The State of Franchising in the Credit-Crunched U.S.

To get to the root of why the United States is struggling toward a jobless recovery, look no further than the franchising business.

In franchising, a company lends its trademark and business system to an owner-operator who pays royalties for the right to use them. Starbucks (SBUX), Quiznos, Jenny Craig, Ace Hardware, Maaco, Pakmail – all are franchise businesses. In the U.S. there are more than 900,000, directly employing more than 11 million people.

From 2001 to 2005, the collective payrolls at franchise operations grew by 22%, to $279 billion. But that growth rate, with its healthy spin-off of jobs, has since ground to a halt, yet another byproduct of the credit crisis that produced the recession some experts tell us is nearly over.

“The flow of credit to franchisees has essentially ceased,” said Matthew Shay, chief executive officer of the International Franchising Association. “A number of banks have either left the market completely or stopped lending to small business. Without credit for people to get started in business and then to operate a business in the short term before it becomes profitable, that makes things very difficult.”

In January, the IFA predicted a loss of 10,000 franchise businesses this year, jettisoning more than 200,000 jobs. That dire forecast was predicated on the estimate that access to credit would be down by 25%, which now may seem like wishful thinking.

“We recently updated that assessment,” Shay said last week. “We now think access to credit is down closer to 40% this year. It's become worse. We are leaving tens of thousands of jobs on the table.”

Franchise consultant and blogger Joel Libava, aka “The Franchise King,” is in the business of “strategic matchmaking,” lining up potential franchisees with the many thousands of companies that dole them out.

“I was talking with a major Cleveland-area lender recently,” Libava said. “I asked him ‘If I sent you someone with a million dollars who was looking for a $250,000 loan for a franchise - putting up $100,000 of his own - what would you tell him?’

“He told me he’d pass,” Libava said. “He said ‘We have no interest in looking at any start-ups now. There’s too much risk.’”

Libava said he’d been hearing similar things from bankers for more than a year now, “but I’d never heard it said as strongly. It’s definitely a new trend going on this year. Banks just aren’t very interested in loaning to startups.”

Businesses with fewer than 20 employees account for 25% of all jobs, but in the 2003-2007 economic expansion, they generated 40% of the job growth, according to Mark Zandi, senior economist for Moody’s Economy.com.

“In their recent efforts to recharge the economy, policy makers have all but forgotten small business, finding it both easier and more visible to help large multinational firms,” Zandi told the New York Times this week. “Unfortunately, though, big business can’t provide the jobs needed to power the economy forward.”

PricewaterhouseCoopers prepared a study for the IFA in 2006 that concluded new franchise growth over the previous five years had generated 140,000 new businesses and 1.2 million jobs.

“Franchising now provides more jobs than many other sectors of the economy, including the durable goods manufacturing and financial activities sectors,” Shay said.  “It is clear that franchising is a critical engine of economic growth in the United States powering local communities across the country.”

Many people think only of fast-food when they think of franchises. But the Franchise Association now lists more than 75 different categories to describe its members. Franchises range from advertising/direct mail to construction to dating services to home inspection to security systems to video rentals. Printing and copying centers, maid services, computer repair, lawn-care services, real estate, lodging and travel agencies. More than 400 U.S. franchise systems operate internationally. Subway alone has more than 26,000 franchises in 84 countries.

Franchising is attractive to many entrepreneurs because it offers many of the advantages of a partnership. According to an IFA brochure: “Franchising means being in business for yourself but not by yourself. Whether it's accounting and financing, advertising and public relations, personnel management, purchasing, or inventory control, franchisors are there to provide 'hands on,' one-to-one assistance.”

For a potential franchisee, the start-up costs can range from $20,000 or less, to more than $1 million. Seventy percent of franchisors charge an initial fee of $40,000 or less, and the average investment, excluding real estate costs, is between $350,000 -$500,000.

But in the current environment, lining up the money is not for the faint of heart. Consider the travails of Tom Drennen as he struggled to open a Beef O'Brady neighborhood pub in Newport, Ky., last year. The franchise operator advised him to apply for a $500,000 loan with New York-based CIT (CITGQ), then the nation's largest National Business Association lender.

"They were very strict," he recalled this week. "I had to put 15% down, I had to get an architect signed up, I got general contractor bids and acquired a lease that I had to personally guarantee."

By October 2008, Drennen said all of CIT's loan requirements had been met, and the loan was set to close in two weeks.

"Then CIT called me and said 'We're freezing all our loans, we can't lend you the money,'” he said. “I asked about all the commitments I had lined up, and they said there was nothing they could do."

Because he already had signed the lease to get the CIT loan, Drennen began paying $5,000 monthly rent on an empty building.

"I hit the streets," he recalled. "I hit up every single bank in northern Kentucky and southern Ohio, from nationally known to community banks. They were all so scared. They didn't want to do any startups, and told me restaurants were especially risky. At least 30 banks turned us down. I tried to find creative ways to get out there, finally reaching real deep into my pockets."

After reading about the federal stimulus money being funneled to banks, Drennen made a second round of all the lenders, this time putting up 60% of the money himself.

"They still kicked me out" he said. "They wanted nothing to do with a startup. It was really confusing, I felt like I was misled. I thought the stimulus money was put there to get back out to the public."

Finally, Huntington Bancshares (HBAN), a regional lender out of Columbus, Ohio, agreed to lend him $100,000. Through his research, Drennen found out about an economic development district that had been formed in Newport in the 1970s after a flood.

"It was a revolving fund that was still operating" Drennen said. "They got with the bank and both went in for 20%."

After paying nine months' lease on the vacant property, Drennen opened July 27.

"We're doing excellent - me and the 40 employees I hired," he said.

His advice: "Be resilient. If you are someone who gives up, this isn't for you. You're gonna be turned down many times, but realize they are giving you constructive criticism all the time that you can use with the next bank. Each turndown made me that much more determined to prove them wrong."

CIT-uation and Obama Addresses Small Business Woes

A month after backing out of Drennen’s loan, CIT filed for bankruptcy, claiming $71 billion in assets and nearly $64 billion in liabilities. The banking group ascribed its losses to tight credit markets and subprime mortgages. CIT made $770 million in Small Business Association loans last year, but its small business lending unit made less than $60 million in loans from October 2008 to May 2009. Under CIT’s re-organizational plan, the government likely won’t recover any of the $2.3 billion in taxpayer money it received, and its shareholders also will get nothing.

CIT funds nearly a million businesses, including such leading franchise operators as Dunkin’ Brands Inc. and La Quinta Inns Inc.

CIT lawyer Greg Galardi told a bankruptcy judge Tuesday, “CIT is the sixth-largest commercial lender, and more importantly, the largest lender to small and mid-sized business, and the leading lender to minority-owned business and those operated by women and veterans.”

On Oct. 24, President Obama urged banks, large and small, to make more loans to small businesses. Banks benefited greatly from the taxpayer-funded $700 billion financial rescue program, he said, and they must now return the favor.

"These are the very taxpayers who stood by America's banks in a crisis -- and now it's time for our banks to stand by credit-worthy small businesses, and make the loans they need to open their doors, grow their operations, and create new jobs," Obama said in his weekly radio address. "And we're going to take every appropriate step to encourage them to meet those responsibilities."

Last month, the administration began offering taxpayer capital to small banks that do much of the lending to U.S. small businesses at a lower cost than it had previously.

"Small businesses have always been the engine of our economy -- creating 65% of all new jobs over the past decade and a half -- and they must be at the forefront of our recovery," Obama said.

Might this provide some light in the small-business lending tunnel?

“I have been encouraged in the past few weeks by statements from the president, the Treasury and the Small Business Administration,” said IFA’s Shay. “They finally are realizing that access to credit for small businesses equals job creation.

“In October of last year we were saying this is not an equity crisis but a credit crisis, and they finally agree with that,” he said. “The unemployment rate is so high, people are finally saying 'what do we do?' The answer is to restore the flow of credit to small business.”

(Rob Reuteman is a Denver-based freelance journalist and former business editor of the Rocky Mountain News.)