Lenders hesitating to back new franchises

  • Article by: ALEX ROBINSON , Star Tribune
  • Updated: August 26, 2009 - 9:37 AM

Franchises usually grow during recessions. But the credit crunch has changed that.

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After being laid off for a third time in 13 years, Don McFee began a duct-cleaning franchise with his two sons, Max, 19, left, and Sam, 20. He runs the business out of his home in Lino Lakes. He couldn’t get recession-shy lenders to provide start-up money, so he used his 401(k) funds.

Photo: Elizabeth Flores, Star Tribune

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Don McFee had lost his job for the last time.

In November 2007, after he'd been told to clean out his desk for the third time in 13 years, the former construction project manager went home and told his wife, "I don't know what I'm going to do, but I'm not going to do it for anybody else."

McFee, like many newly unemployed, decided to go into business for himself and buy a franchise.

The franchise sector usually fattens during recessions; real estate is cheaper, there's a spike in laid-off workers from corporate America and franchises are usually considered less risky than starting an independent business. But because of the credit crunch, many in the industry are expecting this recession to be different.

The International Franchise Association (IFA) predicts a 1.2 percent decrease in the number of U.S. franchises in 2009. That's a small dip, but it's also the first year-over-year decline in more than a decade.

"This really is a big marker for us," said Alisa Harrison, a spokeswoman for the IFA. "We always see an uptick during a recession."

The drop is multiplied in Minnesota, which had 1,186 franchises in fiscal 2009, down 8.6 percent from 1,299 in fiscal 2008, according to the Minnesota Department of Commerce. Also, there was a 22 percent decrease in franchise applications in 2009 compared with 2008.

The reason? Many banks, hobbled by the credit crunch and under closer scrutiny from regulators, no longer want to cough up loans for new small businesses, Harrison said. The IFA predicts franchisees in the United States will borrow 27 percent less this year.

It took McFee more than a year to find and finance a franchise. McFee, 50, said when he was trying to get started in 2008, he talked to about six banks but couldn't get a loan even though he has a credit score in the high 700s.

"The banks wouldn't even look at me," he said. "They kept saying, 'You have great credit but we just don't want to take a chance on a new start-up business.'"

After meeting with two franchise brokers and a lawyer, he finally decided to use his 401(k) to start a franchise of Ductz, the largest air-duct cleaning franchisor in the country. Starting his Ductz business, located in Lino Lakes, cost McFee about $100,000. In return, he got a truck, cleaning equipment, lawyers' fees and the Ductz name. This summer, he recruited his wife and two college-age sons, who are his only employees.

Because loans have been hard to come by, it's common for people to tap into their retirement funds to start franchises, said Lori Kiser-Block, president of Franchoice, an Eden Prairie-based franchise consulting firm.

She said most people's 401(k)s already have taken a hit, so instead of trusting the market to come back, they want to invest in themselves and start a business.

"People are asking themselves 'Can I do better with my own knowledge and hard work?'" she said.

Help on the way

The tough lending atmosphere could improve for franchises and independent small-business owners, according to Edward Daum, director of the Minnesota district of the Small Business Administration (SBA), a federal agency to support small business.

The American Recovery Capital Loan Program, passed in February, set aside $730 million for the SBA, which started offering Recovery Act loans in mid-June. The loans, designed to keep small businesses running through rough times, are good up to $35,000, interest-free and fully insured by the SBA.

Also, the SBA's standard loans, called 7(a) loans, went from 75 percent guaranteed to 90 percent guaranteed thanks to stimulus funding, Daum said.

The buzz around the country is that the SBA loans are slow to make an impact because not many lenders are participating yet and there is a lengthy approval process. But potential Minnesota borrowers have an advantage, Daum said, because the state has more small lenders than many states. Small lenders might only make one or two SBA loans a year, but after a while, they start to add up.

Since June 15, the SBA has backed more than $62 million in loans. Also in that time, the SBA backed 21 loans for franchises, nine of which were new businesses.

"Now is actually a really good time to start a franchise," Daum said. "All of the tools are there right now."

Franchise or not?

Laid-off workers should think twice before deciding on franchising, said Mark Spriggs, chairman of the Entrepreneurship Department at the Opus School of Business at the University of St. Thomas.

Franchise contracts are almost always weighted heavily in favor of the franchisor in order to protect the brand name, Spriggs said. Also, besides start-up fees, franchisees have to pay royalties and advertising fees to the franchisor.

In the beginning, new franchisees often have trouble realizing that a lot of business decisions will be made for them by the franchisor. "As a franchisee, your role is to operate," Spriggs said. "You have to be willing to follow the rules."

But with the rules comes security. Spriggs said about 85 percent of new franchises survive their first year while about 50 percent of independent businesses do. This is because most franchises already have a tested business model and a recognizable brand.

Spriggs said franchises that require less capital will be more attractive to potential franchisees in the recession compared with franchise titans such as Subway or Pizza Hut, which can call for investments of $1 million or more.

During the recession early in the decade, personal care franchises -- pet care, hair salons, senior care, etc. -- grew the most, about 11 percent, according to the IFA report.

"It's a pretty tough time to open a McDonald's, but there's a lot of good lower-capital opportunities out there," Spriggs said.

McFee is satisfied with his duct-cleaning franchise.

"Whenever you go into something like this there's always some second thoughts, but I feel pretty confident," he said. "If we can struggle through this bad time, we'll be OK."

Alex Robinson • 612-673-7405

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