Growth of Franchisees Rests on Solid Financial Plans

The cornucopia of franchisees -- linking with the nearly 900 franchisers listed in the Fall/Winter 2004 Franchise Opportunities Guide, published by the International Franchise Association -- shows that interest in the small-firm strategy has blossomed.

And according to a recent survey done by Franchise Recruiters Ltd., the U.S. franchise business expects to have had a 7 percent increase in development of new units in 2004. The survey noted that this is the industry's fastest pace since a boom in the 1990s.

"Just look down Main Street anywhere," said Mel Aanerud, acting assistant district director for economic development for the Minneapolis SBA office. "Many of the shops are franchises."

Even with such growth, starting a franchise can be difficult, said Steve Weitz, spokesman for M&I Bank. Unlike other types of small-business startups, franchises involve intangible assets, such as franchise fees and licensing costs.

"You pay a nice fee to be able to use a name like Subway," he said.

SBA a big part of it all: David Kutoff, co-owner of three Planet Beach tanning salons in the Minneapolis area, said that he and his partner, Todd Schachtman, went through a regimen that's familiar to many first-time franchisees. At M&I's recommendation, the partners enlisted the help of the U.S. Small Business Administration in Minneapolis before opening their first tanning salon in November 2003. The SBA acts as a guarantor for startup borrowers.

The SBA is increasingly involved in franchise deals.

Franchisees are so numerous at the SBA that the Minneapolis office created a franchise registry site that streamlines the loan-guarantee process. Aanerud said the administration does look at franchises closely to make sure that a franchiser does not have an overly controlling interest.

"We look at the provisions of the agreement carefully," Aanerud said. "If there's too much control, it's not considered a small business."

The administration's guarantee aided in convincing M&I Bank to lend Kutoff and Schachtman the funds needed to get Planet Beach off the ground. Kutoff also credited the franchise's success in other geographic areas as a reason the partners got their financing.

Said Kutoff: "It's harder to sell a bank a brand-new idea, as opposed to one that's already proven."

Friends and family plan: Although Planet Beach and other franchises have started steady and are now looking to grow, securing initial funding can sometimes be hard. Most new franchisees raise starter capital by refinancing their homes or taking out home-equity loans. Loans from friends and family can also figure in, as well as savings or cashing in investment funds.

Weitz said that similar to any type of business financing, franchise funding will be made up of equity and debt. "A bank will want to see between 25 and 30 percent of startup costs in intangible assets like franchise fees covered by equity," he said.

Franchise fees can vary widely, based on whether a franchiser gives a franchisee control over a single location or an entire territory, and what kind of reputation and past success the franchise concept has historically experienced.

Sometimes, the initial cost of opening a franchise location can be as low as $10,000. However, a chain's popularity can drive that fee up. Securing a Krispy Kreme franchise requires approximately $1 million per store, or $30 million for the right to build 10 or more stores in a single market.

Not just any millionaire can start making doughnuts, though. Krispy Kreme requires that franchisee applicants either own multi-unit food-service operations in the market where they want to build, or have extensive previous experience running similar operations.

Banks also consider a potential franchisee's experience in an industry before approving a loan, Weitz said. "As a bank, you're looking for people with passion and experience. You want an individual that has a relevant managerial skill set, but also has capital, or significant net worth."

The lease-back angle: Some franchisees turn to doing lease-backs to start their franchises. This method involves selling the franchise's building and property to an investor, who then acts as landlord.

Keith Sturm, principal of Minneapolis-based Upland Real Estate Group, said that lease-backs are especially attractive to franchise operations, and are used by chains such as Taco Bell and Famous Dave's.

"The big advantage is that you don't have to tie up your capital in property," he said. "The money can go into operations instead.

Joe Brodsky, SBA loan development officer at U.S. Bank, said that lease-backs are regarded with mixed feelings in the banking community.

"I can see how it would be attractive to a franchisee, but we'd prefer that the equity be in the hands of the franchisee, not an investor," he said.

Growing a chain: True to the maxim that nothing succeeds like success, it is often easier to get funding for a second or third franchise rather than initial loans.

"There aren't many programs for people just getting into" franchise ownership, said Reid Sherard, an adviser at Minneapolis-based Capital Growth Advisors.

He noted that first-time franchisees seek help of the SBA and some franchiser-sponsored programs, while more established franchisees come to firms like his. Capital Growth Advisors works with franchises of more than 10 units.

Kutoff agreed that securing funding for the third Planet Beach was smoother.

"We have a proven history in the marketplace now," he said. "We have our own track record, not just the track record of the franchise as a whole."