The banking industry is increasing its conventional business lending activity. Since the recession they have focused on lower risk businesses, which translated into larger businesses with good track records. More recently they have been expanding their focus to smaller businesses with less experience. Concurrently, we have seen the rapid expansion of alternative lenders, led by internet-based lenders, into the smaller businesses/less experience category.
It is a relevant question to ask whether a publicly-funded lending program for businesses is still needed. Government programs that are launched during a time of need often stay around well passed their useful lives, or at least their original purposes. That question is being debated in Congress right now regarding the Export-Import Bank. Should SBA be next?
The SBA’s 7(a) program is on a pace to get close to their authorized cap of $18.75 billion this fiscal year. If conventional lending is on the rise and alternative lenders are moving rapidly into the small business lending space, why is SBA lending also on such a torrid pace? Is it just the result of Congress increasing the individual lending limit to $5 million from $2 million or is there more too it?
As it relates to franchising, the answer lies in understanding the credit characteristics beneath the surface. About 75,000 franchised units in the US will need financing this year, roughly split between 2/3 for new units and 1/3 for sales of existing units. Total loan capital needed to support that level of activity will be between $25 and $30 billion. The lending community as a whole is finally closing the lending gap and should accommodate most of that activity.
SBA-guaranteed lending accounts for about 20% of the total needed by franchisees. While that would seem to be surmountable by the conventional and alternative lending groups, it’s unlikely to happen because of the credit risk profile differences that are found within the SBA-guaranteed borrower group of franchisees. In 2014, 43% of prospective franchisees obtained their financing from SBA lenders. In other words, nearly half of all first-time franchisees relied on SBA-guaranteed loans.
The dependence on SBA lending is even greater when looked at from the perspective of the experience of the franchise brand. The source of borrowing for franchisees of emerging brands, regardless of the prior experience of the franchisee, was SBA lending for about one out of every two new units. It’s all about the perceptions of credit risk. A first time franchisee with an emerging brand is a much higher PERCEIVED credit risk than an experienced franchisee with a mature brand. That is why even very active franchise lenders have a minimum franchise system size threshold somewhere between 25 and 50 units and stringent borrower requirements.
The last categorically significant factor is initial investment size. Intuitively, one would think that a smaller loan would be of more interest to a lender than a larger loan since they have less capital at risk in the former. However, the cost of underwriting a franchise loan is about the same, whether the loan amount is under $100,000 or over $1,000,000. Recovering the cost of underwriting can only come through the interest margin income earned on the loan over time. The larger the loan, the more interest margin income is earned each month to cover the fixed cost of underwriting. Lending economics doesn’t favor the smaller franchisee borrowers. Of the roughly 75,000 franchise units needing financing in 2015, about 35,000 of them will require loan sizes less than $230,000. About one in every six of those 35,000 units will be associated with a new franchisee in an emerging brand.
Lending is a simple business. The lender gives you money and at some point the lender wants it back. Whether it will get it back is the basis of credit risk analysis. Franchise brands have an advantage over independent businesses when competing for money because the industry has the ability to quantify that risk. A franchise system is made up of lots of units that have the same uniformity and conformity. Measuring their performance over time allows a lender to determine with greater accuracy what that assessment of risk is. That simple statement is the foundation of Bank Credit Reports and other risk analysis tools.
As the industry is able to demonstrate brand credit risk profiles more broadly, non-SBA lenders will open up to prospective franchisees and emerging brands. As they do so, less dependency on SBA lending will follow. For all the reasons noted above, SBA lenders will have an important role in the growth and stability of the franchise business model the foreseeable future.
This article was originally published in Franchise Update Magazine.