To effectively apply for and land a commercial loan for new franchises, you must understand the commercial lending business in order to get the best results. My goal here is to introduce you to commercial lending and provide insight into how banks approve and make loans so that you can approach commercial lending with a better chance of approval.
Maybe the place to start is the bank’s perspective on lending money. Most new franchisees are absolutely positive of their eventual success with their franchise business and want the bank to share in that success by approving a loan for the needed capital. From the bank’s point of view, however, all loans look the same. A bank’s return on a loan to a start-up is the percentage rate charged just like it is on a loan to the biggest corporation in America. The bank only wants to control getting the interest on the loan and getting its money back.
The bank distinguishes borrowers based on how likely the borrower appears to be able to make the payments under the note. And when the likelihood of repayment seems diminished, the bank will look for additional and stronger collateral and guarantees to be sure that if the borrower does not make the payments the bank can get its payments from selling the collateral or from guarantors.
In addition to collateral and guarantors, banks often turn to the United States Small Business Administration (SBA) for a guaranty on the loan. The SBA, by providing a guaranty of 80-85% of the total loan balance, makes it easier for a bank to approve a small business borrower that does not present the best package for a loan. If the borrower fails to make loan payments, the bank turns to the SBA for payment of up to 80-85% of the initial loan, thereby lessening the risk the bank is taking on a new franchise owner.
SBA loans have a number of attributes that must be understood to be used successfully by a small business owner. The first is that the SBA does not lend money; it only guaranties a portion of the loan so that the bank can more easily take the risk in making the loan to a small business. If the loan fails, the most the bank will lose is the portion not covered by the SBA guarantee. And the SBA is not frivolous in granting its guarantees. If approved for an SBA guaranteed loan, the SBA will take security interests in business furniture, fixtures and equipment; will ask for personal guarantees of the principals of the business (generally anyone holding in excess of 20% of the equity of the business); and will take a security interest in the business principals’ personal homes. If the loan fails, the SBA will recover against any or all of these assets to recover the money they pay to the bank on the loan under the guaranty.
Applying for a business loan requires that the business owners or managers develop a full plan for how much money they will need, how the money will be spent, and what the return to the business will be after the money is spent. In looking at start-ups, the necessary costs normally include build-out/renovations of the business site, furniture fixtures and equipment (“FF&E”), inventory, salaries and working capital. Considering a franchise restaurant for example, there might be build-out of $50,000, FF&E including kitchen equipment of $150,000, initial inventory of $30,000, three months of salaries of owner/manager, four cooks, eight wait staff at $80,000 and $25,000 of working capital for a total of $335,000.
Banks with an SBA guarantee will likely lend about 80% of the total project, or in this case $268,000, leaving the owners to input $67,000 of the capital required. Generally at this point, small business owners begin to panic. Coming up with $67,000 in cash seems like trying to come up with the whole $335,000. Understanding how the banks and others look at some of the project costs can greatly improve the situation however.
The first thing to consider under the circumstances is the build-out of the restaurant. Depending on the demand for real estate, a landlord will sometimes provide build-out, or at least a portion of build-out, in exchange for higher rent payments. If the rent for the restaurant was originally $3,000 per month, the landlord might provide $40,000 of the build-out for a $400 per month increase in rent on a ten-year lease. Now the restaurant owners have decreased the project costs to $295,000 and the cash down payment (20%) to $59,000.
The next change the new restaurant owner might consider is leasing the FF&E instead of buying it. There can be very good practical business reasons to lease instead of owning FF&E. If technology is constantly improving in your business such that equipment needs to be replaced regularly, leasing can be a better alternative to purchasing because the equipment can have a fixed period of usefulness in your business before it is replaced by newer technology. If the FF&E is used hard by your staff and customers so that it wears out over a short period, leasing can make it easier to replace equipment on a fixed cycle. If your FF&E has a long life in general or if the technology has a long life cycle, purchasing the equipment can be a better way to invest in your business by investing in the equipment of the business, though.
If the owners of our franchise restaurant do lease the FF&E, however, they will reduce their project costs by $150,000 to $185,000 and if they also get $40,000 in build-out costs from their landlord the project costs are now $145,000 and cash required is $29,000. Start-up costs can be further reduced by negotiating payment terms on some of the inventory needed to get the restaurant opened.
Do not be mistaken that these kinds of changes come without a price. The build-out change will increase monthly rent payments; the equipment lease payments now represent a monthly payment that was not part of the business plan at first. Of course, the loan payment is now lower too. The business now must make a higher cash flow each month to support these payments, but the cash to get started is less.
Many factors will affect the analysis of making these changes in a business plan. What are the expected trends in interest rates? How long is the lease on the FF&E and what king of buy-out provisions exist at the termination? These are just some of the aspects one must consider in gauging financing options for a franchise.