By JERRY CHAUTIN
Published: Monday, October 28, 2013 at 1:00 a.m. Originally posted in the Herald Tribune
It is difficult to get a small-business loan without pledging substantial collateral. Although lenders will look at your cash flow and other financial ratios first, they consider collateral to be the secondary way to get paid if you default.
Mature businesses with a track record of cash flow and a strong banking relationship are sometimes exceptions to lenders requiring collateral. But if collateral is required, real estate is preferred and it is usually discounted at 80 percent of its resale worth. Softer collateral such as fixtures, furnishings and equipment, and single-purpose commercial buildings, get deeper haircuts, or may be unsuitable collateral for some lenders.
Examples of single-purpose buildings include bowling centers and movie theaters, because only similar businesses can move into the buildings without costly renovations. In the event of default by the original users, the new occupants would likely tear out the bowling lanes or level the floors of a movie theater.
Restaurants and fast-food franchises also often occupy single-purpose buildings. Customizing the inside and outside is part of their branding. But in the event of default, it is likely that a new, more traditional retail store would remove facades with golden arches, tubs of chicken or overly customized interiors and elaborate kitchens. So prudent lenders will further discount the collateral by the amount of that renovation cost.
“One of the biggest start-up costs for franchisees is store build-outs,” according to an article in “Franchise Times.”
“One challenge for both franchisors and franchisees is walking a fine line between cutting costs while not cutting corners that will negatively impact the brand.”
In other words, the brand determines how much cost is added to a plain vanilla building so that the store is consistent with its others nationwide. Franchisors want Wendy’s patrons from Massachusetts to easily spot their brand while vacationing in Bradenton or Port Charlotte.
In addition to the franchise’s build-out cost and its single-purpose nature, site selection criteria often requires an expensive, highly trafficked location. That’s why franchises line Tamiami Trail throughout Southwest Florida.
Furthermore, many of these stores and restaurants are on leaseholds, so the franchisee does not own the land to offer as collateral. And the building is a chattel, not real estate, meaning ownership transfers to the landlord in a default or lease expiration.
Even so, lenders at BoeFly’s Franchise Lending Spotlight Conference in Atlanta, Ga., this month said they would finance established brands on leaseholds.
When financing a franchisee on leased land, lenders want notice of a default from the landlord and the ability to cure the default by bringing the payments current. They also want the right to sublease the property to a tenant with similar credit.
Then the lender would likely ask the franchisor for help finding another franchisee to take over the existing lease, preferably one who owns multiple franchise units and has an unimpeachable track record.
That’s why lenders prefer to finance franchises with solid financial statements, a record of few defaulting franchisees and a history of stepping in to help lenders when one of their units fails. But even for the most successful brands, lenders still want creditworthy borrowers.
Lenders also look to the U.S. Small Business Administration’s loan-guarantee programs to limit their exposure, especially for borrowers new to franchising.
Notably, SBA has recently clarified its collateral requirements that go into effect on Jan. 1. The agency updated its standard operating procedures and “significantly alters the collateral requirements for SBA loans with regard to the types of assets that principals of borrowers must pledge or mortgage,” says Jeffrey Feldman, a lawyer with Starfield and Smith. “Under the new SOP, principals are only required to pledge their personally owned real estate if their loan is not otherwise fully secured.”
The SOP also says collateral is not required for loans of $25,000 or less. Between $25,000 and $350,000, the lender may secure the loan by filing a Uniform Commercial Code Financing Statement on the business assets.
For amounts over $350,000, SBA requires lenders to collateralize all available assets up to the loan amount. That could include your home if you lack sufficient business collateral.
Many lenders have higher collateral requirements than SBA.
Jerry Chautin is a volunteer with Manasota.SCORE.org, a local nonprofit SBA resource partner offering free business advice and mentoring. He is SBA’s 2006 national “Journalist of the Year” and a former entrepreneur, commercial mortgage banker and business lender. He writes and blogs about business and commercial real estate strategies for several publications and financial organizations nationwide. Contact him with your questions and stories at firstname.lastname@example.org and follow him on Twitter, www.twitter.com/JerryChautin.