Quarter of Franchises Default on SBA Guaranteed Loans

A new government report highlights just how difficult running a franchise business can be. It also shows that taxpayers can end up footing the bill for a lot of business failures.

The report comes from the Government Accountability Office and shows that more than 40 percent of franchises from a single parent company defaulted on SBA guaranteed loans.

As a result, the SBA, and by extension taxpayers, had to pay $11 million.

The report also found that between 2003 and 2012, 28 percent of all franchisees who borrowed SBA guaranteed loans ended up defaulting, resulting in the SBA and taxpayers paying $1.5 billion to lenders in compensation.

Such a steep price for a business failing is just another cost that the American public has had to shoulder in the years since the Financial Crisis.

Steep price or not, many entrepreneurs rely upon SBA loans to begin their operations and to launch into the market.

SBA Financing in Franchising

Jim Coen, Executive Director of the Maine Franchise Owners Association, said that commercial loans are often seen by franchisors as giving a budding business owner the needed cash to succeed.

He further elaborated on how rare bootstrapping is for franchisees. Franchisors tend not to approve franchisees that lack the necessary capital to succeed, so franchisees without high net worths and large amounts of saved cash turn to financing.

“The worst thing that can happen is that a franchisee runs out of capital prior to breaking even or reaching profitability,” said Coen.

Whether through bootstrapping or borrowing SBA guaranteed loans, businesses can improve their chances of success a number of ways.

Franchisors may offer franchisees financial programs to assist them. These may not necessarily include business loans but they can include reduced royalties, fees, and advertising assistance.

While any funds coming from either the SBA or a franchisor certainly fuel starting businesses, it matters little if the local economy will not generate cash flow for the new franchise. This is especially important in the current slow economy that has not fully recovered from the last recession.

“The economy is showing signs of picking up, the degree varies depending on the market area,” said Coen. “Prospective franchisees must do their homework to make sure the projections they are setting in the pro-forma are achievable in the current state of the economy where they are considering locating.”

Part of a franchisee’s homework is ensuring that they have the necessary funds to see their business become a success.

Daniel M. Janssen, the National Head of the Quarles and Brady Franchise Law Team, said that a prospective franchisee should have a cache of their own money invested into his or her business, alongside financing.

“Government-sponsored programs, such as the SBA, are often willing to take greater risk in funding a startup business,” he said. “But the franchisee should expect that these dollars may also come at a higher cost, in terms of fees and interest rates.”

Of course this cost can be mitigated by a business’ success. One upcoming industry that will be successful in Janssen’s estimation is the new healthy fast food industry.

“Health conscious consumers are demanding natural and healthy alternatives to more traditional franchised offerings,” he said. “Frozen yogurt franchises such as Pinkberry and Red Mango are expanding in existing markets and are experiencing tremendous growth in new markets.”

Even though the healthy fast food industry is poised for growth, some experienced industries still see many of their franchisees fail at business and default on SBA loans.

Why Franchises Default

Rick Bisio, Author of the Educated Franchisee, said that one key reason for the high percentage of defaults is because of low demand in the economy. The economic downturn has been affecting many businesses, including franchising.

“Normally, the annual failure rate for SBA guaranteed franchise loans is about 3 percent and for non-franchised businesses it is about 6 percent,” he said. “The economic downturn has increased the annual failure rate and this rate will remain high until the problematic loans work their way through the system.”

Rather than attributing franchise failure to low funds, Bisio estimates that bad management, bad fundamentals and personal problems are the primary reasons that franchises end up going under. Additionally, franchisees can have misconceptions about what it takes to be successful.

“One of the misconceptions that new franchises have is thinking ‘All I have to do is turn the sign from Closed to Open everyday and I will be successful,” said Hal Sklar, Vice President of Franchise Development for LashDip. “I have witnessed numerous times where the existing franchisee was not successful and the business is sold to a new franchisee and the business turns around and becomes extremely successful.”

Sklar elaborated on how despite the resources offered to franchisees, new franchises can still end up in cash flow trouble. To lessen the chances of failure, mentor programs can help guide franchises into becoming successful businesses.

“I have instituted a company-sponsored Mentor Program where successful franchisees are assigned new franchisees to mentor and be there for them,” he said. “New business owners must understand that they must become the spokesman, networker, and face of their business in their local community.”

Despite the failure rate revealed in the government report, the SBA will continue to play an important role in both the nation’s recovering economy and in the lives of many entrepreneurs eager to succeed at gaining wealth.

“Although there is always risk when taking on debt, business loans are a necessary part of business success,” said Bisio. “The SBA guaranteed loan program has been an invaluable part of entrepreneurship in the United States and has helped tens of thousands of people achieve their dream of business ownership.”