- Personal tax returns on all principals for at least the past 2 years.
- Tax returns, financials and details on any other businesses you own that contribute to your overall cash flow
- A business plan including 3 year projections, resumes of management personnel, and a time line for expansion if you have signed a multi-unit agreement.
- Letter of intent from a Landlord with details as to why and how you selected your location.
- Copies of equipment quotes, invoices and contractor bids.
- A copy of your LLC agreement, partnership agreement or corporate minutes
- Summary page of your lease if you already have a location showing term, conditions and rent
If you are a currently a franchisee and you want to expand, you should also include the following items:
- Business tax returns, P&L statements, and Balance Sheet (internally prepared is generally acceptable in franchising provided they are accompanied by tax returns)
- Most recent interim statements. (If interims are used to evaluate and approve a transaction at year’s end, there will more than likely be a contingency that will require completed tax returns, financial statements and an updated interim by the time that transaction funds)
- A debt schedule showing all loans, interest rate, monthly payment, original balance and term of loan.
- Approval of the location and expansion plan by the franchisor
If the lender indicates that they want to move forward with the transaction you should also be prepared to provide a copy of your lease and a copy of your multi-unit franchise agreement showing the time line of subsequent store openings.
If you prepare this type of package you will understand your loan request from an underwriting standpoint. Remember that your loan package will be evaluated objectively. There is a common misconception that Lenders look for ways to turn transactions down. While it may seem this way it simply isn’t true. Lenders don’t make any money unless they successfully underwrite and approve lending requests. Lenders are looking for ways to approve loans. This is why it is important for you to define your needs and convey your request as concisely as possible. If you do not do this and randomly send your loan package to multiple lenders hoping one of them will approve it there is an excellent chance that you will experience the rejection that leads applicants to believe that lenders are really out to sabotage your loan application.
One of the most repetitive questions that a lender has to address is the question of why the principals are required to personally guarantee. The answer to this, especially in a multi-unit franchise organization, is because the franchisee is the organization. The franchisee provides the direction and management, knows the franchisor, and is generally the person who has been responsible for building the business. The Lender wants the franchisee tied to the business. From a risk management standpoint, the franchisee is so essential to the success of the operation that tying them to the business by requiring a personal guarantee is seen as an important risk mitigation strategy. In this case, the financial strength of the franchisee may not be as important as the operational strength of the franchisee.
If the request is for a less mature company or a start-up then the financial strength of the franchisee is going to be even more important. This is because the business has little or no “enterprise” value and lacks the financial strength, repayment history, and track record of the more mature franchise operation. The franchisee, in this case, is often seen as a primary source of repayment until the business begins producing enough cash flow to service the debt associated with the loan to the business.
As the business evolves the personal guaranty of the principals evolves, from less of a guaranty of repayment, to more of an “operational guarantee” that is important because the franchisee is responsible for a consistent and stable operation. A consistent and stable operation theoretically produces consistent cash flow thereby decreasing the risk of default as the transaction ages.
In most cases, lenders will also want the guarantee of spouse or significant other. This is because most states consider all marital property as “community” property. In a divorce situation, the franchise rights and\or business could be split between the divorced couple even though one member of the couple has little or nothing to do with the business. This may leave the remaining spouse with a shortage when it comes to paying the debt service associated with the business. Additionally, the business will undoubtedly be a primary source of family income so the spouse derives a direct economic benefit from the business. It should be noted that a spouse cannot be compelled to guaranty and, in cases where the spouse refuses to guarantee, the underwriter will look at the applicant on a standalone basis.
When evaluating a loan request where there is a request that the spousal guarantee be waived, the lender will “split the sheet”, meaning that the assets of the couple will be divided equally between the spouses. The single applicant will have to have enough tangible assets and individual cash flow to support the transaction at the ratios required by the lender. Once the assets are split, the spouse that is trying to apply for the loan rarely meets the tangible net worth test. Beyond that, most franchise and small businesses involve husband wife or significant others as an integral part of the business. Even if a spouse is left off the loan documents, in a divorce or dissolution, community property laws may award half the business to the non-guaranteeing spouse. Most lenders will view this as a major risk factor unless the business is truly capable of supporting the loan request without guarantees. This is a rarity in the case of closely held business organizations. Be advised that a lender cannot require the guarantee of a spouse as a condition of extending credit but, by going through the process outlined above, a lender may decline a transaction because only the joint assets will qualify the applicants for the amount requested. It should also be noted that attempts to move assets to one spouse for the purpose of obtaining a loan approval will generally be discovered by any lender during the due diligence process.
If the applicant owns another business that provides the bulk of the applicant’s income expect to provide full disclosure on that business including financial statements and tax returns, banking information and possibly trade references. The operation of that business by the applicant will be viewed as information that is “highly material” by the lender. This is because that operation, aside from providing the income that supports the applicant’s current life style, pays the bills and probably provides some, if not all, of the capital for the new venture, the operation of that business will demonstrate the kind of business acumen the applicant possesses.
An applicant that has an excellent reputation, pays suppliers on time, and operates a profitable business, will be seen as representing far less risk in the operation of a new franchise venture. In the modern credit environment, where transactions are most often priced for risk, using an existing business as a corporate guarantor, may favorably affect the rate and terms of the approval, especially if the applicant can demonstrate that the existing business can support not only the new business in the ramp up stage, but the continuing lifestyle of the franchisees.
The Business Plan
You should do your best to put a concise narrative together for the lender. This should include the following:
- Why did you select this particular franchise system?
- How did you select the location (include demographic analysis of the area, ingress\egress, competition, etc?
- What are the terms of your lease?
- Will the landlord be providing you with a Tenant Improvement allowance?
- The due diligence that you have completed independently of the franchisor and\or on the franchisor?
- A summary of the method and rationale used for your projections (i.e. Projections are based on Worst, Average, Best case scenarios. The assumptions used in the projections are based on interviews with ____ franchisees who shared limited financial information such as rent, labor expense, food cost, etc.)?
- Who will manage the business?
- What additional resources are available if the worst case scenario were to materialize?
- If multiple units have been purchased the plan should summarize the terms of the multi unit development agreement and provide a time line detailing when additional debt will be needed.
- Do you have an exit strategy if the business does not work as planned?
Stick to these primary points in a business plan document. You want to inform the lender and explain your plan. Lenders do not care that you are fulfilling a “lifelong dream” or that you are starting a business to insure your family security. While those are all good reasons for going in to business they do not demonstrate how the business will succeed and how the loan will be repaid. That should be the primary thrust of your business plan.
Remember that a Lender does not make money unless they can make loans. Lenders will, within the bounds of their underwriting guidelines, do their best to make the loan “a fit”. This generally means that minor deviations from guidelines can be handled with additional structuring, i.e. lower the amount advanced, take additional collateral, support the transaction with a security deposit, etc.
The amount of flexibility that can be applied to the underwriting is directly proportional to the number of underwriting parameters that will need to be adjusted. Furthermore, there are simply some items that cannot or should not be adjusted with loan structuring. For example, previous bankruptcy or other serious “character” issues, chronic late pay, or failure to pay another lender on a previous loan.
Underwriting standards are currently tight and they are expected to tighten further before the environment improves. The information detailed above however is nothing more than the summary of what is prudent for packaging any transaction. Lenders are in business and expect to take a reasonable amount of risk. Since no lender has a crystal ball that will tell them which of their customers won’t repay their loans, they develop underwriting standards that are objectively applied to all applicants. Some applicants are better than others. Unfortunately that fosters the perception that lenders only want to lend money to “people who don’t need it.” As explained above, that is simply not true. While underwriting standards have tightened significantly that does not mean that “good deals” won’t get done. Rates may be slightly higher and they may require additional structuring but, if the transaction has merit and risk is adequately mitigated, the applicant’s request will be approved. It is not going to be as easy as it was in recent years. There will be additional questions and while it may appear that underwriters are looking for reasons to decline transactions, this is not the case. When there is intense pressure by regulators and auditors to “cross the t’s and dot the i’s” the best advice to the applicant is to be patient and understand that there are “opportunity costs” associated with doing business in almost any market. Because of the current environment there will undoubtedly be a shortage of qualified applicants that can find the money to open or expand franchise concepts. If you understand this and set your expectations accordingly, you will find your lending experience to be much more palatable and your chances of succeeding in putting together the type of deal you want, will increase exponentially.