URL: http://www.entrepreneur.com/franchises/franchisezone/viewpoint/article66044.html

Investing in a franchise may be the beginning of a long and prosperous road to financial security. But for many, strong work ethic and dreams aren't enough to open the doors to a franchise when you lack capital. Whether they've been sympathetic to the financial challenges hindering potentially qualified franchisees or simply seeking avenues to facilitate swifter growth, franchisors have offered some form of financial assistance to franchisees since its inception.

Lately, however, financing by franchisors has slowed down. To understand what may be causing this trend and what franchisors view as the pros and cons of assisting franchisees in purchasing into their operation, we spoke to Scott Shane, professor of economics at Case Western Reserve University's Weatherhead School of Management in Cleveland. With over a decade of research in the franchising field, Shane offers insight into the finance side of franchising.

Why do franchisors offer to finance franchisees?

In general, franchisors do this because they need to attract franchisees, and in large numbers. For many kinds of businesses, the capital requirements are such that it's hard to attract franchisees unless they are financed. There are two very different kinds of financing of franchisees: One is direct financing of franchisees by franchisors; the other is indirect, where third parties are actually doing the financing. Indirect financing seems to make more sense.

In certain kinds of industries, like hotels or restaurants, where the capital requirements of opening an outlet are actually pretty high, it's hard to find qualified franchisees-the kind you want as single-outlet operators-with the capital to do that. They need financing. At the simplest level, that takes the form of channeling people to lenders. Sometimes it guarantees at the other end-the loan may be guaranteed by some aspect of the contractual relationship, so if the franchisee isn't delivering, that's going to take effect on the contract. It provides some protection to the lender.

What makes a little less sense is the direct financing arrangement. For one, if the franchisor is financing the franchisee, it's actually taking no cash out of the system from the franchisee. It makes you wonder why franchisors don't drop their upfront fees to zero and just make money off of royalty rates. And if they're not just financing upfront fees but also the cost of opening the outlets, then the only benefit the franchisor is getting out of this is to have an outlet operator, and there are other ways to give incentives to outlet operators than franchising.

Like what, for example?

You could just hire a bunch of people to be outlet managers and give bonuses and equity stakes in the business. But one of the things that accounts for the survival of a franchise system over time is the size of the franchisees' upfront cash investment. So when you finance, you're actually undermining one of the key success factors of a franchise system, because you're now dropping that to zero. If I'm a potential franchisee and have a lot of confidence in my abilities and am good at managing an outlet, franchising makes a lot of sense to me, more sense than being a manager for somebody. But if I'm not so good at my own job, I'm probably better off being a manager for somebody, because it would be his or her money, not mine, that's being invested. When franchisors start financing people, this ability to say, 'kick in your own money if you have any confidence in your abilities' goes away. So the odds of getting good, talented franchisees drop dramatically.

Also, where is the franchisor getting the cash for this financing? In established systems, financing franchisees might make more sense, but in new systems, it's hard to say.

What are the pros and cons of a franchisor financing a franchisee?

Franchising provides benefits to franchisors in several ways. For one, there's efficient management of an outlet by having an owner/operator. Another benefit is franchising gets cash to the franchisor faster. If upfront fees are being paid to the franchisor, that money comes in before the outlet is up and running.

Often there's a difference between one who's a talented operator and one who has capital. For example, you might find the best people to run sandwich shops are immigrants, where their families are working, and the operators are willing to work 16-hour days, but they may have very little capital. The people who have a lot of capital-the dentist or doctor who wanted this as a side investment-may not be good managers. Franchisors may be better off financing if the skills to run the outlet are found primarily in people who don't have money. Maybe the best way to do that is through indirect financing.

One of the big reasons franchisors finance franchisees, especially in a young system, is because the systems need large amounts of economies of scale. They need to get big quickly because of advertising costs and things like that, and [the costs] could be spread out with more units. However, more and more franchising is occurring in industries where there's actually less advertising expense, where there's less of an advantage of being big, especially quickly. In areas like quick service, there's an incentive to be big, and franchisors might finance people because they figure they can't really advertise in the New York City market until they've got 20 outlets. But if it's another kind of industry where each city may only have one franchise and it doesn't require a lot of advertising, there's not this incentive to grow the system big really quickly. And you don't need to finance to make this go faster.

How would you explain why there are less franchisors offering help?

One of the reasons we probably see a downward trend, especially in down economic cycles when businesses need cash, is there's a natural tendency for franchisors to say, "Why should I finance these folks?" At the same time, in a down economic cycle, there are more potential franchisees available, as people get downsized out of large corporations. So if there are more people to sell franchises to, and there's a reason franchisors need cash, those would be both be incentives not to finance franchisees.

Should financing franchisors charge interest rates?

Presumably if there's a prevailing market interest rate and they're charging that interest rate, that would make a lot of sense. If they're not charging any interest at all, again it makes you wonder why they just don't cut the fees. Obviously, from a franchisee point of view, the less they pay the better. So if they're paying interest, and the interest rate is higher, it's just more costly. Right now the interest rates are actually relatively low. But if we had periods where interest rates were really high and if the business doesn't have high profit margins, it could be that the franchises are profitable, but the franchisees who had to borrow weren't. If interest became 15 percent like they were in the early '80s, franchisees' bottom margin gets wiped out.

Take the case of Boston Market. Did the old management get into bankruptcy problems by financing their franchisees?

There were several problems; one is that they became a finance company and not an operating company. But one of the other problems was that if franchisors finance people buying the outlets but can't make money on an outlet level in franchising, the more outlets you have, the more money the franchise is going to lose. Boston Market didn't really make money at an outlet level. By financing franchisees, they're just getting bigger and bigger at something that loses money. They would've been better off focusing on the operations than on financing.