Franchise Update Magazine Issue II, 2015 | Page 54

GROWING YOUR SYSTEM

Market
trends

Franchise Lending Outlook
SBA lending will continue to be important
BY DARRELL JOHNSON

T

he banking industry is increasing
its conventional business lending activity. Since the recession,
banks have focused on lower-risk businesses, which translates into larger businesses with good track records. Recently,
banks have been expanding their focus to
smaller businesses with less experience.
At the same time, we have seen the rapid
expansion of alternative lenders (led by
Internet-based lenders) into the smaller
business/less experience category.
Therefore, it is relevant to ask
whether a publicly funded lending
program for businesses is still needed.
Government programs launched
during a time of need often stay
around well past their useful lives,
or at least their original purpose.
That question is being debated in
Congress right now regarding the
Export-Import Bank. Should the
SBA be next?
The SBA’s 7(a) program is on
pace to get close to its authorized
cap of $18.75 billion this fiscal year.
If conventional lending is on the rise
and alternative lenders are moving
rapidly into the small-business lending space, why is SBA lending also
on such a torrid pace? Is it simply
the result of Congress increasing the individual lending limit to $5 million from
$2 million, or is there more to it?
The answer, at least as it relates to
franchising, lies in understanding the
credit characteristics beneath the surface. About 75,000 franchised units in
the U.S. will need financing this year,
split roughly about two-thirds for new
units and one-third for sales of existing
units. Total loan capital needed to support that level of activity will be between
$25 billion and $30 billion. The lending
community as a whole is finally closing
the lending gap and should accommodate

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most of that activity.
In total, SBA-guaranteed lending accounts for about 20 percent of the total
needed by franchisees. While that would
seem to be surmountable by the conventional and alternative lending groups, it’s
unlikely to happen because of the credit
risk profile differences found within the
SBA-guaranteed borrower group of franchisees. In 2014, 43 percent of prospective franchisees obtained their financing
from SBA lenders. In other words, nearly

half of all first-time franchisees relied on
SBA-guaranteed loans.
The dependence on SBA lending is
even greater when looked at from the
perspective of the franchise brand. For
about one out of every two new units,
the source of borrowing for franchisees
of emerging brands (regardless of the
franchisee’s previous experience) was
SBA lending. It’s all about the perceptions of credit risk: a first-time franchisee
with an emerging brand is a much higher
perceived credit risk than an experienced
franchisee with a mature brand. That’s why
even very active franchise lenders have a

minimum franchise system size threshold
somewhere between 25 and 50 units and
stringent borrower requirements.
The last categorically significant factor
is initial investment size. Intuitively, one
would think that a smaller loan would
be of more interest to a lender than a
larger loan, since they have less capital
at risk in the former. However, the cost
of underwriting a franchise loan is about
the same whether the loan amount is less
than $100,000 or more than $1 million.
Recovering the cost of underwriting can
come only through the interest margin
income earned on the loan over time. The
larger the loan, the more interest margin
income is earned each month to cover
the fixed cost of underwriting. Lending
economics doesn’t favor the smaller
franchisee borrowers. Of the roughly
75,000 franchise units needing financing
in 2015, about 35,000 will require loans
of less than $230,000; about one in six
of those 35,000 will be associated with
a new franchisee in an emerging brand.
Lending is a simple business.
The lender gives you money and
at some point the lender wants it
back. Whether it will get it back
is the basis of credit risk analysis.
Franchise brands have an advan