Franchise Financing Special Report: Keeping track of economic trends will maintain growth in '08

Financing is the lifeblood of expansion for franchisors and multiunit owners alike. Whether for advertising and marketing to sell additional franchises, or whether to remodel or build more company stores, without financing there is no growth and development. And, despite the rapid growth of new concepts and new units in the aftermath of the dot.com crash in 2000 and 2001, many forecasts of the economic climate and its effect on business growth in 2008 range from gloomy to dim--especially when it comes to credit and lending.

Factors contributing to this outlook in the near term include the subprime mortgage crisis and housing slump; a lame duck president putting his best spin on a faltering economy; the U.S. dollar declining on world markets; the hedge fund debacle; U.S. consumers saddled by increasing debt loads; and banks tightening their lending policies.

Globally, overall economic uncertainty brought on by events such as $100/barrel oil and political instability in the Middle East, combined with the growing economies of China and India, are stressing markets for both capital and raw materials. Beyond oil, the growing economies of those two giants has pushed up the price of building materials such as lumber and steel--and the price of building new franchise units.

But, as experienced franchisors and entrepreneurs know, well-run businesses selling needed goods and services (with consistency and a smile!) can prosper even with the macro-economic trends arrayed against them. People still need haircuts, will spend for that morning coffee, need their vehicles maintained and repaired, their lawns mowed, their children, pets, and, increasingly, parents cared for, and more.

What follows is a brief look into some of the economic forces likely to affect franchise financing and development in 2008:

Mortgages - With home prices down and a glut of houses on the market, today's aspiring franchisees are less able (or less willing) to use the equity in their home to buy a franchise. Those with second homes are more likely to hold onto them until their value rebounds, reducing another historical source of franchising. This is unlikely to change in the coming year, putting a damper on the use of personal real estate to fund franchise growth.

Consumer debt - Credit card debt is at record levels and increasing. Consumers are falling farther and farther behind on their credit card payments with each passing month. Interest rates and penalties for late payments are at obscene levels, often exceeding 25 percent, and bankruptcy laws for credit card debts have been tightened. Financing a franchise purchase by maxing out credit cards is still possible, but the increased risks and penalties can only serve to discourage this practice. Debt-laden consumers also have fewer disposable dollars to spend, putting downward pressure on the economy in the U.S., where consumer spending accounts for 70 percent of GDP.

Falling dollar - The plunging value of the dollar against major international currencies has U.S. exporters happier than they have been in years--but is little help to retail and service businesses, which are local. The weakening dollar also is putting pressure on interest rates. And although China holds an increasing share of U.S. debt, the country continues to open its economy and could be a prime target for franchise expansion overseas. China also recently revised its franchise regulations, giving foreign companies a clearer picture of how to operate in its huge, rapidly changing economy. This could be a golden opportunity for considering overseas expansion--especially with the 2008 Olympics in Beijing approaching. Can anyone say Master Franchise?

Private equity - The news is not all bad, especially for small and medium-sized organizations. Despite all, there remains a vast source of capital available for companies that are well run and have a track record of generating a positive balance sheet. Franchising is an ideal business model for investors seeking a solid, reliable return on their investment--with the possibility of cashing out in the medium term, even through an IPO if conditions are favorable. Why franchising? For the usual reasons, which an increasing number of investors and lenders are discovering: cash flow (recurring revenue streams), established brand name, proven business model, geographic diversification--all very attractive characteristics for equity and debt investors alike.

Stricter loan underwriting - Darrell Johnson, president of FRANdata (and a former banker), says whatever the causes, expect more restrictive lending terms in 2008: more equity, higher coverage ratios, more collateral, and shorter terms, to name a few. "An irrefutable law of banking is that credit departments become more influential during times of economic uncertainty. We are in such a time now," he says. And, he adds, as bank credit departments regain the upper hand, access to capital is becoming the greater challenge--not just the cost of that capital, but its availability.

Interest rates - Commenting on current interest rates, Johnson provides some historical perspective. He notes that although the prime rate and LIBOR rates have about doubled in the past 4 years, by historical standards they are "still well within ranges that encourage continued growth." And on the fixed-rate side, he says, 10-year Treasuries, although higher than a few years ago, recently have signaled recessionary fears and dipped to the 4 percent range. Unusually low rates earlier in this decade, he says, make current rates seem high, but on their own are not an impediment to growth.

More brands, more competition - The increase in the past six years in the number of new franchise brands is good news for the industry as a whole, but not necessarily so good for individual franchises. Many new franchise brands enter with deeper pockets and more rapid growth schedules than their predecessors--drawing off talent from the more established brands, not only potential franchisees. Another result: management and top executive talent is thinning, driving up compensation.

Suggestions for 2008
First, keep on your toes. Stay abreast of the confluence of all the economic trends cited above; it's not one magic bullet that will kill growth, but the combination of several working together. Also, pay some extra attention on the dynamics of your industry--not only among your franchised competitors, but rather the entire sector. We know people will get haircuts no matter what, for example, but as their disposable income shrinks will consumers let car repairs lag, skip that second latte, or mow their own lawn?

Second, talk to your banker--a lot, says Johnson, the former banker who now spends his time tracking the franchise industry. In fact, talk to other bankers as well; get a second opinion, and a third. For franchisors, this will help to ensure that their financial qualification criteria for franchise candidates are in line with the changing criteria at the banks. Keeping up with these changes can help your development plan stay on track this year. Says Johnson, "You don't have a franchisee until the franchisee has arranged all the capital needed to start a unit."

For area developers and multiunit owners, keeping their financial fingers on the pulse of their banker's changing funding requirements will keep that economic lifeblood flowing, and their unit count growing in 2008.