Risky Business? Franchise defaults are up--how does it affect your ability to get a franchise loan?

Franchisees defaulted on nearly $900 million in funding in 2001, quadrupling figures from 2000, according to a study by financial research firm Fitch Ratings. Regardless of who's to blame for this staggering leap--the franchisee, franchisor or lender--the impact on franchising is already evident, as lenders become increasingly wary of providing franchisees with funds.

So will it be harder for you to get a franchise loan? Franchise Zone spoke with Kevin Burke, managing director of Los Angeles investment-banking firm Trinity Capital LLC and former senior executive of Franchise Mortgage Acceptance Co., about what caused this increase in loan defaults, and what the franchise industry can do to help you.

Franchise Zone:Why are loan defaults so high right now?

Kevin Burke: For a couple of reasons. One is that some of the predominant systems began to slow their rate of growth toward the end of the '90s, and a lot of franchisees and entrepreneurs bought stores with 100 percent financing in a high-growth market and were highly leveraged. When the growth bubble burst and/or when sales actually declined, they were ill prepared to meet their obligations. This was further compounded by the fact that many of them had inadequate liquidity when the transactions were initially capitalized. Operators who relied on 100 percent debt financing were not prepared to weather a storm of rising costs in labor and utilities and soft sales growth.

How can franchisors help franchisees?

Some of the major franchisors have been very proactive in trying to ensure the financial health of their franchisees--some of them have offered loan assistance programs or agreed to provide facility enhancement. There's a whole range of things a franchisor can do. That doesn't mean the franchisor gets stuck with the bill; it means they play the role of an interested party and sponsor in the process, which includes steps to rectify some of the over-leveraged franchisees.

What role should the over-leveraged franchisees play?

Franchisees should work with their franchisor and their lenders and be disclosure-minded. The franchisor, franchisee and lender are sort of like three legs on a table. Everybody has a significant concentric alignment of interest and is compelled to seek a consensual solution when somebody is critically over-leveraged and possibly facing bankruptcy.

What can prospective franchisees do early in the research and selection process, and also when they are applying for franchising, to make sure they don't become delinquent on their loans?

They have to make sure they aren't paying too much for a store or stores, have a proper mixture of debt and equity in their capital structure, put down a significant amount of equity to eliminate the risk associated with the 100 percent debt financing structure and have adequate liquidity and resources to deal with seasonality, dips in sales, etc. They need to make sure their projections include adequate reinvestment in their business and capital expenditures.

Another thing they need is a good understanding of the actual expense of facility enhancement, which takes place over the life of the franchise agreement; a franchise agreement renewal fee, which will be due in some number of years, and any franchisor-sponsored initiatives that may be mandated from time to time to keep the brand competitive. Those costs have to be factored into purchase price, leverage and liquidity equations, so they can establish a robust financial model that is as prosperous in its fifth, tenth and fifteenth year as it is initially.

Will this growth in franchise loan defaults have a lasting impact on franchising?

Yes. In the short run, it will make financing more expensive and retard any growth of available financing. In the long run, it will make lenders more thoughtful and cautious and probably require both franchisors and franchisees to reflect on the economic model of some concepts.