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One of the most common problems in the franchise sales process is helping prospective franchisees secure financing for their new investment. As a franchisor, should you offer financing to your franchisees? Or should you just not get involved? How much help is too much? And when should a franchisor say enough is enough?

Options for Franchisee Finance

In addressing this issue, you should first realize there are a myriad of options for franchisee financing assistance. These range from a relatively low level of involvement (such as assistance in the development of a business plan or becoming registered on the SBA's Franchise Registry) to a high level of involvement (such as providing direct financing to franchisees).

In the middle of these more extreme options, franchisors can establish preferred relationships with lenders, provide limited guarantees to facilitate franchisee loans or provide other credit enhancements that allow the lender additional comfort in working with a specific franchise company.

The level of involvement that a franchisor should have in the finance process should be based on several factors: size of investment, nature of the assets financed, the profile of the targeted franchisee, the ability of the business model to carry financing, the financial strength of the franchisor and the relative demand for the franchise in question.

Since significant involvement on the finance side involves some degree of risk, the first question you should address is the extent to which your involvement is necessary to meet development goals. In essence, if you are not having any difficulty in selling franchises, a minimalist approach will certainly suffice. Provide outlines for business plans and register at the Franchise Registry, but do not put any of your hard-won assets at risk.

There are also some non-finance alternatives to easing the franchisee's financial burden that would open a franchise opportunity to a wider market of prospective franchisees. Some new franchisors have chosen to reduce or waive franchise fees altogether for their initial franchisees. Franchisors who double as manufacturers or suppliers may offer discounts or extended terms on initial inventory. But franchisors should beware. If these provisions are structured as an "introductory offer," they need to be disclosed. In addition to creating barriers with future franchisees, this type of structure is often frowned upon by state regulators-thus, we generally advise our clients to steer clear of this type of inducement

It is a New Business

While a franchisor thinking of "getting more involved" in the franchise finance process may initially look at the advantages of providing financing to franchisees ("Just think of how many more franchises we will sell!"), the downside can be considerable.

Yes, providing financing assistance can increase the number of prospective franchisees who might otherwise qualify for your franchise, but these same franchisees will likely be the worst credit risks with the highest likelihood of loan default. And there is certainly an argument that we should allow Charles Darwin to sort our prospects for us. Anytime a franchisor is taking on any incremental exposure in the lending process, the default rate on these franchise loans should be of substantial concern, and should not be overlooked.

Likewise, it is important to understand that providing limited guarantees, credit enhancements or direct loans to your franchisees will encumber your balance sheet with contingent liabilities that may, in turn, make it much more difficult for you to obtain a loan should the need arise. Such a posture may make it difficult or impossible to build that new building, finance additional corporate growth or acquire that competitor. In essence, this financing can eliminate the very leverage you were trying to create when you turned to a franchised growth strategy in the first place.

Moreover, most franchisors are distinctly unqualified to get into the lending business. First and foremost, they are not in the lending business, which is ultimately a business of assessing risk and assigning a fee to that risk. And equally important, the franchisor who gets into the direct lending business has a built-in conflict of interest that could easily cloud his or her judgment.

Even if a franchisor can overcome the difficulties of mastering this new business, many will not qualify from a financial perspective. To provide a meaningful guarantee of any type, you must first evaluate your own creditworthiness-as each such guarantee will encumber your assets, and a fast-growing franchise can rapidly outstrip its balance sheet. And, if those guarantees come due because of loan defaults, that debt can easily consume an organization.

Get Paid for Your Risk

If you do choose to provide some form of credit enhancement or otherwise assume risk on behalf of your franchisees, you should treat this credit enhancement as any other part of the value proposition-and turn it into a profit center.

It is not enough to benefit from the existence of incremental franchisees. The economic benefit you receive from those fees and royalties represents your return for the value proposition you have created by being a good franchisor.

Over time, even the best finance program is likely to see some defaults, and you should seek to offset those defaults by realizing interest on those loans-enough to offset administrative costs, forecast defaults and still provide some profit.

The bottom line is that the finance business is a new business for most franchisors, and, as such, has many inherent risks. While financing also may hold some advantages, most franchisors are better off allowing the Laws of Natural Selection do their work.