The SBA Predicted the Current Franchise Loan Fraud Crisis in 2002

0n September 16, 2002, the SBA Office of the Inspector General (OIG) submitted a report entitled “The SBA’s Experience with Defaulted Franchise Loans.”

Screenshot of title page of SBA OIG Report

At the bottom of page 1 and top of page 2, the report hits the nail on the head.

It reads:

Screenshot(s) from Bottom of Page 1/Top of Page 2

The quote begins, “Despite the notion of franchisee success, OIG audits and investigations have identified potential origination problems in some purchased loans identified by SBA as franchise loans.” The authors’ choice of the word “notion” speaks volumes.

There is a common “notion” of franchisee success among everyday Americans who haven’t fully come to grips with the scope of this problem. Franchised businesses are part of Americans’ everyday lives. We eat their food, enjoy their services, and buy their products. We assume that their ubiquitous presence in our towns and cities demonstrates legitimate growth and financial success.

And why not? What else besides a thriving, free market could be driving their dominance?

The report goes on to explain. Quoting the findings of an SBA-funded study,* it states that “a franchisor must reach a minimum efficient scale to lower its (as opposed to franchisee’s) [SIC] costs.”

In other words, in order to succeed financially and spread its brand name into your life, a franchiSOR must reach a certain level of minimum efficiency. If it falls below that cusp, it will fail. You can be pretty dang sure that the successful franchised businesses you know and love have lowered the franchiSORS’ costs and have met that minimum number.

But, there’s a big caveat. And that caveat is found in the parenthetical statement: “a franchisor must reach a minimum efficient scale to lower its (as opposed to franchisees’) costs.”

In order to survive and push its way into the market, the franchiSOR must meet the minimum efficiency scale. Not the franchiSEE. In order to succeed, the franchiSOR must maintain efficiency standards. The franchiSEE, on the other hand, does not need to be succeeding financially. Because think about it: the brand name expands into your town because the franchiSOR is meeting a successful financial cusp. The brand’s presence in your town says nothing about whether or not the franchiSEE is also succeeding.

The franchiSEE is the grunt worker who runs the local outlets. While franchiSEES as a class are essential to the industry, their presence and their initial financial investments into franchiSORS are more important than their financial success. They’re necessary to feed the franchiSORs with investment money and to work hard to run individual outlets, but it is franchiSOR efficiency that determines brand name success. The success of the grunt workers, the franchiSEES, is not essential.

FranchiSEES are expendible. FranchiSORS can “churn” through franchiSEES in the form of franchiSEE transfers, franchiSEE terminations, franchiSEE non-renewals, and franchiSEE ceased operations. “Churn’ is defined as: (transfers + terminations + non-renewals + ceased operations)/total number of franchised units. It is not uncommon for franchiSORS who are considered “successful” to “churn” an unhealthy percentage of units each year.

The report goes on to read, “Given this necessity plus the need to collect franchisee-paid fees, franchisors have an incentive to encourage as many prospective entrepreneurs as possible to become franchisees and find financing.”

FranchiSORS win every time someone decides to become a franchiSEE and take out financing. A successfully recruited franchiSEE takes out a loan, signs a franchise agreement with a personal guarantee (offering up the franchiSEE’S home and life savings to the success of the business) and then pays a hefty franchise fee… that franchiSEE-paid fee that benefits the franchiSOR and helps the franchiSOR meet minimum efficiency standards.

It costs the franchiSEE a lot, of course.

But after the franchiSEE pays that hefty fee, the franchiSEE is expendable. The franchiSOR can “churn” that franchiSEE right out of the system. Or, if the franchiSOR is particularly unethical, the franchiSOR can sue the “churned” franchiSEE for future royalties using the franchisee agreement and contract law. And remember, the agreement is written in the franchiSORS’ favor. The franchiSOR will probably win. The franchiSEE will lose everything.

The last sentence of the paragraph gets us to where we are today. “Moreover,” it reads, “there is always a risk of some franchisors’ overly optimistic financial projections enabling underqualified prospective franchisees to obtain — and default on — SBA guaranteed loans.”

Yep. That’s what is going on. FranchiSORs are submitting overly-optimistic projections to SBA Preferred Lenders, lenders are breaking SBA rules that are already in place, and are “backing into the numbers” so that the franchiSEES can “qualify.” All of this despite the fact that the franchiSORS’ business the franchiSEE is purchasing has no historical revenue data to justify the projections.

Then, the franchiSEE signs and guarantees the SBA loans, and the franchiSEE signs a franchise agreement, also with a personal guarantee. Then, when the franchisEE gets “churned,” the franchiSEE loses everything.

The franchiSOR, however, has used the churned franchiSEE to help it meet its minimum efficiency standard.

The franchiSOR’s business survives, the taxpayer helps pay the guarantee on the bad SBA loan, and the public is none the wiser because the franchised location they visit when they want products and services looks solid and healthy.

* Shane, Scott, “Why New Franchisers Succeed,” Small Business Research Summary, No. 178, August 1997, (U.S. Small Business Administration, Office of Advocacy), p. 1.

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