Where the Money Is

If you think franchisees have it tough these days, think back to 1979, when Deena Yaris opened her first storefront franchise, a beauty salon called Lafemmina, in New Hyde Park, New York. The Federal Reserve's basic interest rate had doubled in a matter of months to 14 percent, and there was no ceiling in sight. Any new business would have to be hugely successful just to meet loan payments on start-up capital, let alone generate income for its owner.

But Yaris had confidence in the concept and her business acumen-a faith that was ultimately borne out. She went on to open one more Lafemmina salon and two The Lemon Tree salons. Five years ago, she did what most franchisees only dream of: She bought out the company's founder and became the franchisor. Today, 58 franchise salons from Connecticut to Florida carry The Lemon Tree name, and Yaris has plans for another 100.

A key factor in franchisee growth is-you guessed it-low interest rates. Many new The Lemon Tree franchisees fund their initial investments with home equity loans of 5 percent or less.

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The Lemon Tree isn't alone. In fact, many experts consider the huge increase in untapped home equity, coupled with low interest rates, to be the most important development in franchise financing in decades. But that's not the only force contributing to the dramatic shift in franchisee financing over the past quarter century. There was the FTC's decision to require full financial disclosure by franchisors, thereby legitimizing the industry in lenders' eyes. There was the discovery of franchising by banks, which once shunned chain outlets in favor of local independent stores. There was the proliferation of aggressive nonbank lenders such as GE Capital Corp. and CIT Group Inc. with more flexible risk-assessment criteria. Take these combined factors, and you can understand why franchising has become one of the most powerful forces in the U.S. economy.

The Two Camps All this doesn't mean financing is no longer a problem for current or prospective franchisors. A recession-induced wave of defaults in 2001 and 2002 has made lenders skittish, and some, including Pitney Bowes Inc., have dropped out. Moreover, obtaining growth capital is still, and will likely remain, the number-one challenge for individual investors. Finding money for that ice cream franchise is still harder than, say, refinancing your house. But you can improve your chances by knowing your options and how lenders view your business.

It's important to recognize that financiers sort prospective franchisees into two big camps. The first, which might be called "Camp Success," consists largely of individuals who have significant hands-on business experience and are looking to purchase an existing moneymaking franchise location. Lenders evaluate such opportunities in the same way they assess nonfranchise businesses. They look at objective measures of the business's health, such as its cash flow, growth rate and profitability. Then they try to assess, based on your resume and financial history, whether you are likely to keep the business on course. If you and the business have good records, you can almost count on banks to court you. "Nothing makes a lender happier than a proven cash flow and customer base," says R. Neal Westwood, managing member and a founding member of business brokerage firm Alpine Business Brokers LLC in Orem, Utah.

Members of the other franchisee group, which we'll call "Camp Start-Up," have little or no entrepreneurial track record, are looking to establish a new franchise business from scratch, or both. These situations are much more difficult for loan officers to evaluate and thus are considered high-risk. Many banks want nothing to do with them, and virtually all others will require the borrower to put up other collateral, preferably securities or real estate, that's worth at least the full amount of the loan. In such circumstances, smart borrowers will simply take out a simpler-to-get personal loan or credit line. That's when nonbank lenders often step in. Of course, since nonbank lenders take on more risk, you'll pay a higher interest rate or extra fees to offset that increased risk.

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