What to Consider When Lending to a Franchisee

by: Smith and Howard

August 28, 2018

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Buying a franchise allows entrepreneurs to run a business with a tried-and-tested operating model. Yet franchise systems vary significantly both in their support of franchisees and their long-term viability. While some franchisors offer financing, first-time franchisees often find themselves in need of traditional bank loans.

It’s not just new franchisees that need access to capital. Established ones frequently need funds to purchase new equipment, remodel their locations and meet short-term cash crunches. Here’s how to evaluate these types of loan applications.

Learn about the franchise system

While many profitable franchises exist, franchising doesn’t guarantee a path to riches. In fact, franchised businesses may fail for a variety of reasons. Take the time to learn about the franchise your borrower plans to join.

It’s important to be aware that franchisors must provide prospective franchisees with a franchise disclosure document (FDD). This document includes extensive information on the franchisor’s system, enabling a prospective franchisee to make an informed decision regarding the investment. Read the FDD in detail before you decide to fund or reject a loan.

The Federal Trade Commission mandates the contents of the FDD. Once you become familiar with one system’s document, it will be much easier to review and analyze other franchise systems’ documentation.

Conduct independent research

The long-term success of a franchise depends on its ability to deliver value for its customers. To evaluate a franchise’s value proposition, conduct online research to ascertain its reputation, customer satisfaction, and ability to support and nurture franchisees. In particular, litigation between the franchisor and its franchisees can provide a window into the overall health and stability of the system.

If a borrower operates franchise locations in your area, visit one or more of the locations to improve your understanding of its business model. Pay close attention to the overall environment, including customer volume, customer disposition and employee demeanor. Note concerns, such as a lack of cleanliness, that could indicate a bigger problem with the franchise system.

Understand the borrower’s motivations

What’s driving the borrower to buy a franchise? This question is critical in your evaluation of a franchisee’s loan application. Ask the borrower these questions to gauge interest in the franchisor’s system and ability to function as a franchisee.

  • Does the borrower have a passion for the franchise concept?
  • Why is he or she opting to enter a franchise system instead of forming a start-up business?
  • What are the borrower’s plans for the franchise’s future?
  • Has the borrower met with existing franchisees to learn about their experiences?
  • Does the borrower have any concerns about his or her ability to operate a franchise?

Red flags at this stage may signal the borrower’s lack of enthusiasm or lack of understanding about the business he or she intends to own and run.

Evaluate business experience

While a franchisor may provide access to a proven business model, operating a successful franchise requires the application of sound business practices. To evaluate a potential borrower’s business experience, request an up-to-date resumé, as well as a detailed review of his or her background.

It’s a good idea to ask the borrower to explain how his or her business experience is relevant to running a franchise. Bear in mind that extensive business experience doesn’t automatically guarantee success as a franchisee. Successful franchises typically depend on franchisees following a proven business model, without much improvisation. So, your borrower needs to be willing to follow the franchisor’s system — even when it seems counterintuitive.

Develop an expertise

According to the International Franchise Association, franchised businesses operate in approximately 800,000 locations and employ nearly 9 million people in the United States. Not every loan applicant fits the mold of a successful franchisee. But given the number of companies with franchise models in place or under development, lenders who develop an expertise in this arena may prosper.

Establish a relationship with the franchisor

While your bank may receive applications from prospective and established franchisees directly, some franchisors select banks as preferred lenders for their system. If your bank wants to increase its exposure to franchise-related lending, with the potential to receive a steady stream of applicants, contact the development departments at various franchisors to determine how they select preferred lenders.

After you’ve been selected to participate in a franchisor’s preferred lender program, consider hosting networking events for new and established franchisees. By doing so, you’ll increase recognition of your bank’s franchise-lending activities while improving your understanding of the franchisor’s system.

Questions? Please complete the contact form below or contact David Lee at 404-874-6244.

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