How lenders underwrite franchise brands

Jessica SarterSmall Business Lending

Video Transcript:

Mike Rozman:
Great. So shifting from how you acquire and connect with borrowers, talk to us about underwriting the brand and how critical is that for you today. And Eric, I’d like to kind of shift to you on that. At US Bank what are you guys doing to get a handle on the brand?

Eric Daniels:
Yeah, I think we talked about the BCR _____, so I’m not sure if Darrell’s on the phone –

Mike Rozman:
Why don’t you first share your views on what you’re looking for the BCR to accomplish for you? And then I think it’s the perfect time to shift to Darrell. Thank you.

Eric Daniels:
It’s meaningful to us to be able to get data with regards to the historical performance of the brand, taking a look at rates of additions, deletions, and so forth – terminations – gives us a really good insight. But we really look at the – the underwriting of the brand is really twofold. It’s first about taking a look at the numbers and then working at developing relationships with the franchisors. So I think we were talking earlier about what can the brand do. That’s where having a relationship with a brand and understanding how they operate and getting really good insights in terms of their philosophy on how they add franchisees and what happens if they have an open store, and how they look at those types of things. That’s what helps us out. So I would say that, you know, in a nutshell it’s meaningful. We do look at our customers. We are not the kind of shop that’s going to qualify a concept and then just make loans subsequent regardless. We do look at our customers one at a time.

Mike Rozman:
Okay, I appreciate that. So Darrell, I appreciate you joining with us today. Tell us what – you know, give us the overview of the bank credit report as it relates to underwriting the brand.

Darrell Johnson:
Sure, Mike, and thanks for having me involved in this today. There’s only one reason the bank credit report exists, and that is that a brand’s performance history is a great indicator of future expected loan performance. Said another way, if I’m a banker and I look at a brand, I need to have some idea of what the likelihood is of me getting my money back on any loan, regardless of how well I underwrite the borrower. There’s a performance history there, and that’s what the bank credit report tries to uncover. It is not a recompilation of an FDD. It really looks at three main risk factors from a banking perspective. It looks at unit performance, it looks at system performance – and by the way, that’s where a lot of banks look at SBA data, as _____ as that data is, but they use it as a proxy. And in some cases it works; in other cases it’s a very poor proxy because of the quality of the data. And the third is looking at the franchisor’s performance. Some of the things have been discussed on this call today about some of the things that franchisors do or might be expected to do from a lending standpoint to assist a lender either at the front end or the back end if a loan is either being put on the books or isn’t working out according to terms. That’s fundamentally what a bank credit report is trying to do on behalf of helping a lender get to an approved credit decision.

Mike Rozman:
Great. And one of the things – I’ll share this now – we’re going talk about very briefly at the end, we’re hosting a webinar to discuss the bank credit report in detail. So for those of you who aren’t familiar with it, it’s acquired by – it’s sponsored by the franchise brand. They’re going make the investment to go ahead and get FRANdata to do an independent analysis of the brand, and we’ll be talking about that on March 1st. That’ll be our next webinar. So thanks, Darrell, and you know, continue to chime in as this conversation goes.

I want to continue on this view of underwriting the brand, what else we’re considering. Kevin, you know, do you guys have specific policies at Atlantic Coast that you first start with to understand the brand?

Kevin Ellis:
Absolutely. You know, first and foremost we are funding these deals for the most part via 7(a) and SBA 504 loans, so you know, we are only considering those that are on the registry. You know, brands that do meet acceptable standards but are not on the registry, they could be subject to review and approval of their FTD and bank council to determine their eligibility. Now in terms of importance, I’m going to kind of split this into two. From a startup standpoint, you know, our brand and franchise underwriting is crucial. Brands that we considered – that we will consider for startup financing we rate using an internal scorecard and it’s based on a certain minimum criteria and parameters. Now switching gears, on a business acquisition of a franchise business already in operation, we are going to – it’s of very little importance.

Mike Rozman:
Okay, thank you. And as far as a tangible charge-off failure rate number from the SBA side, can you share some thoughts you have there?

Kevin Ellis:
Yeah. Currently we are looking to have a charge-off and failure rate of no more than five and seven percent respectively. And certainly I will say that there are exceptions made on a fairly regular basis. You know, for example I’ve got a deal that I’m – a franchise startup restaurant deal here in Florida that I’m working on right now where the failure rate was far – far exceeded our guidelines. I had a strong borrower, but what really got us comfortable was I was able to talk to the CEO personally on the phone. We had a 30-minute conversation, and the explanations were very – you know, very quantifiable and very easy for us to understand, and you know, we are now able to work on that deal. So you know, we obviously use our scorecard and the five and seven percent as a screening tool, and that’s where we like most of ours to fall, but there are a number of instances where we have made exceptions, because there’s – obviously there is a lot of _____ information in those numbers, and we understand that. So, you know –

Mike Rozman:
So on that ______ information piece, Darrell, share with the audience as far as what the SBA in support with FRANdata are doing to go ahead and get a handle on this data issue.

Darrell Johnson:
Okay. The issue that exists is twofold with regard to using SBA data, which is largely inaccurate for many franchise brands. And whenever that information is provided by the SBA it comes out with a caveat at the very beginning saying, “Do not rely on this credit ________.” The reason they say that is twofold. One is improper lending reporting. Lenders are not required to report on every franchise loan that they have that it is a franchise loan associated with a particular brand. And because of the lack of enforcement of that, it often is underreported the amount of activity that’s done, and if it’s underreported on the amount – the activity for a particular brand that’s done, it does get corrected if the loan goes bad. So the bad loans are almost always acknowledged. The good loans aren’t always acknowledged, with obviously distorts the percentages.

Having said that, the other issue is keeping a current list of all of the franchise brands that are out there. FRANdata tracks usually in the neighborhood of 200 to 300 new franchise brands per year. And so a lender that is trying to report accurately may not even have the ability to pull down an accurate listing of all of the brands so that they can identify it. To that end FRANdata is working with the SBA and at the end of this month will put in a required new coding system for all SBA loans that will be effective I believe January 30th. And it’s called _______, FRANdata’s unique numbering system, and it’s associated with every brand, so on an ongoing basis it will be constantly updated, and that part of the issue of inaccuracy of data will get corrected for every SBA loan. It has broader implications because every franchise brand in the United States that FRANdata can assess and validate will be given a unique number, and that will allow lenders to track both SBA and non-SBA lending in their portfolios in an accurate and consistent way. So this is coming out at the end of this month.

Mike Rozman:
I appreciate that, Darrell. So you SBA lenders on the line, although it may make you angry that you now have to provide more information, hopefully will all get the benefit from it in better information. So thanks, Darrell. I want to kind of stay on this because obviously underwriting the brand is so critical. I’m also mindful of time, so we’re going work through a few additional points. The panelists have agreed to stay on a little bit longer to handle questions. So we’re going keep going on this content. We’re going expect to get to a Q&A probably just before the hour, maybe a little before, get some Q&A out there to get to your questions that haven’t been addressed. I’ve been trying to work them in. So we’re going keep going now. Those of you who can’t stay on past the hour, we will be recording this and that Q&A session will be recorded as well.

Doug, I know that you guys do a lot to underwrite the brands and make sure you’re comfortable with them. You know, we heard about the bank credit report as a tool. We heard about SBA default data. What else are you looking at to get a handle on the risk of the brand?

Doug Bagnasco:
Well, for us it is very critical because we do not have the SBA guarantee, so it’s imperative that we get the other parts right, that there’s historic cash flow, that we’re comfortable with the borrower, and that we’re comfortable with the brand. And in getting comfortable with the brand, I guess it all really starts with us with a franchise disclosure document. A lot of the information that’s in there would focus on a great many things, but not the least of which is the exit rates there. And we’ve always put a lot more emphasis on the exit rates that are listed in the franchise disclosure document versus the SBA, ‘cause it’s also a little bit of apples and oranges for us when you consider that a lot of the 7(a) loans that occur more often or not are for if not first-time franchisees, second unit franchisees, and not really our borrowers per se. But having said all that, we look hard at the FDD, then we do look at the bank credit report if it’s available for the franchise concept. It’s extremely helpful when it is.

And then lastly it’s really about the relationship with the franchise company itself and our ability to talk with them, to dig down a little deeper on things like site selection and on things like what sort of support is available in a worst-case scenario. And we look for a partnership and for a long-term relationship, and that’s our ultimate goal.

Mike Rozman:
Great, I appreciate that. So – and that – obviously, Doug, you’re investing the time and resources to spend time with the brand. I know I met with one of your colleagues when we joined the Dunkin’ Donuts lender session where they hosted 50 lenders at their Massachusetts headquarters to share ____ story, but not every community bank can go to that. So I’ll shift back to you, Kevin. You know, you picked up the phone and called that CEO. How do you get in touch with the brand? How do you get information on the brand in a way that allows you to make better decisions?

Kevin Ellis:
Yeah. You know, when we’re doing our scorecard and we’re trying to qualify those franchises, you know, for us to be able to finance them, you know, I would say that my two go-to platforms would be FRANdata and Darrell’s team, and they’re fantastic. They’re very responsive and it’s been a pleasure working with that group. And I also utilize the BoeFly platform, the intelligence center. You know, there’s a franchise section with documents that I’m often able to pull down and review. So between those – those are typically my kind of go-to platforms.

Mike Rozman:
Great. And I’ll just add a little color. You know, when a franchisee of a franchise or member of BoeFly posts information, the brand’s information is securely presented to the lender. The franchisee won’t see it out of disclosure concerns, but the brand is able to share information securely with lenders so guys like Kevin can get at it. Thanks, Kevin. Kristy, you know, I want to just get another thought from you on the number of units that you’re looking to do – if a brand were interested in connecting with you and they have a limited amount open, do you have a sense of where that hurdle is going be as far as how many open units you guys are going be looking for within your group?

Kristy Hall:
We have – we’re actually establishing our guardrails or our criteria with those specific brands. Again, we’re focusing on a specific industry or a specific sector. But we’re also looking at a minimum 50 number of units within that franchise, as well as years established. We’re looking at – right now we’ve gone back and forth between like the five to ten years, but we’re going have an established number of years out there as well.

Mike Rozman:
Okay. I appreciate that, Kristy. That’s helpful.