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Do you agree with the claim we have too many restaurants -- and the evidence in this article?

Are we due for a shakeout -- because it has been so long in coming, have people in the industry forgotten what it will be like?

burn the ice.jpeg

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Here is an interesting article about compliance.

The following is the complete text of the letter, published at the SEC, Marcato Capital Management wrote to Buffalo Wild Wings, dated August 17, 2016.

I edited slighlty for readability on the web.
It is important because it raises questions that can and should be asked of every public franchise system.
James Damian
Chairman, Board of Directors
Buffalo Wild Wings, Inc.
5500 Wayzata Boulevard, Suite 1600
Minneapolis, MN 55416
As you know, investment funds managed by Marcato Capital Management LP ("Marcato") currently own securities representing beneficial ownership of 5.2% of the shares outstanding of Buffalo Wild Wings Inc. (the "Company").
It has been two months since we first sat down with management to begin a private dialogue about opportunities to enhance shareholder value.
Given the Company's lackluster analyst day presentation and observable discontent among shareholders and research analysts, we have determined that it is appropriate at this point to share our perspectives with the investment community.
Along with this letter, we are filing the analysis that we shared with management at our first meeting in June and hope that research analysts as well as current and prospective shareholders will consider this information and express their views on the subject matter.
I should emphasize that we are exceedingly optimistic about the future of Buffalo Wild Wings.
In the crowded and competitive restaurant universe, Buffalo Wild Wings offers an experience that is superior to and highly differentiated from those offered at any of the sports-themed competitors in its markets. The benefits of its national scale, from marketing to purchasing to best practices, will continue to position Buffalo Wild Wings as the preferred destination to experience televised sports outside of the home.
In fact, we think the Company's estimated addressable market of 1,700 units (compared to 1,220 expected by year-end 2016) in the United States and Canada may be far too low and deserves to be revisited.
We also believe, however, that Buffalo Wild Wings must make substantial changes to its business practices if it hopes to reach its full potential both as a company and in terms of shareholder value.
Our initial conversations with management focused on the Company's capital allocation decisions, which we discuss below and detail in our attached analysis.
Following months of engagement with the Company, we have come to appreciate that suboptimal capital allocation behavior is symptomatic of a larger organizational deficiency: a tendency to favor gut feel and thematic proclamations without tangible evidence or appropriate analytical support.
The management team of Buffalo Wild Wings communicates its strategic and financial rationale to the investment community with inveterate avoidance of specificity. The chronic absence of detail around even the most basic of metrics causes us to question whether the right questions are being asked and answered.
We direct this concern not only toward management, but also toward the Board of Directors whose duty is to oversee, evaluate, and incentivize management in such a way as to ensure that the business is run in shareholders' best interests.
We are committed to doing our part to help the business achieve its full potential. We expect that the necessary changes will include the following:
The introduction of fresh talent at both the Board and management levels. The Company must improve its experience and sophistication in areas of restaurant operations, franchise system development, corporate finance, and capital markets. We are confident that the Board would benefit from adding independent directors with operating experience in the restaurant industry, in particular with a franchised restaurant concept. We note that no current director has direct restaurant operating experience outside of the CEO. We would also stress that any changes to the Board should only be made after consultation with interested shareholders, and we would view any unilateral action to change the composition of the Board as a hostile act of entrenchment.
A greater focus on operational excellence within Buffalo Wild Wings' core business. The Company must improve in key operational areas such as food quality, price/value perception, speed of service, technology implementation, food cost optimization, and labor engineering - all areas where it is substantially underperforming its potential, and, that if improved, can drastically help restore the Company's customer value proposition. Efforts to drive "growth" primarily through new unit openings and franchisee acquisitions currently take unwarranted precedence over maximizing same-store sales and restaurant-level margin opportunities at core Buffalo Wild Wings. Over the long-term, neither system growth nor franchisee acquisitions will be able to compensate for a decline in the profitability of the core concept.
Cessation of "emerging brands" growth plans. Buffalo Wild Wings' continued success is not an inevitability; as such, we believe the Company should remain singularly focused on its largest earnings driver rather than placing wild bets, however small, on hit-or-miss "growth drivers"-- particularly those in the highly competitive, non-core, fast casual space. Experiments with new restaurant concepts are distracting management from advancing Buffalo Wild Wings' core brand. At this point in time, any corporate resources, be they personnel, capital, or attention, would be better allocated to addressing the operational improvement opportunities at core Buffalo Wild Wings.
A profound increase in urgency, follow-through, and accountability. A review of past years' earnings reports reveals a number of Company "priorities" that have since dragged on without meaningful progress, the most obvious example being the bungled roll out of table-side order and pay functionality. The commentary in the current period regarding the near-term goals

for these programs is the same that it was two and three years ago despite the Company having missed its initial execution objectives. Even now, management is content to highlight the opportunity while very little tangible progress has been achieved. This issue is representative of a much larger issue of management's persistent failure to execute and the Board's failure to hold management accountable.
An audit of managerial decision tools and a reconciliation of business outcomes as compared to forecasts. Despite frequent assurance from management of the use of DCF- and IRR-based forecasts to approve investments such as remodel campaigns, new unit openings, or acquisitions, our experience with retail and restaurant businesses has taught us that those processes can be highly flawed. We take seriously the tendencies of development staff to reverse-engineer projections to achieve a stated hurdle rate or highlight data with a selection bias to support past decisions. The Board must review past capital investments to ensure that outcomes compare favorably with the underwriting process. We recommend starting with an assessment of the Company's large franchisee acquisition in 2015, which based on all available data, has been an unmitigated disaster. That such an obviously misguided decision could be made under the guise of rigorous analysis underscores the weaknesses in the Company's capital allocation processes and need to commit to a disciplined capital allocation program.
The list above speaks to functional changes that will improve business performance.
At a higher level, however, there is an intellectual divide that must also be addressed: there is a glaring deficiency of understanding at the Company in how capital deployment relates to shareholder value creation.
Yesterday's announcement of a $300 million share repurchase authorization further highlights this point.
Management self-identifies its objectives to be those of a "growth company" but does not appear to have a clear sense of what that exactly means or how (and if) achieving this poorly defined "growth" objective is best for shareholders.
Growth in revenue or earnings simply cannot be evaluated without consideration for the capital deployed in the achievement. This basic principle of corporate finance is tragically underappreciated by the current management team.
Instead, management celebrates consolidated revenue growth without discriminating between revenue derived from growth in royalties from franchisee unit development, same-store sales growth (itself a product of tension between higher price and declining traffic), new company-operated unit growth, and the purchase of units from franchisees.
Each of these revenue streams has a radically different margin profile and comes at a radically different capital cost (franchise royalties in particular come at no cost whatsoever).
Most importantly, the income derived from each of these different revenue streams receives a radically different value in the market due to its unique degree of capital intensity and predictability. Management and the Board should be solely focused on growing market value per share, determining which types of revenue growth will best deliver that outcome.
Additionally, management frequently highlights growth in average unit volumes, but fails to acknowledge that this growth has been accompanied by an increase in per unit construction and pre-opening costs from $840K in 2003 to $2.6M in 2015, leading to a significant decline in the returns on invested capital.
We perceive that the pursuit of higher average unit volumes (management's barometer for "growth") has led the Company to deploy ever-greater amounts of capital into larger units tailored to more populous, but also more competitive, and more expensive markets.
Similarly, remodel costs for the current Stadia program are increasing over prior remodel budgets, and the Company has not articulated the basic return on investment methodology that illustrates why the new remodels are attractive, why the current remodel cost is appropriate, or if similar outcomes could be achieved at a lower cost.
Might shareholders and customers alike be better off if capital were instead invested into smaller-format units that, at the expense of lower AUV's, could profitably succeed in smaller, less competitive markets with lower construction and operating costs, producing higher returns on capital?
Management appears to believe that realizing its identity as a "growth" company means delivering EPS growth of 15% or greater. However, even this statement is made without any design as to how that will be achieved.
Beneath the headline, there is no calculus as to how same-store sales, operating margin expansion, franchise vs. company unit growth, franchisee acquisitions, and share repurchases will combine to produce such a result. Just how this earnings goal is achieved, and in particular how much capital is required to achieve it, will dictate the multiple of EPS at which the shares will trade.
This is the vital and missing link between earnings creation and shareholder value creation. The apparent lack of sensitivity to this connection is the primary impediment to shareholders earning an attractive return on their investment in the future.
Unfortunately for shareholders, the easiest growth to come by has been the kind that is BOUGHT, requiring the most capital and offering the lowest returns.
As same-store sales have decelerated and the law of large numbers has made it difficult for new unit additions to sustain historical revenue growth rates, management has turned to buying in franchisees in its pursuit of "growth."
The large franchisee acquisitions in 2015 were telegraphed to investors, under the pretense of being "opportunistic," as helping the Company achieve its goal of growing sales and net income.
At the same time, the Company did not offer any concrete rationale for why this transaction would create more shareholder value than allowing the units instead to be sold to a third party buyer - an outcome that would have retained the existing high-value franchise royalty stream and avoided a major capital outlay at an excessive and unprecedented multiple, and moreover would have avoided the additional cost and distractions of transaction fees, remodel requirements, regional G&A investments, integration risks, and operational complexity.
Despite the Company's refusal to disclose key financial metrics of the transaction, it is clear to us that the acquisitions of 2015 were mistakes and would not be approved today if an appropriate methodology were employed.
This acquisitive behavior is almost certainly reinforced by an incentive compensation system, designed by the Board, that rewards (if not preconditions) management for maximizing absolute growth in revenue dollars, net income dollars, and store openings - all metrics that fail to acknowledge the capital required to achieve these outcomes and whether the returns on that capital investment are appropriate.
In contrast, most other high-performing restaurant companies emphasize metrics more explicitly tied to shareholder value, including operating income (not sales), EPS (not net income), and ROIC and total shareholder return -- all of which are absent from management's incentive compensation design.
We are confident that Buffalo Wild Wings is in a strong position to compete and succeed in the future. However, we believe this opportunity will be squandered if our concerns highlighted here are not addressed with urgency. We look forward to a vigorous discussion of these factors with the Board and management going forward.
Mick McGuire
Dale Applequist
Cynthia Davis, Compensation Committee
Michael Johnson, Chairman of Compensation Committee
Warren Mack
Oliver Maggard, Compensation Committee
Jerry Rose
Sally Smith, CEO, President

Your CFO has the ability to play a very important role in your quest to make your company successful. But it's an opportunity that goes untapped in too many companies.

Part of my mission in this blog, and in my consulting work, is to change that.

The key is to bring your CFO into the core of how you create credibility and trust with your Board of Directors, shareholders, and lenders. You have a network of people who are interested in, or invested in, your financial success. Make sure your CFO plays a leading role in helping you develop that credibility and trust.

It starts with taking a more strategic approach to how you manage the financial side of your business. Smart financial management is made up of these three components.

  • Confidence
  • Insight
  • Accuracy and speed

This is where you can turn the role of CFO, and the role of your accounting function as a whole, into a strategic asset. You want to transform their role into one of helping you create trust and respect and away from the old view of accounting as just gatekeepers and people who are just a cost center.

Begin evaluating the CFO role, and the accounting function as a whole, in each of these three areas.


The foundation for success in managing the financial side of the business is captured in this one word - confidence.

You have a very unique opportunity to build confidence, trust and credibility with everyone who has a stake in the financial success of the company - your management team, lenders, investors and shareholders.

They need to have confidence in the financial information they receive and have confidence in the people who provide that information.

A lack of confidence from that group of people is a big warning sign that your accounting function is letting you down.

Note: Here is an interactive, graphical dashboard you can use to grade the confidence level each group has in you and your accounting function. Check it out. It's a fun tool.


Next, the information you provide about the financial side of your business needs to be insightful. Too many CFOs fall short here because they see their role as just preparing financial statements... or just preparing a tax return... or creating an analysis schedule you asked them to prepare.

Insight goes way past that. It's about providing information that helps management make better decisions. It's about providing information to lenders and investors to help them better understand the key drivers of performance.

Financial information that is insightful and helpful is an important part of creating confidence and trust in their eyes.

Accuracy and Speed

And the third component has to do with the accuracy and the speed with which you provide financial information. Provide slow and inaccurate information and you kill your credibility. No one will trust your numbers if you do that.

And nothing kills your credibility more than providing financial information that is inaccurate or tends to bounce around and change.

But when you provide accurate information and you provide it quickly after the end of the month, and you do that consistently month to month, you set yourself out as a company that has its act together. Lenders and investors love that and it will help you forge a strong relationship with them that will last a long, long time.

(The Monthly Confidence Package is an important tool I use every month to grow that kind of strong relationship. Here is an article I wrote for the Business Bank of Texas that talks in more detail about the components of the Monthly Confidence Package.)

Where Do You Stand?

In an upcoming post I'll share an assessment tool to help you evaluate your accounting and financial function based on those three key result areas.

And I'll go into more detail about how a strong accounting function will make your life easier and help you win financially in the game of business.

Let's make sure your accounting function is doing its part to help you grow your business.

That's the smart (and fun) approach!

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Small business today generally refers to businesses generating under $3 million in annual sales. That's not so small to most people. And big business was small business at one time. The challenge is "how do you get there from here"? The financing community is about to get some real financial assistance-and it's called Factoring. Traditionally, start-ups use the Small Business Loan as seed capital, and this still remains the ideal, lowest risk choice.

Once up and running however, the issues of cash flow, funding growth, dealing with seasonal slumps and the like, become the day to day issues that determine the financial stability and future potential of the company.

The present financing options available to serve these purposes are (1) traditional bank financing, and (2) additional private investment. Each of these options achieves the goal of providing funds to your business but as is always true, there are associated costs.

Bank financing has the nasty side effect of burdening your business with additional debt, not only capital repayment but additional debt by way of interest.

If the goal is to fund growth, taking on additional debt certainly takes a chunk out of the disposable funds available to finance that growth and affects the financial position of the company for years to come. The application process is long and cumbersome. The delay between the time of submission of the application to disbursement is substantial as well, putting extra constraints on the timing of your financing needs. And...what if traditional bank financing is not an option for you? In some cases, you may not be creditworthy, many have used up your available credit limit, or be in violation of debt/equity ratios.

The other common route is private investment. In these cases, the injection of capital is given in return for an equity interest in the business. There are a variety of forms this can take but suffice it to say, that the end result is a dilution of your equity in the company that you have built. While often a great choice for large corporations, the effects are more widely experienced in small companies, especially family run or owner operated businesses.

Diluting equity, or granting an ownership interest to an outside party generally waters down the value of all shares and creates a situation where one shareholder has a preferred status and priority in payment over the original investors. As well, it often creates a loss of control over the decision making processes depending on the clout of the private investor and the amount of money invested. These are serious hidden costs.

So, what now? You can't go to the bank because you are at your credit limit and you don't' want a private investor, but you just got this huge $10 million dollar deal and you need to build a warehouse. Well, there's a new financial hero to the rescue and its name is "Factoring". To say it's new is really a mistake since it has been around since the days of the Roman Empire. The United States factors 50 times as many transactions as Canada and over $1 trillion in sales is factored worldwide annually. In the United States, many banks even have factoring divisions. Some scandals in the United States have left factoring with a undeserved tarnished reputation. In fact, it is a champion of small business and an essential tool in the arsenal of financing options.

Factoring involves the sale of accounts receivable at a discount. Essentially, you sell the receivables that are due to you by your customers to a "factor", who discounts the value of them and pays you in advance. The discount depends on many factors but is generally between 3-6% for a pre-negotiated period of time and a fraction of that thereafter. In essence you are raising funds not on the basis of your creditworthiness but that of your customers. So you may not be able to get credit but as long as your customers are creditworthy you can leverage that to raise funds for your own business.

For example, you may do home stereo installations and work from your truck, but your customer could be Future Shop! BUT, here's the beauty, you have not created the extra burden of debt, nor have you diluted your equity. Yes, you have taken a hit up-front, but, the money did not come out of your pocket and is a cost of doing business. The important thing is that it allowed you to fulfill your main goal of getting financing in a timely manner and being able to take advantage of a growth opportunity that would have otherwise evaded you.

The same line of reasoning works for seasonal businesses who need to maintain a continual cash flow to fund operations. This is a great tool for that! Now, I must confess that I came upon this discovery because I have a client in this field, but sincerely (and morally), this is no sales pitch, it's an honest opinion, because the beauty of this little known source of financing was like a secret that was too good not to share.

The legalities of this financing are equally as simple. If bank financing is in place then all that is required is that the bank give up its first ranking security on the receivable being factored. The bank is generally amenable to as it still has security on everything else. The factor then takes the place of the bank on that receivable and takes security much in the same the bank would. Furthermore, because there are no interest charges on your money, none of the banking legislation is applicable, making the entire transaction simpler all around. The charges you pay are discount fees, the cost of having your money now and avoiding all the burdens of other methods of financing. Second mortgage anyone?

I think what you will find most surprising is that factoring is highly endorsed by financial professionals, including banks. It makes a lot of sense though that they should. Business clients have many needs and professionals, be it lawyers, accountants or bankers need to respond to them. Banks like that it keeps their clients financially afloat when they cannot help them. Small and medium businesses often fail because of short term cash flow problems, not because business is bad!

Traditional bank financing and private investment can never be replaced. They are the cornerstones of corporate finance. The problem is getting to the point where you can truly benefit from their value. Small business to medium, and medium to large, factoring is fulfilling an untapped niche in the financial industry.

While it takes a lot of (paper) work away from us lawyers, I am still all for it. I guess the secret's out of the bag!

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Last April 5, 2012, President Obama signed into law the "Jumpstart Our Business Startups" Act (the JOBS Act) The intended purpose of the JOBS Act is to spur job creation by small companies and start-ups by relaxing the regulatory burdens of raising capital. In this article, we focus on Title III of the JOBS Act, otherwise known as "crowdfunding," and how franchisors and franchisees are uniquely suited to take advantage of this new registration exemption under the Securities Act of 1933, as amended, to sell unregistered securities to the public.

Crowdfunding enables small or start-up businesses that may not have access to traditional methods of capital financing to raise capital via the Internet and social media, typically from small-dollar investors.1

At first glance, crowdfunding appears to be an innovative and easy way for start-ups to obtain financing by using the vast reach of the internet. However, Congress's concerns over investor protection and fraud prevention are evident throughout Title III. Issuers, brokers and funding portals must comply with substantial informational disclosure requirements and undertake affirmative fraud prevention measures.2

Aspiring crowdfunding issuers should note that the JOBS Act requires the Securities and Exchange Commission (SEC) to adopt "such rules as the [SEC] determines may be necessary or appropriate for the protection of investors" within 270 days after the JOBS Act being signed into law. Thus, the SEC, which openly expressed its opposition to crowdfunding prior to the passage of the JOBS Act (including criticism by SEC Chairwoman Mary Schapiro that crowdfunding regulation would be akin to "walking backwards"), will most likely implement burdensome compliance and disclosure requirements.3

Why is this good news for franchises? Unlike other potential issuers, franchisors, and to a lesser extent franchisees, are already subject to rigorous disclosure requirements.4 Much of the disclosure mandated by Title III is already encompassed in a franchise disclosure document ("FDD").5

Therefore, while complying with the extensive disclosure requirements of the JOBS Act may be cost prohibitive and time consuming for most startups, franchisors will have a leg up in that they've already prepared most of the disclosure.6 From the franchisee side, much of the business planning, financial reporting and financial statement preparation mandated by a franchisor can provide the disclosure necessary to meet the likely standards, or at least provide the basis for rapid development of the necessary information.

The basics of crowdfunding are fairly simple. Crowdfunding offerings are capped at $1 million per year. The issuer must be a U.S. company and cannot be a reporting (i.e., filer of periodic reports under the Securities Exchange Act of 1934) or investment company. There are caps on annual investment amounts for investors.

Investors with an annual income or net worth below $100,000 may only be permitted to invest, in the aggregate, the greater of $2,000 or 5 percent of such investor's annual income or net worth. For an investor with an annual income or net worth greater than $100,000, the aggregate annual investment is limited to 10 percent of such investor's annual income or net worth, with a maximum aggregate amount capped at $100,000. Except under certain circumstances, crowdfunded securities are restricted securities with a one-year holding period.

Conducting a crowdfunding offering requires substantial issuer and offering information disclosure. Issuers are required to file certain information with the SEC, and must provide the same to potential investors and intermediaries, including information regarding their business, ownership and capital structure, and the offering itself. A condensed version of some of the issuer disclosure requirements and liability risks appears below.

Issuers must make an initial filing with the SEC which contains, among other things, (i) name, legal status, physical and website addresses; (ii) the names of directors, officers and 20 percent stockholders; (iii) a business plan and description of the business; (iv) financial information, which, depending on the size of the offering, may only include a certified income tax return for an offering of $100,000 or less, or audited financial statements for offerings of $500,000 or more; (v) a description of the purpose and intended use of the offering proceeds, the target offering amount, the price of the securities and the method of their valuation; (vi) the ownership and capital structure of the business, including the terms of the offered securities as well as each class of the issuer's securities, a description of how the issuer's principal stockholders' rights could negatively affect the purchasers of the crowdfunded securities, risks associated with minority ownership and examples of how future securities will be valued; and (vii) any other information required by the SEC.

At least once a year, issuers must also file with the SEC and provide to investors their financial statements and reports of results of operations, as the SEC deems appropriate.

Purchasers of crowdfunded securities will have a private right of action against an issuer's officers or directors for material misstatements and omissions in connection with the offering. An issuer will be liable if it makes an untrue statement of a material fact or omits a material fact required to be stated or necessary to make a statement not misleading, provided the purchaser did not know of the untruth or omission.

Though crowdfunded securities are considered "covered securities," and thus not required to be registered with any state agency, an issuer will still be liable under state securities laws prohibiting fraudulent or unlawful conduct in connection with a securities transaction.

Issuers are also prohibited from advertising the terms of a crowdfunding offering, except for notices directing investors to the funding portal or broker, and may not compensate any thirdparty promoters without disclosing the compensation to investors.

Does this mean that a franchisor can slap a new coversheet on an FDD and launch a crowdfunding offering? No, but with a modest supplement describing the corporate documents and attributes not otherwise covered in the FDD, a franchisor can be quickly compliant with the likely SEC rules and the launch of the offering will be achieved more quickly. Additional considerations will include obtaining consent from the auditors to use the franchisor's financial statements and audit opinion for such purpose, and creation of an investor questionnaire, modeled in many respects on the franchise application, that will elicit the eligibility and limitations of potential investors.

How often does a franchisee ask whether he or she can invest in the franchisor? With public companies, the answer is simple. With a new or small franchisor, the answer is usually not often, because the franchise and securities offering are separate. Crowdfunding offers franchisors the opportunity to consider paired or "paperclip" offerings, where the prospective franchisee is also offered the opportunity to invest in the franchisor's equity.7

Existing franchisees who are successful and committed to the success of the franchise concept offer another readily available pool of potential investors. The FDD Item 20 information about franchisee contact information is a potentially useful tool for a crowdfunding offering.8 The regular communications vehicles between franchisor and franchisee offer the opportunity to promote the offering to a group of potential investors without the need for any public solicitation. That communication pipeline, together with the franchisor's extranet accessible only to franchisees with authorized access, could be a major benefit for the issuer-franchisor.

From a legal theory perspective, the legal duties, obligations and interests of the parties in a crowdfunded franchisor where franchisees are participating investors will need some further thought and guidance. The franchisor and its officers are not fiduciaries for its franchisees, but the officers are indeed fiduciaries for their franchisee-investors and the franchisor. Will a franchisee who is an investor be able to assert an aggressive position under the franchise agreement that can harm the franchisor without liability to co-investors? Defining these roles and the associated legal conduct standards will evolve as SEC enabling regulations permit crowdfunding to commence.

1.JOBS Act: Crowdfunding Summary, Practical Law Company (last visited Jun. 8, 2012).

2. See H.R. 3606 §§ 302(b), 304(a).

3. Benn Protess, Regulator Seeks Feedback on JOBS Act, (Apr. 11, 2012, 4:16 PM),

4. FTC Disclosure Requirements and Prohibitions Concerning Franchising, 16 C.F.R. § 436.5 (2012).

5. Compare H.R. 3606 § 302(b), with 16 C.F.R. § 436.5 (2012).

6. 16 C.F.R. § 436.5 (2012).

7. Franchisors would need to review and comply with state securities laws, often administered by the same regulatory authority as franchising in merit review registration states, before undertaking such an offering.

8. 16 C.F.R. § 436.5(t)(4) (requiring disclosure of "the names, and the address and telephone number of each of their outlets"). Franchise agreements routinely designate a legal notice contact for official notices, which is another source of the information.

Mr. Buckberg focuses his practice on representing franchisors and multi-unit franchisees in franchising, governance and other transactions. Ms. Jumper practices in the areas of corporate, securities and franchise law. This article originally appeared here.

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Franchisees who invest in publicly held companies should have a line of communications with the investors in their system that is uninterrupted by corporate management.

After forty years of successful growth the McDonald's restaurant system hit some potholes in the 1990s. Coincidentally we had just launched Franchise Equity Group and were in a position to monitor the trauma that the second generation of McDonald's managers were inflicting on the system.

After our efforts in the interests of McDonald's franchisees were mentioned in the major media we were contacted by Wall Street analysts and institutional investors. Working with these people was an extraordinary learning experience.

At that time McDonald's had been an NYSE listed company for over thirty years, had a market cap of over $30 Billion, and yet there was an stunning lack of knowledge among investors. Our discussions covered franchisee profitability, the results of an unrealistic growth program intended to impress investors, management's history, franchisee morale, and other basic topics.

Over these past fifteen years I've had the pleasure of assisting many investors in learning about not only McDonald's but the franchised industry in general.

Franchisees in publicly held brands should develop the philosophy that the corporate people (who are temporary employees) don't own the company.

The only significant investors in the brand are franchisees and shareholders - two entities that should be in constant communication.

FAQs About Franchisees Communicating With Investors.

1. Should franchisees attempt to influence the value of the corporate stock?

Absolutely not - If your brand is to be a good opportunity for franchisees it must be healthy at all levels. However, problems develop when management uses short term strategies that might help the share price but damage franchisees. Think about this activity as the education of investors for the long term health of the entire system

2. know my business intimately but don't know much about high finance and Wall Street?

Hey, join the club. I've rarely been asked about a stock price or P/E, ratios. The analysts want to know about commodity costs, minimum wage issues, management changes, remodeling programs, franchisee debt, etc.

3. How will corporate management feel about franchisees chatting with investors?

They won't like it but won't say much. This activity is most effective in those franchise systems where management controls 100% of the information about the franchised side of the business. In those cases they've told investors franchisees are supportive of management's initiatives and there is complete "alignment"between management and franchisees. Of course they want franchisees voiceless.

4. Will I be divulging proprietary information?

If you think you are walking around with a lot of proprietary information you should consider canceling that speech to the local Kiwanis Club. Discerning franchisees would never divulge information that would benefit their competitors.

5. Do Wall Street analysts care about my personal success as a franchisee?

Not so much - But they want to know if the corporate initiatives will be successful and if resistance to management's direction might retard corporate growth. As analysts they understand the franchise model must be a good investment but they
won't fuss over every franchisee's survival. Especially if all they hear is corporate's side of the story.

In summary, most publicly held franchised systems operate with a few corporate people strutting around like they own the brand while the real investors are franchisees and shareholders. In most cases management has been successful in building a towering wall between the true owners of the brand.

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QUESTION: I would like to protect my small business assets from those who might file frivolous lawsuits like slander, personal liability, etc. Is a LLC the best option to protect small business assets?

ANSWER: For most assets and businesses, a Limited Liability Company ("LLC") is your best option. Similar to other limited liability entities, so long as proper accounting and other formalities are followed, LLC's and Corporations both offer asset protection from Company creditors and judgment holders (i.e., inside creditors).

Unlike Corporations, however, LLC's also offers unparalleled asset protection from personal judgments and creditors (i.e., outside creditors).

So, if someone were to win a lawsuit against you personally, they could not take away the assets inside the LLC.

Setup properly, what the personal creditor would receive is a "charging order" against your Membership Interest.

A charging order does not give the creditor management rights over the LLC. At most, they would be entitled to any distributions made out of the LLC, if any.

It is strictly up to the LLC Manager whether or not to make distributions.

Let's say the LLC made $50,000 in profits and you (as the Manager) decided to keep it all in the LLC and reinvest it. In other words, no distributions were made.

The creditor holding the charging order cannot participate in management, and therefore, cannot force a distribution or liquidation of the LLC assets. In addition, there is a strong possibility if the charging order is foreclosed on, the creditor would owe the IRS income tax on any Company income. Ouch!

Because a properly setup LLC's prevents outside creditors from interfering with management,and limits a Member's creditor to a charging order remedy, when faced with a LLC, lawyers usually encourage their clients to settle their claim rather than face the uncertainty and waiting-game imposed by LLC charging orders.

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1. Myth: Banks are not making new business loans.

Reality: Banks are more selective in making a new loan or renewing a loan. Banks are risk adverse and thus the borrower must be better prepared to answer the questions the bank requires. We help businesses get start-up and expansion financing nationwide.

2. Myth: SBA loans are more difficult to get because of all their regulations.

Reality: Most banks like SBA guaranteed loans as it reduces their potential loan loss risk. If a bank makes a conventional loan its risk is 100%; however with an SBA loan guaranty that risk can be reduced to 25%.

3. Myth: It takes 6 months to get an SBA loan.

Reality: Only if you approach the bank without being properly prepared. If your business plan meets the bank's requirements; you have 25% to 30% of the total funds required of your own cash, you have a FICO credit score of 680+, you have related industry experience, your business plan answers the Who, What, When, Where and Why, and your monthly financial plan is realistic an SBA Preferred Lender can approve your loan in as little as 3 to 5 business days. If the bank is not a preferred lender they must submit the package to the SBA for approval and that can take 3 to 5 weeks. We help you prepare the business plan loan package the banks need to make a loan commitment and then we take it to a bank that's interested in making you the loan.

4. Myth: Using a software based business plan helps you create a good business plan.

Reality: Business plan programs have to be everything to everyone and thus they do not get you to focus on the critical questions a bank requires. Banks are not fazed by the razzle dazzle of fancy graphs and charts...they love cold hard facts.

5. Myth: The business banker was excited about my business plan and said the bank is anxious to make new business loans. Weeks later you receive a "sorry we cannot make the loan you requested"; what happened?

Reality: Often the business banker you first meet with is a business development officer -- think sales person. Their job is to take your business plan and perform a "light" review so they do a "new business report". They have no lending authority and your business plan goes to the bank's credit analyst for an in-depth review as to its feasibility. Banks compare your business plan financials to similar type businesses and if your plan is too optimistic or conservative it's rejected.

6. Myth: If one bank declines my loan request will all banks decline it?

Reality: Definitely not. If your business plan meets the bank's requirements; you have 25% to 30% of the total funds required of your own cash, you have a FICO credit score of 680+, you have related industry experience, your business plan answers the Who, What, When, Where and Why, and your monthly financial plan is realistic, a bank may still decline your loan. BUT they may decline your loan not because of your business but because they are risk adverse due to loan losses (won't do loans to startup businesses) or they have a large concentration of loans to your industry.

7. Myth: If you have a great business plan and it answers the Who, What, When, Where, and Why and you have the cash to invest, good credit and related industry experience, you still get funded.

Reality: Often it's because your lifestyle requires more income than your business can generate (especially if it's the first year of a startup business). If your current or last job provided you $100,000 of pretax income and your new business can at best provide $36,000 the first 2-3 years, where will the extra money come from to pay your lifestyle expenses?

8. Myth: Banks want you to have medical insurance.

Actually it's True: Why because if you or family members were to require health care and you did not have medical insurance, banks know that you would use the loan's working capital to pay the medical bills -- leaving the business not enough money to pay bills on time, buy inventory and marketing; a receipt for failure.

9. Myth: If you have 10% of the total funds required to open and operate your business and you have a solid business plan you will get funded.

Reality: Banks must minimize loan loss risk. Without 25% to 30% of your funds in the business the bank is effectively "buying" you a business. The bank would have nearly all of the risk and you would have all of the upside reward. The most the bank would get would be the interest if you were successful. Banks help you finance your loan but are not your equity partner!

10. Myth: SBA loans don't require collateral.

Reality: As a guideline the SBA only requires collateral on the loan if it's available. Banks are free to have more stringent requirements and most do. Most banks won't do an SBA loan without 25% to 75% of the loan collateralized. Conversely, most banks require conventional loans to be 100% to 150% collateralized depending on risk.

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Some franchisors are "pure play" restaurant, Dunkin Brands (DNKN), Burger King (BKW), and DineEquity (DIN). Sonic Drive In (SONC) and Domino's (DPZ), because they have more than 90% franchised units.

Each of these has moved towards or has always has been at a 100% franchised model for years, eg. (DINE, BKW).

Wall Street likes these storylines: "asset light", "capital light" and "franchisees are exposed to commodity risk, not the company" logic lines.

Lofty stock valuations follow, at least for many of them.

But these "stories" do raise some questions for investors:

(1) Who is then paying for expansion, or for commodities;

(2) If the company essentially franchised, how is the underlying health of the company being reported or analyzed?

Franchisors rarely talk about this, and on some earnings calls, there is not one question from the sell-side community on this (perhaps anticipating resistance from the company).

McDonald's (MCD) has made franchisee owner/operator cash flow (EBITDA) narrative in several recent calls, and DPZ did once.

In the past, what few questions asked by the sell-side revolved around:

(A) same store sales levels;

(B) stores opening or closing, or;

(C) franchisor bad debt expense from uncollected royalties.

While these factors are interesting, they only collaterally get at the true health of the system.

Here are six factors that could be asked by the sell-side community and reported by companies to improve investor disclosure:

(1) What is the store development pipeline (stores under franchise agreement that haven't been opened yet)?

(2) What is the 5 year historical miss of stores in the pipeline that don't get opened?

(3) How many franchisees are in default of their franchise agreements but still open?

(4) Is the franchisee operator expanding number of stores or not?

(5) What percentage of total franchisee operators are franchisee cash flow positive (store level EBITDA isn't the best number, but its something).

(6) How many franchisees are remodeling or current on their remodels?

These are all metrics that the franchisor has or should have, that could be reported either annually, or on a trailing twelve months basis.

Disclosure: When I originally wrote this almost 2.5 years ago this was true: "I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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Recently, we've been talking about the different types of buyers we work with and how the buyer market has changed during the past few years; some good and some "to be determined".

In this article, we talk about the private equity group (aka PEG) of buyers and what that means to sellers of smaller privately owned businesses like yours.

There's been a lot of news recently about PEGs, mostly in a political and tax related context (e.g., Mitt Romney's success as a partner with Bain Capital and the income tax rate he pays). We'll stay away from that. That's a whole other discussion!

What is a PEG?

They've been around since the 70s starting as larger, "mega" buyout firms (Bain, etc.)

They are investors who have private funds (a combination of personal funds and investor funds) to invest and are seeking alternative investment opportunities (i.e., privately owned businesses) where financial returns can "beat the market"

They buy companies across all industries and usually want a 100% ownership, or at least a majority ownership (51%) in the companies they buy.

They typically buy mature, established companies - not early-stage or startup businesses.

The goal of the PEG is to improve and grow the company with a goal to "exit" their investment in the next 5-10 years, at which time they return the gains to their investors and "close the fund".

What's this mean to you?

Here's the change that's going on. In the last 3 years, we've talked with numerous nationally based PEGs who are investing in smaller privately owned businesses. A typical investment opportunity is a company with:

  • gross revenues of $2-$20M
  • a stable management team
  • a growing industry and
  • an opportunity to either grow or combine a new opportunity with a similar business they already own.

Specifically, the PEGs we've talked to and met with are interested in businesses we represent in the following markets:

  • Health care services
  • Distribution
  • Food Service.

If you are considering selling your business, especially in one of these industries, we believe that, in the right circumstances, PEGs are a legitimate pool of potential buyers that should be considered.

As we've pointed out, the buyer pool is constantly changing and much more diverse than it was 3 years ago.

Today's business seller needs to be more aware than ever of how the pool is changing and what impact this has on potential sales opportunities.

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Last July 2014, Bloomberg Businessweek had a detailed cover story about Burger King's (NYSE:BKW) leadership.

It's not much of a useful analytical piece. The piece did not move the market, the Bloomberg editorial standard. Deep analytics must not sell anymore in our time-starved span of attention. The piece is Wall Street personality and issue focused.

Franchised Restaurant companies require a lot more investor due diligence, on both the equity and bond investor side, and on the franchisee side. And I want to talk about that.

First, franchisors don't release their franchisee financials results other than same store sales. 100% franchisors like DineEquity (NYSE:DIN), Burger King and Tim Hortons (NYSE:THI) don't release a single franchise operations number.

Popeyes (NASDAQ:PLKI) alone of the publicly traded group releases franchisee EBITDAR - EBITDA less rent.

Some limited clues may be possible from the 10Q/10K statements and the franchisors' Franchise Disclosure Document that details unit opens/closes.

The 10Qs/10Ks don't detail why units open or close, but the FDD broadly classifies closings into categories.

The same store sales metric is more visible.

But to focus in isolation as Businessweek tried (Burger King's same store sales exceeded McDonald's) is flawed: a .5% same store sales gain on a $2.7 million sales base yields a much more healthy picture than 2.0% on $1.0M store AUV base.

Actually, both comps and unit opens/closings need to be examined together, it's very possible to open a lot of stores but realize negative same store sales trends (Five Guys, Smashburger are best recent examples, experiencing both conditions).

Positive same store sales are nice, but are they profitable sales (might not be if discounting is involved) and are they high enough (restaurants need about 2% growth per year typically to cover inflation).

Bad debt expense, the value of franchise royalties not paid to the franchisor and eventually aged and reported, is also a poor, lagging metric. Once bad debt expense is posted, it's really late in the business cycle, the franchise model problem is very intense, the horse is out of the barn.

Franchisees don't talk much - they are afraid to and told not to, and are constrained from communicating via franchise agreements. More research and due diligence is needed. Consider the 3G Capital and Fortress experience, their astoundingly bad 2012 Quiznos investment ($350 million investor group loss and counting).

Getting franchisee EBITDA is great (it is possible, but you have to dig and hire the right people) but it's only half of the story. Restaurants are capital expenditure (CAPEX) intense and some measure of after tax, after debt service, after loan amortization economic gain or loss number is needed.

As usual, business analysis is not what you read on the cuff - it's not what you expect, it's what you inspect.

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When you're buying a franchise you probably need money - most buyers do - and numerous lenders are lining up, especially at franchise expos, to be of service. One option that buyers often overlook is leasing, and it's worth your time to check out the possibilities.

If you're investing in a franchise that includes equipment, such as a POS system, or ovens and appliances for the kitchen, or if you need a truck, such as a van, you may be better off leasing than borrowing. Leasing equipment is the equivalent of "renting" the equipment, which means that you won't take money from your working capital to buy the equipment.

With a lease, you get to use the equipment and pay monthly, and at the end of the lease you can acquire the equipment, or upgrade it and roll the package into another lease.

Here are eight reasons why you should consider a lease when you start a franchise:

1. Hold on to your working capital.

Cash on hand is a huge advantage.

2. Claim a tax benefit.

Section 179 of the U.S. Internal Revenue Service Code allows you to write off a percentage of a monthly lease payment.

3. FICO requirements are usually lower for leasing.

There's less risk with a lease so credit rating requirements may be lower.

4. There are no prepayment penalties.

If it turns out you've got extra cash on hand, pay off the lease without a penalty.

5. You can choose the term.

24 to 60 months. This helps you keep the payment amount in line with your cash flow.

6. If you're expanding your business by opening a second unit, you may be able to use the first business to guarantee the lease and not have to sign a personal guarantee.

7. Securing a lease may be faster than securing a loan.

Especially, if you're leasing an equipment package or a vehicle that's recommended by a franchisor. Leasing companies like franchise deals.

8. Closing costs are minimal.

Almost always less than $500.

There are few disadvantages to a lease.

Of course, you still need to provide personal financial information and provide a variety of documents to the lender, but this is all the easier when you're buying a franchise. Savvy franchisors develop relationships with leasing companies to expedite franchise sales and development.

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You'll find more information about franchise financing in my Amazon best-seller: 12 Amazing Franchise Opportunities for 2015. Chapter 2 is titled Funding Your Franchise Acquisition.

We had a client who was seriously considering buying a business & had to explore all financial avenues to complete the purchase. The client understood financing quite well.

To secure financing was quite complicated not only in light of the 7 figure purchase price but also because of the intricate structuring. We explored with him using his 401(k) monies to assist in the capitalization of his purchase.

Done properly, this transaction could be accomplished without penalties or taxes.

Both the client and his wife were CPAs. The more we taught them about about this structure the more they became intrigued and ultimately decided to include ROBS. The client compared us with another firm doing similar work.

And now, I want to toot our horn. Mine and the Walker Business Advisory, who I work with.

"I made contact with both firms and it was abundantly clear to me that after several conversations, Walker Business Advisory was hands down the better of the 2 firms. My questions were answered in a concise and clear fashion.

They had an in-depth knowledge of the structure, the laws and the process. They have a platform that is unique i.e. they shoulder all responsibility and liability for matters that relate to the plan. Their process is totally turnkey. There are two real important parts of their plan.

1. They have a Safe Harbor 401(k) with 15 different investment options and 5 asset allocations.

2. They are the fiduciaries and trustees of the plan.

All of this is can be accomplished for the same price as their competitors. If you take into consideration all that they do, they are dollar for dollar less expensive. I would like to thank Brian for introducing me to Fred Whitlock and Monty Walker. Fred was exceptional in explaining the product, service and process."

As previously referenced, my wife and I are CPAs and Monty, also a CPA, shed light on areas we were not familiar with and provided the solutions................nothing short of amazing!

Now it is great to have clients like this.

Why does that matter to you? Because if you are as smart as these two CPA's, you probably still don't know why is it important to design a plan with: a Safe Harbor and why being a fiduciary is necessary.

If you think that you need to know more, then just ask for more.

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Ever wondered how much it costs to own a McDonald's franchise. If you are interested, here are the details... direct from the McDonald's site:

Acquiring a Franchise

Most Owner/Operators enter the System by purchasing an existing restaurant, either from McDonald's or from a McDonald's Owner/Operator. A small number of new operators enter the System by purchasing a new restaurant.

The financial requirements vary depending on the method of acquisition.

Financial Requirements/Down Payment

An initial down payment is required when you purchase a new restaurant (40% of the total cost) or an existing restaurant (25% of the total cost). The down payment must come from non-borrowed personal resources, which include cash on hand; securities, bonds, and debentures; vested profit sharing (net of taxes); and business or real estate equity, exclusive of your personal residence.

Since the total cost varies from restaurant to restaurant, the minimum amount for a down payment will vary. Generally, we require a minimum of $750,000 of non-borrowed personal resources to consider you for a franchise. Individuals with additional funds may be better prepared for additional or multi-restaurant opportunities.


We require that the buyer pay a minimum of 25% cash as a down payment toward the purchase of a restaurant. The remaining balance of the purchase price may be financed for a period of no more than seven years. While McDonald's does not offer financing, McDonald's Owner/Operators enjoy the benefits of our established relationships with many national lending institutions. We believe our Owner/Operators enjoy the lowest lending rates in the industry.

Ongoing Fees

During the term of the franchise, you pay McDonald's the following fees:

  • Service fee: a monthly fee based upon the restaurant's sales performance (currently a service fee of 4.0% of monthly sales).
  • Rent: a monthly base rent or percentage rent that is a percentage of monthly sales.

Source: McDonald's Franchising

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  • Restaurants were said today to be a leading indicator of investment market power in 2015.
  • Five recognizable realities exist in the space that are both challenges and addressable opportunities.
  • Insufficient restaurant profit flow through rates, M&A upside and downside, dysfunctional early IPO valuations, franchisor overfishing and CAPEX measurement are issues.

The restaurant space slogged it out in 2014.

Finally, with meaningful wisps of economic recovery seen in Q4 and more disposable income running in the system, hope of discretionary spending is seen.

Several attractive IPOs, Habit (NASDAQ:HABT), and Zoe's (NYSE:ZOES) made it through the gauntlet and with more to come in 2015 (SHAK and others).

On January 5, Jim Cramer of CNBC said that domestic restaurants are key to the market performance in 2015. That sets a high bar.

Of course a reality gap exists between Wall Street wants and needs and Main Street corporate realities. The prism restaurants operate is not really seen by Mr. Market. Looking beyond the veil, restaurants are a tough business, talk to the departed CEOs of Darden (NYSE:DRI) and Bob Evan's (NASDAQ:BOBE) about that

There are several ongoing dynamic restaurant financial realities that underpin restaurant performance.

All are realities.

All are opportunities.

And, all can be fixed & are addressable.

1. Need to manage and improve restaurant profit flow through. Also known as PV ratios, we should not have been surprised to hear that the ten year US McDonald's (NYSE:MCD) average sales per unit (AUV) grew $770,000 but flow through grew by just $70,000, or 9%. Was it all those beverages that cannibalized food? A national survey just reported the McDonald's average consumer expenditure reported at $3.88 per person, which is shockingly low.

It's a broader restaurant issue however: For a client, I recently examined three QSR brands [McDonald's, Burger King (NYSE:QSR), Wendy's (NASDAQ:WEN)] and three casual dining brands [Denny's (NASDAQ:DENN), Bob Evans and Applebee' (NYSE:DIN)] that grew average store sales only $46,000 and unit EBITDAR by only $500 between 2009 and 2014, about a 2% flow through rate. Shockingly low sales gains, even worse flow through.

Both Chili's (NYSE:EAT) and Outback (NASDAQ:BLMN) added a boatload of new menu items at or under $10 to their menus in 2014, and Chili's added their signature fajitas to its 2 for $20 menu. This exasperates the flow through problem; let's hope additional upsell initiatives kick in to maintain the average check.

This is the result of hyper food inflation, and some labor cost inflation and a lot of discounting. The fix? Multi dimensions required. Start by not listening to the ad agencies to take the fast, cheapo way out and simply discount; get staff to upsell.

2. M&A is both a value enhancer and a destructor: Both good and bad M&A are in the background and the foreground. Bad M&A can be seen considering Darden and Bob Evans this year. Good: future possible spinoff BEF foods for $400M ($413 million value estimate by Miller Tabak). Its current EBITDA baseline is only a few million dollars. Spin it and give the money to shareholders.

Bad M&A: waiting so long to dump both Red Lobster and Mimi's . Interestingly, financial disclosure and visibility of both brands by their HOLDCOs was awful. Who really knew before Darden spilled the beans in 2014 that weekly customer counts were only 3000/week? That is unacceptable for investors. The fix: the sell side and shareholders should demand better disclosure. Vote with your feet.

3. Restaurant IPO valuations need a reality check. First year restaurant IPO valuation ratings need an asterisk. There is nothing fundamentally wrong with Noodles (NASDAQ:NDLS) other than their unsustainable claim to get to 2000 US units. It's a nice, differentiated concept. They will grow but not at Chipotle (NYSE:CMG) rates. Potbelly (NASDAQ:PBPB), El Pollo Loco (NASDAQ:LOCO) and Papa Murphy's (NASDAQ:FRSH) may grow if they can grow profitability beyond their geographical base. The Chipotle of 2015 is not the Chipotle of 2006. It can't be: The US is proportionately more overloaded with more restaurants during the Noodles 2013 IPO than CMG's 2006 IPO.

First year restaurant IPO price earnings ratios and Enterprise Value to EBITDA ratios need an asterisk because they may well fall later and resume upward momentum later after the post IPO equilibrium is found and real earnings and free cash flow growth is achieved.

Why does this matter? Growing restaurant brands that are over pressured by high valuations do stupid things. Good brands need to be given a chance to grow solidly.

4. Franchise overfishing, resulting subpar restaurant cash flows in the US: earlier in 2014, when fears of US restaurant wage increases were at its peak, several industry studies noted how low restaurant franchise EBITDA flow really was: 10 to 11%. The SS&G (now BDO) restaurant data survey in December just backed that up. For investors, franchisors, franchisees and anyone else: 11% EBITDA on a $1 million AUV base isn't high enough level to service debt, cover overhead and provide funds for maintenance and remodeling capital expenditures in the amounts needed.

The US is overfished, with too many franchise restaurants. One million restaurants in the US! Until the supply issue is addressed, franchise restaurants will chase the temporary +1 or +2 same store sales customer flow that migrates from one brand to another.

Franchisors need to take responsibility for their brand's future evolution. That they don't fully can be seen in the minimum wage debate. Franchisors, notably McDonald's, Burger King/Tim Horton's and Wendy's indicated that it was their franchisees that set the wages. While technically true, it is the franchisor that is the steward of the brand. If the wage goes to $20/hour, it is the responsibility of the franchisor brand to regenerate a store level model that works.

A place to start is to rightsize store physical plants smaller to get the CAPEX lower and to find ways to thin the system of weaker operators who want or need to exit. Closely associated with this is issue poor franchisor earnings disclosure: Sell side analysts covering Dine Equity have given up asking for meaningful information about the 100% franchised brands, and we noted one intrepid sell side analyst who was a journalist earlier could not pry the Burger King international new Russia and China sales levels. This was a pillar of their stated growth strategy and a metric that should be disclosed.

5. Restaurant free cash flow matters. For a client recently, I composed a 45 year snapshot of how sales components and building size has changed over the years. Guess what: while customer traffic (transactions) has declined, the building size has not come down.

The perception gap between the signal of the profit/loss statement and the other costs, and outlays that determines free cash flow is a material problem for an industry so CAPEX heavy. This same concern applies to the "asset light" franchisors, whose franchisees are the investors and have to make a return to be viable. This is not so complicated; performance appraisal systems at any level could be rejiggered to include CAPEX. You manage what you measure.

You need $50,000 for your business. You have several choices: merchant cash advance, lease or loan.

How much does each option cost you?

What would you want to pay for the use of $50,000? Here are the numbers: daily Advance payment of $445 daily, a lease payment of $1,062 monthly or a loan payment of $580 monthly? There's not much of a decision here.

Cash Flow is king.

A new SBA guaranteed bank loan program available to franchisees at 6-7% interest over 10 years and is less expensive with longer terms than equipment leasing for acquiring new equipment or fixtures or a MCA for either equipment or working capital.

The result is cheaper money.

In addition to this fresh money many franchisees will also qualify for re-writing older more expensive debt such as equipment leases, credit cards and merchant advances into lower cost and greater terms.

The loan is available to any franchisee that has been in business for over 2 years and meets reasonable credit criteria that most will meet.

By utilizing new online technology a franchisee may get pre-qualified in 5 minutes, pre-approved in 30-60 minutes and funded in as short as ten days.

Call me, Bob Shaw, at 734-929-3800 to discuss your options.

I have been fortunate to meet with over 3,000 businesses over the last ten years - from start-up restaurants with big dreams, to mature chains facing tough decisions. No matter what stage a company is in, payroll is constant; it is that big number that you have to hit 26 times a year.

These days, margins are getting pinched and cash flow is tighter.

Here a few reasons why using a service company may help you sleep better.

1. Peace of Mind - You are paying two important groups of people that frown upon mistakes - The IRS and your Employees. A service bureau takes full liability and responsibility for calculating, depositing, and filing all payroll taxes. If there is ever a payroll-related tax penalty or you get a love letter from the IRS, you are protected.

2. Back-up/Support - If you or your payroll clerk are out, sick, on vacation, etc. - you know you'll have an on-time, accurate payroll with no special arrangements. Also, by outsourcing, you're putting a tax and human resources expert on staff - protecting you from a broke government and a litigious society.

3. Cash Flow - By ACHing the funds for you directly to the IRS, you spread out your tax payments equally throughout the year. No surprises at quarter or year-end.

4. Time - Printing and signing checks, making multiple tax deposits, filing quarterlies, accurately preparing W-2's and other time-eaters. All non-revenue producing tasks - tangible hours that can instead go toward growing your business.

5. Other Features - Once the payroll engine is in place, you open up possibilities for direct deposit, time and attendance/POS integration, human resources assistance, pay-as-you-go workers compensation, archived electronic reports and pay-stubs and much more.

In the end, not only can you focus on what you do best, you can shift energy toward learning and embracing new revenue-producing tools such as social media, that brings money in, so you're ready for when it's time to send it back out.

When a C-corporation sells an asset and the corporation's owner goes to work for the buyer, there may be an incentive for the parties to pay the owner a higher salary than the market will bear, as disguised payments for the asset. That's because the purchaser can currently deduct salary, but must capitalize any purchase payments.

At the same time, there may be a trap: if the payments are found to be in substance purchase payments to the selling C-corporation, the payments will face double taxation, once at the corporate level and again upon distribution as dividends.

In H&M, Inc. v. Commissioner, T.C. Memo 2012-290 (October 15, 2012), H&M, Inc. agreed to sell its insurance business to a local bank and competitor. Under the purchase agreement, H&M agreed to sell "all files, customer lists, insurance agency or brokerage contracts, the name of [the insurance business], and all the goodwill of [the insurance business]" for $20,000.

The deal was contingent upon the agreement by H&M's owner - Mr. Schmeets - to work for the buyer for six-years and also enter into a covenant not-to-compete for a period of 15 years. Under these latter agreements, Schmeets would receive over $600,000 during the six years. The agreement was later modified, so that some of the compensation would be deferred, would earn interest, and would be payable to Schmeets' estate in the event that Schmeets died.

The Court found that there had been no appraisal of H&M's assets prior to entering into the agreement. In fact, the buyer didn't even examine H&M's financial records. In addition, prior to the sale, H&M had paid Schmeets a salary of about $29,000 per year.

The IRS argued that Schmeets' wages were actually disguised payments to H&M for the sale of the business and urged the Court to apply the "substance-over-form doctrine" to recharacterize the transaction.

While lamenting the parties' failure to adequately document the transaction, the Tax Court rejected the IRS' position. To demonstrate that the business was worth more than $20,000, the IRS would need to show that the assets were undervalued. But the only intangible that the IRS pointed to as being undervalued was the goodwill of the business.

Generally, there is no salable goodwill where the business depends upon the personal relationships of a key individual, unless there is an agreement that prevents that individual from taking his relationships, reputation and skills elsewhere.

Here, "there was convincing testimony that . . . . no one knew insurance better than Schmeets." Furthermore, Schmeets had no agreement with H&M (of which he was the sole owner, incidentally) that would have prevented him from going to work elsewhere. Thus, the business' goodwill had no value.

The Court also gave "no weight" to the opinion of the IRS' expert, who opined that Schmeets' new salary was excessive, since the expert ignored Schmeets' particular skills and level of experience.

Finally, the Court noted that, in negotiating the sale and related agreements, there was "virtually no discussion" about the tax consequences of the transaction.

The employment relationship was motivated by Schmeets' desire for guaranteed employment and the buyer's desire to harness his skills, not for "massaging the paperwork for its tax consequences."

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In the franchise finance world, the most discussed number is the EBITDA--EBBADABADOO as some call it. EBITDA is earnings before interest, taxes, depreciation and amortization. It is really a sub-total to the income statement. It is earnings without any charges for cost of funds, taxes or capital spending.

EBITDA's use began popularized as a credit metric, used in the 1980s M&A and credit analysis world--to test for adequacy of debt coverage. EBITDA is often the common denominator to track and report company buyout values:  the acquisition enterprise value to EBITDA ratio is a very commonly reported metric. So much so that that's where the focus goes. And its use as a simple business valuation tool: the company is worth some multiple of EBITDA; the higher the multiple, the higher the price, and vice versa.

In the franchising space, where franchisors might report a simple EBITDA payback for an investment, or report EBITDA value in their franchise disclosure document item 19 section. The special problem there is this EBITDA is stated in terms of the restaurant level profit only--before overhead. Really, the problem is this: EBITDA doesn't show the whole picture. It is a sub-total. It doesn't show full costing.

EBITDA alone as the metric misses at least eight costs and expenses, that are vital to know, calculate and consider in operating and valuing the business as a cash and value producer.  Using a business segment such as a store, restaurant or hotel as an example, here are the eight required reductions to EBITDA that must be subtracted, listed in order of magnitude of the cash outlay, to really get to operating economic profit.

  1. Interest expense:  the cost of the debt must be calculated. Interest is amount borrowed times the interest rate times the number of years. One can have rising EBITDA but still go broke.
  2. Principal repayment:  the business cash flow itself should contribute to the ability to pay back the principal debt. That often is in a 5 or 7 year maturity note and is another very large cost that must be considered.
  3. Future year's major renovation/remodeling: once the storefront is built, it has to be renewed and refreshed in a regular cycle, often every 5-10 years, via capital expenditures (CAPEX). That often is 10-30% of the total initial investment, or more, over time.
  4. Taxes, both state and federal: Financial analysis often is done on a pre-tax basis as there are so many complicating factors. But the reality is the marginal tax rate is about 40%.
  5. New technology and business mandates: aside from the existing storefront that must be maintained, new technology, and new business innovation CAPEX must be funded to remain competitive. Example: new POS systems for restaurants, new technology for hotels.
  6. Overhead: if the EBITDA value is stated in terms of a business sub-component, like a store, or restaurant or hotel, some level of overhead contribution must be covered by the EBITDA actually generated. Generally, there are no cash registers in the back office, and it is a cost center.
  7. Maintenance CAPEX: for customer facing businesses (retailers, restaurants, hotels, especially) some renovation of the customer and storefronts must occur every year and does not appear in the EBITDA calculations.  New carpets, broken windows, you get the idea. In the restaurant space, a good number might be 2% of sales.
  8. And finally, new expansion must be covered by the EBITDA generation, to some level. New store development is often a requirement in franchise agreements, and new market development necessary. While new funds can be borrowed or inserted, the existing business must generate some new money for the expansion.

You might say...these other costs and expenses are common sense, they should show up in the detailed cash flow models that should be constructed. Or they can be pro-rata allocated. But how times does this really happen? The EBITDA metric becomes like the book title....or the bumper sticker that gets placed on the car. You really do have to read further or look under the hood. And the saying is true...whatever you think you see in need more.

Two weeks ago, McDonald's (MCD) announced it planned to refranchise up to 1500 units out of Europe and Asia Pacific, and announced a series of increased dividends and share buy back plans.  In 2013, Wendy's (WEN) announced refranchising of 450 units in its non core markets.

In 2012, Burger King (BKW) and Jack in the Box (JACK) kicked into serious refranchising, so much so that Burger King (BKW) now only owns and operates the 52 units in Miami out of a 13,667 worldwide unit total. 

Even Starbucks (SBUX) is finally franchising its flagship Starbucks brand, refranchising units in the UK and Ireland.  YUM has been furiously refranchising since the mid 2000s but intends to keep China Company operated.

Franchising has a high percentage margin--McDonald's has an 83% worldwide franchisee operations margin, and is among the highest. YUM's David Novak seems to confirm that when he says "we love franchising--it's the highest possible margin business we can be in. "

The debate in restaurant circles about the proper mix of company and franchised units has been legendary.  In the 1970s and 1980s, the trend was towards company owned locations.  In the 1990s, as return on invested capital (ROIC) and awareness of  free cash flow--profit less capital expenditures-- expanded, refranchising picked up.

See GE Capital's presentation slide below, from a presentation Managing Director Todd Jones gave last week, which has some telling comments on this topic:  

GE Capital.png


Refranchsing means the company thinks it can make more on the royalties, and on rent surcharges (if it owns the real estate) and by reducing G&A and capital expenditures (CAPEX), versus operating the unit.

In my view, most times, refranchising involves weaker profit stores, lower than a magic profitability toggle point and typically involves weaker brands or weaker geographies in a brand.

Therefore, investors may like it, especially in the short term. But who is it good for?   

Benefits of refranchising

  • Refranchising can be a stock catalyst, that is, it is some corporate new news, particularly if it funds increased dividends or buybacks, or if it is associated with more debt that can fund dividends or buybacks, that juices the stock. That what McDonalds is doing.
  • Optical improvement of the numbers:  refranchising takes the lower units out of the base, and optically makes restaurant sales and margins improve, as both Wendy's and Jack in the Box have noted.
  • Refranchising should lower debt, to allow for special dividends or to improve credit ratings, to ultimately lower interest expense.
  • Wall Street hopes refranchising will smooth out earnings variability and will shelter the franchisor from food cost and labor inflationary forces.
  • Boost Return on Invested Capital (ROIC) metric: with unit sale proceeds and capital investment falling lower or to near zero, it provides a bump to ROIC, at least in the short term.
  • It can help out franchisees, as large franchisees have a need to get larger. This was the case in the 2013 Wendy's refranchising.
  • And, in some cases, if the company can't operate stores well, refranchising is a type of outsourcing  of the problems, to others.  Both YUM (KFC) and Burger King (BKW) have admitted franchisees operate more efficiently.

Limitations with refranchising

  • Over time, the ultimate risk is the company becomes an outsourced restaurant provider--no expertise in running restaurants.
  • Adaptability/flexibility hampered: franchised concepts take longer to get new products to market and keep the physical plant remodeled and renewed. In the US, Starbucks will always have an advantage over McDonalds as it can make decisions and implement market change quickly, while in McDonalds case it takes years to attain buy in and effect market change. 
  • Franchisees live a narrower existence. They do have to pay a royalty and are generally territory constrained. In addition, the availability of funds and cost of debt for franchisees typically are unfavorable versus that of the franchisor. This implies higher cost of debt and missed opportunities. Franchisees have higher debt to EBITDA ratios. For example, the McDonalds 2013 US franchisees debt /EBITDA ratio is app. 5.4 times, versus about 1.4 times at MCD corporate.  Higher debt=higher risk=higher cost.
  • As the franchised ratio increases, investors get less visibility. Restaurant franchisors universally avoid talking franchisee performance. Currently, Popeye's (PLKI)   is the only publicly traded chain restaurant franchisor reporting its franchisee's profits quarterly--a EBITDAR number, which isn't perfect, but that  is something.
  • Decreased company structure. Good franchisors run their company units as a training and development ground for franchisees. If the company store base is deteriorated or nonexistent, quality development staffing comes at risk.
  • Once the refranchising is done, that arrow is no longer in the quiver. What next?  

The Bottom Line

Business is business. Every number and signal needs to be scrutinized. Refranchising is both a bullish and bearish indicator at the same time. It is not a panacea.  

Ironically, in reaction to the McDonald's plans last week, Wall Street was not happy. They hoped for more catalysts to juice the stock higher.  

Kudos once again go to Popeye's Louisiana Kitchen Inc. (PLKI) not only for a good Quarter One 2014 earnings results reported just last evening, but also for continuing the practice of being the only publicly traded restaurant franchisor that I'm aware of that reports its franchisees cash flow proxy number.

Popeye's reports franchisee EBITDAR--earnings before interest, taxes, depreciation and rent. 

It's only a semi useful metric, as it misses rent and related expense, but also debt service and capital expenditures (CAPEX). Depreciation expense is an inperfect proxy for CAPEX.

In the first quarter of 2014, Popeyes franchisee community had an EBITDAR of 21.3%, compared to a 20.1% for the prior year. Franchisee same store sales were up 4.3%. Many more costs and expenses need to be subtracted to arrive at franchisee real economic gain, but at least it is some number.

Popeye's EBITDAR number is about 3.7% percentage points better than the GE Capital QSR survey sample published earlier this spring. Of course, you have to look at both dollars and percentages, per store to analyze fully.

Other franchisors do not want to talk about franchisee numbers. They don't have them, or the numbers are not good. Sometimes, franchisors are afraid and don't want to know them. But in any case, they should have them or should care.

Compare the Popeye's treatment to that of an article published by The Street's Laurie Kulikowski last week timed for Small  Business Week. 

Titled "Looking for an Investment-- Here are Eight of the  Best Franchises". The Street collaborated with a franchise survey group that surveys franchisee satisfaction. 

Not a single point of "return on investment" data or quantification was listed, despite that the survey had a "financial return satisfaction metric".

Satisfaction is nice, but what about making money? Not a useful article.

Sloppy staff work perhaps. But the franchisor should have the numbers. You manage what you measure.

Or, as my first boss in QSR operations drilled: "It's not what you expect, it's what you inspect."


  • Activists shouldn't have been surprised by the Red Lobster sale to private equity.

  • Darden missed opportunities over time.

  • Some Red Lobster levers for improvement exist.

To any close observer of the ongoing Darden (DRI) conflict as it has unfolded with its opponent activists Barington, and Starboard since late 2013, a Red Lobster sale to private equity was not a shocking outcome.

red lobster.jpeg


Private equity has dry powder--unallocated funds-- available that it must put to use to earn a fee.  Golden Gate had owned three restaurant brands and continues to own one, California Pizza Kitchen.

Darden, which was in trouble since at least 2007 trying to hit a 15% EPS model with the mature Red Lobster and Olive Garden restaurant brands, bought a lot of restaurant concepts at high price in 2008-2013, and wound up with a lot of debt. As the rate of casual dining traffic decline fell after the Great Recession, (Darden noted the casual dining overall space traffic fell 18% versus the peak) and core earnings fell, it had both dividends and buyback demands going up at the same time. A true cash flow squeeze resulted.

Darden had remodeled the entire Red Lobster chain by 2013 and needed to get some money out of its investment. (Why it remodeled Red Lobster first versus Olive Garden is a fascinating question.)

Red Lobster had underlying real estate that could be levered to lower the effective Golden Gate purchase price.

The question, is what now to do with Red Lobster? What are the "Lobster Levers"?

On the positive side, the brand ratings are not weak. It ranks roughly in the middle of the pack via the 2014 Brand Keys Customer Loyalty index but near the top of the 2013 Q4 Goldman Sachs Brand Equity Survey. The downside is there are no other national seafood players to steal market share from. Bonefish (Bloomin Brands) (BLMN) is just growing and Joe's (Ignite Restaurant Group) (IRG) has built its own crab niche.

It's not going to work its way out of trouble with more $10 television advertising that it has been pounding way with this week. It's going to have rent to pay. Darden has noted Red Lobster's customer base indexes older and lower income than the most desirable casual dining peers; it's got 706 units in an overbuilt US restaurant space. Keeping the same units and doing the same thing won't solve anything.

But what it can do is the following:

Close some units. Now that it is private and protected from the intense investment community focus on every metric, it can examine its store base. Note that American Realty executed sale leasebacks on 500 of the 706 units. A number of units were excluded for a reason, some were leased, some undesirable to do so.

Red Lobster reached its unit count peak in the US in 1996, at 729 units. It then closed 75 stores over the next four years, to arrive at 654 units in 2000, to then slowly grow again until 2013. The natural US unit cap seems to be much smaller than 700. A privately held company can work this.

With a rather low 9% reported adjusted brand EBITDA, the law of large numbers is there must be a number of units that are in the lower profit quadrant that upon closure, could result in positive cannibalization, and will improve the overall brand average profile.

Test and rebrand. Maybe because it was part of the central heritage of Darden, other than remodeling or wood grilling, there has been no real new concept ideation for years. A self serve Red Lobster lunch platform and Red Lobster/Olive Garden combo stores were tested recently and were a total waste of time and money. Such poor quality tests are indicated of a big concept ideation problem. Too much seafood on the menu and a very low level of alcohol sales are indicative of the problems.

Work international. All of its peers are. Darden just began a brief foray into ex-Canada international and franchising in 2013. As late as 2013! Missing the international opportunity was a great strategic flaw. The US is filled up with restaurants. Can't Red Lobster work internationally, somewhere?

Work franchising, joint and limited partnerships. Darden's problems with franchising went all the way back to a failed franchised venture in the 1970s. Franchising is difficult, well funded and capitalized franchisees have to be found. Darden said they didn't have the expertise. But it can be found. A new management mindset embracing franchising has to be developed. It can work in casual/fine dining: Ruth Chris (RUTH) has had 50% of its stores franchised to solid players forever, and Cheesecake Factory (CAKE) is working franchising and joint venture partnerships to get its international growth jump started. The Cheesecake founder, restaurant operator, David Overton "got it", but not Darden.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Summary - 3 Points

  • Think beyond Darden's real estate to determine if long term value is present.

  • Both the activists and Darden provided incomplete analysis.

  • Restaurant level EBITDA is a poor metric; free cash flow metric is better.

Watching the ongoing war between the Barington and Starboard activists that have stalked the Darden (DRI) casual dining giant since late 2013 has been like watching a tennis game where the two players volley consistently in the air above each others heads. The value of Darden's real estate is the real objective and no one is making the points properly.

Imperative for Investors: Ask for more information. Think: do I want my bonus now or later? Does divesting real estate do anything to fix the fundamental issues at Darden? The real essence of the Darden real estate argument hasn't been laid out by either side well, and a lot of analytical foundation is missing. Look beyond the initial real estate splash to assess long term value.

Background: Darden Issues Over Time

Darden owns and operates eight casual and upper end fine dining brands. For years it was on a strict 15-20% EPS target. It didn't franchise and until very recently was only US and Canada focused. As the US filled up with restaurants, and as casual dining sales growth began to slow down for many reasons in 2006-2007, it struggled to extract enough pennies and free cash flow to both remodel and execute buybacks and a rich dividend payout.

In 2008, Darden executed a $1.4 billion buyout of RARE Hospitality-the operator of Long Horn and Capitol Grill. Two other pricey buyouts occurred later, the small Eddie Vs seafood house in 2011 ($59M) and Yard House in 2012, the small but growing brew house ($585M). The buyouts as a group were costly, at well over 11X EBITDA, with Eddie V's almost 25X EBITDA. In each case Darden promised operating and G&A savings. The problem is, as the activists pointed out, the G&A savings didn't happen. DRI remained focused on the US and didn't even begin franchising or international until 2013 via tiny baby steps. Darden GAAP earnings and free cash flow dollars both were down per their 10K display:

Darden was sued in 2009 for a SEC 10b5 claim of unreasonable earnings claims coming from the RARE acquisition, but the Orlando Federal Court dismissed the action in 2009; given the high bar to securities litigation initial motions in the era after the 1995 Litigation Reform Act.

Full disclosure: I worked a special investigation of Darden's earnings projections after the RARE acquisition and didn't see how then how the acquisition synergies were "reasonable".

Guess what happened.

We are now where we are.

Darden faced the circumstances of slowing casual dining sales and traffic-which Darden itself did not create, but tolerated-- this weakness was apparent in 2007, before the Great Recession-but also having remodeled Red Lobster, now remodeling Olive Garden and putting a load on CAPEX, building very costly new restaurants--$5-6 million per box, pressure to increase dividends and buybacks...and covering the interest from the RARE, Eddie Vs and Yard House purchases. Check out the following Barington slide:

DRI's stock performance lagged in 2012 and 2013.

Barington pounced and was right on some of its calls in its introductory volley on December 17, 2013:

The Barington pitch was pretty logical until it got to two points:

· Spin off the so called high growth brands-Capital Grill, Seasons 52, Bahama Breeze, Yard House, Eddie V-the entire DRI Specialty restaurant group, and

· Spin off the owned restaurant real estate into a REIT or sell the underling land.

While they weren't operators (Barington had some experience with the now fading Lone Star Steakhouse and the Pep Boys auto oil change chain as investor), they could read balance sheets and saw the company owned a lot of store real estate. Owning real estate was a restaurant financing and development strategy. In the early days it provided a veneer of security for the bankers but it also provided for a great mode of control: there were no landlords to hassle with, no step rent increases in the outyears or costly lease terminations should a site have to be closed. Working restaurant litigation matters as a one element of my consulting practice, I can testify that among the most common are real estate disputes.

Analytical Problems

In conference calls, Darden said that its Specialty Restaurant Group was profitable and could stand on its own. That was a bad admission, because almost certainly, that profit basis was an EBITDA value and not a free cash flow basis, which would have covered the CAPEX and debt service cost to build $5 million boxes. Restaurants don't highlight that metric.

Barington and Starboard have endlessly speculated on what a Darden REIT could trade for. Of course, there are no restaurant REITS to provide comparables.

See the following video from Howard Penny of Hedgeye, supporting Starboard and his super long call on Darden. Note that he touts the potential value of the REIT.

Starboard issued a 100 page "Darden Real Estate Primer". Despite all this, Barington and Starboard have failed to prepare analysis on the following key points:

1. What is the projected free cash flow profile for the outyears for a separated Olive garden/Red Lobster, and Specialty Restaurant Group?

2. What is a realistic REIT cash flow profile for some crappy real estate that Darden owns and needs to get out of? How much will Darden be liable in payments to the REIT?

It's not as simple as the Barington slide below, shows:

Restaurants and Real Estate

McDonald's (MCD) and Tim Horton's (THI) also are real estate centric, for the control and for the potential for real estate margin. Once the property is paid for, then it's practically a 100% profit flow through. As Jonathon Maze, Editor of the Restaurant Finance Monitor pointed out recently, "restaurant executives tend to take a longer view of real estate. It's a safety value; providing the company flexibility with options should things get bad."

The activists want short term gain, as does Wall Street generally. They tend to talk about "unlocking value". But over what time? Not many contemporary restaurant chains have such real estate intense balance sheets, as restaurant construction and land costs both rose in the 1990s-2000s.

The implication in their pitch is that because the real estate is owned and because DRI does not pay cash rent, that it is somehow "sheltering" or incentivizing its RL and OG underperformance. From my long corporate staff experience, the corporate staff members who drive this-don't understand these intricacies at all. See the Starboard slide:

Memo to Starboard: any EBITDA metric is a very poor metric to judge performance.


So the real estate can be sold and proceeds generated to generate a big one time dividend, or a first time restaurant REIT will make big news splash. Good for 2015 or 2016 or when this is pulled off. But two questions are raised:

(1) Will the decoupling of the real estate fix the problems at Darden?

(2) What will you, Darden, do for me tomorrow?

The answer to Question One is almost certainly not. In fact, losing control of the real estate to either a REIT or a landlord owner should make it more difficult to reposition either Red Lobster or Olive Garden. Population and retail/restaurant trade patterns shift in the US, and there are too many casual dining restaurants now. That is one of Red Lobsters and Olive Garden's realities that Darden failed to address. While the land has value forever, many restaurant sites have an effective peak economic life of 20-25 years.

In terms of Question Two, it seems not clear. The activists have failed to lay out future year cash flows with and without real estate rents, and with and without portfolio breakage. They are talking the REIT valuation in one hundred page detail, however. Wrong entity to think about. Can Darden really close stores and not be stuck with big lease make whole payments? Darden hasn't laid it out clear case either.

If it's a church or a dollar store that comes in to backfill some closed Darden sites (two of Darden's closed sites in Indianapolis are that), think about being disappointed, either in the REIT, or decreased cash flow from Darden's core business.

In the franchise finance world, the most discussed number is the EBITDA--EBBADABADOO as some call it.

EBITDA is earnings before interest, taxes, depreciation and amortization. It is really a sub-total to the income statement. It is earnings without any charges for cost of funds, taxes or capital spending.

EBITDA's use began popularized as a credit metric, used in the 1980s M&A and credit analysis world--to test for adequacy of debt coverage.

EBITDA is often the common denominator to track and report company buyout values:  the acquisition enterprise value to EBITDA ratio is a very commonly reported metric. So much so that that's where the focus goes.

And its use as a simple business valuation tool: the company is worth some multiple of EBITDA; the higher the multiple, the higher the price, and vice versa.

In the franchising space, where franchisors might report a simple EBITDA payback for an investment, or report EBITDA value in their franchise disclosure document item 19 section.

The special problem there is this EBITDA is stated in terms of the restaurant level profit only--before overhead.

Really, the problem is this: EBITDA doesn't show the whole picture. It is a sub-total. It doesn't show full costing.

EBITDA alone as the metric misses at least eight costs and expenses, that are vital to know, calculate and consider in operating and valuing the business as a cash and value producer.  

Using a business segment such as a store, restaurant or hotel as an example, here are the eight required reductions to EBITDA that must be subtracted, listed in order of magnitude of the cash outlay, to really get to operating economic profit.

  1. Interest expense:  the cost of the debt must be calculated. Interest is amount borrowed times the interest rate times the number of years. One can have rising EBITDA but still go broke.

  2. Principal repayment:  the business cash flow itself should contribute to the ability to pay back the principal debt. That often is in a 5 or 7 year maturity note and is another very large cost that must be considered.

  3. Future year's major renovation/remodeling: once the storefront is built, it has to be renewed and refreshed in a regular cycle, often every 5-10 years, via capital expenditures (CAPEX). That often is 10-30% of the total initial investment, or more, over time.

  4. Taxes, both state and federal: Financial analysis often is done on a pre-tax basis as there are so many complicating factors. But the reality is the marginal tax rate is about 40%.

  5. New technology and business mandates: aside from the existing storefront that must be maintained, new technology, and new business innovation CAPEX must be funded to remain competitive. Example: new POS systems for restaurants, new technology for hotels.

  6. Overhead: if the EBITDA value is stated in terms of a business sub-component, like a store, or restaurant or hotel, some level of overhead contribution must be covered by the EBITDA actually generated. Generally, there are no cash registers in the back office, and it is a cost center.

  7. Maintenance CAPEX: for customer facing businesses (retailers, restaurants, hotels, especially) some renovation of the customer and storefronts must occur every year and does not appear in the EBITDA calculations.  New carpets, broken windows, you get the idea. In the restaurant space, a good number might be 2% of sales.

  8. And finally, new expansion must be covered by the EBITDA generation, to some level. New store development is often a requirement in franchise agreements, and new market development necessary. While new funds can be borrowed or inserted, the existing business must generate some new money for the expansion.

You might say...these other costs and expenses are common sense, they should show up in the detailed cash flow models that should be constructed. Or they can be pro-rata allocated.

But how times does this really happen? The EBITDA metric becomes like the book title....or the bumper sticker that gets placed on the car. You really do have to read further or look under the hood.

And the saying is true...whatever you think you see in need more.

In the old days, Accountants could help you understand what happened during the past months and years but they could also help you understand your productive capacity--which is really about your future ability to continue to operate and produce revenues and profits.

This was possible because of an elegant solution to capital expenditures with a benefit beyond the current operating year. Instead of being expensed, these investments are capitalized on a balance sheet.

Over time the net effect of these tangible capital expenditures (adding new investment and subtracting depreciation) showed whether the company was continuing to invest in building and maintaining its factories, equipment and infrastructure.

With the shift that we so often talk about from the tangible to the intangible economy, this changed.

Intangible capital expenditure is largely treated as a current year expense even when it will have a benefit beyond the current operating year. No big deal, you may be saying.

But cumulatively, it's been a huge deal.

It's how the balance sheets of most American companies have gotten completely out of whack. Given the steady investment in intangibles over decades, today the average balance sheet explains just 20% of the company's corporate value.  

This is true for public franchisors, also.

We've gotten used to this issue and, as a consequence, the balance sheet is useful only for understanding current assets, current liabilities and equity. But there are no numbers for the intangible infrastructure, the intangible assets.

This means that it's nearly impossible to get a sense of the productive capacity of a company by looking at its balance sheet.

(And that there are few norms for talking about these assets outside the balance sheet short of, well, talking about them.

But as the Coloplast experiment shows (and our own experience tells us), talking about something and measuring it systematically are very different activities.

And, guess what? Narrative isn't nearly as effective as measurements.)

Why is this a problem? Because the future of your business depends on it.

You are like businesspeople in the industrial era who needed to know how much they could produce at what cost and what investment would be to add productive capacity and--here's the big one: how well the factory is working.

You need to answer the same questions for your intangible infrastructure. So what's a businessperson to do?

Learn to measure your intangibles.

Start with an inventory, build a working model of how they fit together and then measure them.


Are you a businessperson who wants to looks forward? We have open source tools to help you do much of this and we also offer a platform for easy measurement, all at

On July 25, 2013, Starbucks (SBUX) delivered a Q3 double beat and stellar worldwide comparable sales (comps) of +8% (+9% in the U.S.)

Some analysts were concerned about the SBUX Q4 forecast of a mid-single digit comp. The high comps were said to be a kind of spike. SBUX explained that mid single-digit comps were likely in Q4.

CEO Howard Schultz explained that it would be irresponsible for SBUX to forecast high comps if it believed they were not attainable and that SBUX business trends were very solid.

He sharply concluded:

Now having said that, our expectations of ourselves that we are going to deliver a healthy comp growth in Q4 that our investors will be proud of. Let's get off the comp number, because it's not the issue, issue is we are building a great extraordinary endeavoring company and the comps are going to follow that.

Were the sell-side analysts right to be concerned about Starbucks' comp "slowing up?" See the below Starbucks comps chart. 

Starbucks Comp.png

My opinion: perhaps.   Of course, the beginning of comps deceleration is an important investor signal and will first be seen on quarterly or monthly comps reporting.  Only McDonald's (MCD) reports monthly comps.

But there are other more important questions.

In the retail and restaurant space, comp sales from year to year are given way too much emphasis in reporting and analysis. It becomes the headline bumper sticker. The metric, which strips out newly opened or closed stores that are "immature," is a proxy for business cadence and optempo momentum, and sometimes a proxy for profit flow through.

But the analytical problem is the year-to-year comp is only so meaningful. What happened last year - the base for the comp - could have been impacted by many factors such as weather, calendar shift, competitive and marketing calendar shifts and so forth. It's certainly possible to have a great 10-year, five-year or two-year comp trend, but to have a flat or modest current quarter comp calculation.

In the future, we urge investors of all sorts - and analysts - to ask more meaningful questions about the comp trend.

After getting the comp results, and a customer traffic and average ticket breakout, here are 10 more meaningful questions:

1. Did the comp achieved meet your internal budget?

2. What is the comp on a two-year basis, a five-year basis?

3. What tradeoffs to get this comp?

4. What's the comp on a rolling 12 month or rolling two-year basis?

5. How much profit flows through to the store level from this comp?

6. How much is the flow through on a percentage of incremental sales basis?

7. What is the standard, or theoretical profit flow through?

8. Is the incremental flow through attained via higher cost percentage leverage?

9. How much does incremental store level profit flow through to the corporate bottom line?

10. How does this comp affect variable compensation payout accruals?

One question to consider is whether this is a monthly period, or how many weeks were included in this comp and the prior period? The hugely symbolic and massive market cap McDonald's for instance, is still reporting on a traditional monthly basis, which makes for calendar noise, which we discussed previously on SA.

In the restaurant space, there is an inordinate amount of short-term action to maximize the comp.

Better investor and sell-side questions will enable the company to explain its rationale, and send truer & better picture to the market.


When you need an authority on understanding public franchisors, connect with me on LinkedIn - or just give me a call.

In one of the best IPO results of the year, the first restaurant IPO of the year, Noodles (NDLS) raised almost $100M and stock price more than doubled from its initial pricing at $18 to close at $36.75 on its first day. The Noodles CEO, Kevin Reddy, came from Chipotle (CMG), at an earlier stop in life.

Is Noodles the new Chipotle?

Chipotle IPO'd in June 2006. They are both fast casual concepts, Colorado based, both early movers. And there are many fundamentals comparisons. See the table below, prepared from both the Noodles and the Chipotle SEC S-1s, for their last full fiscal year before IPO, which shows the key fundamentals drivers:

Nooeles IPO.png

Store economics look similar? Yes, in some ways:

· Fast casual operators, new buildings, new food types and popularized styles.

· Average Annual Restaurant Sales in the $1.2M to $1.4M range.

· Solid restaurant margins - Noodles now actually exceeded that of Chipotle in 2005 by 210 bpts.

· Totally or primarily company operated model.

Noodles' success demonstrates there is investor demand for new restaurant offerings and validates fast casual investor demand. I understand NDLS was twenty times oversubscribed. Catterton, Morgan Stanley and Cowen did a nice job.

The issue to keep in mind is the United States consumer space is not the same as it was in 2006.

Recession, fundamental changes in population, income, eating and dining preferences, commercial real estate site characteristics, and more U.S. restaurants in operation each year make for a more difficult 2013 and out conditions.

Noodles must deliver good quality, service, cleanliness and price/value, in a differentiated fashion, with good corporate stewardship and continue to build connections with guests, employees, investors and other stakeholders via its culture.

Mathematically, as it expands, it has to think a lot about occupancy costs. NDLS occupancy costs are now 9.9%. Chipotle's was 7.6% in 2005. Site supply is tight. Many legacy brands, the real first movers, like McDonald's and Dunkin' Brands (DNKN) got the early best U.S. sites.

Restaurants economics was built on 6-8% rent, but some restaurant operations are facing 15-20% rent for some sites. Too much push for too fast expansion will test the rent leverage especially for a $1.2 million sales concept.

The imputed IPO valuation from the NDLS IPO is already $800M, or an EV/EBITDA multiple of 26.6X. That's rich. But it's just the first day. I hope the pressure cooker investment world will take a break and give them a chance to grow smartly.

Wouldn't it be great to spend more of your time on the fun stuff in your business? The work you are uniquely gifted to do? The work that can help you increase sales, improve profitability, and grow your business into your dream of success and pride?

That's one of the key challenges we all face running a business.

We have to carve out enough time to focus on the things that matter most. We have to figure out how to focus on the things that will really move the success needle... the things that only we can do to create exciting results and dramatic improvement.

One of the obstacles in your way is the struggle... and the doubt... and the hesitancy that sets in when you are worried about your cash flow. It's a HUGE distraction.

The interesting thing I have noticed in my 28 years as an accountant and CPA is that much of that worry and struggle results from a lack of understanding about your cash flow. It's not necessarily a real cash problem.

It's that uneasy, "wake up in the middle of the night in a cold sweat", kind of feeling that is rooted in not understanding what happened to your cash last month. And not knowing how to quickly, and easily, take control of your cash flow.

There's a good chance you are in the worried category if you can't pass what I like to call The Spouse Test.

What if your spouse asked you "Honey, I noticed the business had $75,000 at the beginning of the month but only $45,000 at the end of the month. What happened to the cash?"

Your ability to answer that simple question tells you whether you understand your cash flow or not.

Profit or Loss Does Not Equal Cash Flow - I'll Prove It

Do this quick test to see if you can pass The Spouse Test.

  1. Grab your income statement (Profit & Loss statement - your P&L) for a recent month and look at your net income number (your profit or loss). Write that number down.
  2. Then calculate the change in your cash balance for the same month (by looking at the cash balance on your balance sheet as compared to the prior month). Write that number down.
  3. Now compare the two numbers. (I can 100% guarantee you the two numbers are different. Why? Because profit or loss DOES NOT equal cash flow.)

Now explain to your spouse what happened to the cash for the month. Explain what caused the cash balance to go up (or down).

As an example, let's say your profit last month was $23,000. And your cash balance went up by $12,000. When you can very quickly explain what happened to the cash to your spouse or business partner, you understand your cash flow. You know what's going on financially. Which means you can put financial management aside for a bit and focus your time and efforts where you can make an exciting difference in the business.

That's why understanding your cash flow is so important. So you know what's going on. So you know what to do to improve cash flow. And so you can skip past the struggle, the worry, and the doubt and go right to the high-payoff activities that only you can do in your business.

That's the ultimate reason to make sure you understand your cash flow each month.

I am doing a live webinar on June 11, 2013 that you are going to love.

  1. I'll show you how to understand your cash flow in less than 10 minutes, and
  2. I'll show you how to explain what happened to the cash in your business last month (to your spouse or business partner) in a 2-minute conversation

And this one is FREE.

Understanding your cash flow used to be a time-consuming, complicated, and frustrating task. Not anymore!

Click here to learn more.

Or Click here to register NOW.


When lender experiences a default for an SBA guaranteed loan, there are several considerations the lender must review.

If a borrower defaults within 18 months of initial disbursement (or, if the final disbursement was made more than 6 months after the initial disbursement and the borrower defaults within 18 months after the final disbursement), the SBA considers the loan an "early default".

The date of default is generally determined by the first uncured payment default of 60 days or more.

However, if a borrower, during the first 18 months, has significant problems making full principal and interest payments as scheduled or is granted a payment deferment of 3 months or more, the loan is considered an "early problem" loan.

Early default and early problem loans are subject to heightened scrutiny. There are two considerations a lender needs to review.

1. Under SBA regulations, a full denial of liability is justified if the loan involves an early default, or early problem and the lender failed to provide credible evidence that it verified the borrower's financial information by comparing it to relevant IRS tax return transcripts, as required by the version of SOP 50 10 in effect at the time the loan was approved.

2. Additionally, if there was an early default or early problem loan, the lender's failure to verify and properly document a material portion of an injection of cash or non-cash assets required by the Loan Authorization raises a rebuttable presumption that the default was caused by the lack of the injection and a full denial of liability is almost always justified.

However, in both cases, a full denial may not be justified, however, if the lender provides credible evidence that the business failure was due to factors unrelated to any financial difficulties that the lender could have identified through the IRS verification process or which were caused by the lack of equity.

To rebut the presumption, the lender must provide credible evidence that the primary cause of the default was something other than the lack of the required injection or information used in the repayment analysis, e.g., the death of an irreplaceable key employee or a natural disaster that destroyed the borrower's business premises and customer-base.

As a practical matter, the failure to adequately verify equity injection or obtain IRS tax transcripts is an automatic denial of the guaranty if the SBA considers the loan to be an early problem or early default loan.

However, there are some limited circumstances in which a lender may be able to rebut the above-described presumption.

For more information on SBA loan programs, please contact us.

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We sat down with Joe Caruso and discussed franchise lending loan amounts with Joe Caruso out of Balitmore.  We talked about the current deal making environment in franchising.

We focussed on deals about the $350,000 limit.  Are things getting better, we wondered?


Bob Coleman: We're talking with Joe Caruso on the Strategic Committee of the International Association of Franchisees and Dealerships out of Toronto, a trade-based organization. He's also the President of the Capital Area Franchise Association. Joe, welcome; tell us about franchise lending today. What's it look like for you and your peers?

Joe Caruso: Well, at the Capital Area Franchise Association, or CAFA, we just had Steve Caldeira from the IFA in January commenting on a variety of things in franchising, but one of the most important topics was the access to capital.

Bob: Is it getting easier?

Joe: Yes, it is absolutely getting easier and the lenders that I talk to on a regular basis are saying that as well. It's getting easier for those people borrowing greater than $350,000; that $350,000 or less loan amount is still a challenge. The thing I hear recurring from originators and lenders is it costs us just as much money to originate a $350,000 loan as it does to do a $3 million loan.

Bob: Absolutely.

Joe: And the quality of the borrower, they're more organized at higher levels; they're more sophisticated; it's just easier to get the deal done and it's more profitable.

Bob: Are you seeing that the deals that are being done - are they for second and third concepts, or can we still get financing for that start-up Franchisee who's just retired on out of Boeing?

Joe: The lenders are much more interested in seasoned operators who have existing operations that want to add to their portfolio, either with the brands that they already have, or they want to add an additional brand. There's no question about that, although a lender I spoke to this week is focused on, interestingly enough, Franchisors with less than 100 locations, but more than 25; and they are willing to do first time Franchisees. And the loan amounts are just above that 350 level; they're really in the $375,000 to $500,000 loan amounts; and they're focused on that. But they're more of a niche player, and more of a boutique firm.

Bob: Great. Joe Caruso out of Toronto; thank you very much for joining us and giving us an update.

The term "Factoring" has gotten a bad reputation in the world of small business credit over the years.

Many small business owners view it as financing of a "last resort" and worry about what their employees or customers will think about the longevity of the business once they learn their employer/supplier has entered into such a financing arrangement.

While business owners should be concerned about how their customers perceive their business, entering into a factoring arrangement is rarely the "red flag" that many fear it will be due to the fact that factoring has become a much more common means of providing a company with access to working capital. The odds are excellent many of your customers are RIGHT NOW paying many of their invoices to factoring companies in lieu of their suppliers who have taken advantage of this valuable financing tool.

Since access to credit for small business owners has contracted over the last several years, it has become more challenging for small businesses to obtain traditional credit lines. Many lenders reserve these facilities for only their "best" customers, which are often defined as those who have strong profits, increasing revenue trends and high balances on deposit.

Financing may still be available to these strong companies who also have "hard assets" to pledge as collateral. These are often defined as property, plant and equipment. In other words, if you own a business with good profits and stable revenue trends and have equity in a commercial building filled with valuable equipment, you may qualify for a small business loan. However, if a business owner operates out of rented space and provides a product or service which does not require much in the way of equipment, small business loans can be elusive.

Factoring can be a convenient alternative to businesses which cannot meet today's stringent criteria for small business loans but have a strong base of customers. Under most factoring arrangements, the factoring company ignores the financial condition of the client and strictly focuses on the credit quality of their customers.

If the customers are creditworthy, there is an strong likelihood a factor will be interested in "factoring" the accounts receivable. When factoring a receivable, a business sells the right to be paid by their customer to the factoring company in order to receive the bulk of the amount due (usually 75%) shortly after issuing the invoice, with the balance, less a factoring fee, remitted to the business once their customer makes payment to the factoring company.

Fees can range from 2% - 5% of the invoice amount for each 30 days an invoice is outstanding. In other words, if a customer typically pays their invoices in about 40 days, the business would take on average about a 3% discount on their invoices in exchange for the factoring company advancing 75% of the invoice amount shortly after it is issued.

Like any industry, there are also unscrupulous factoring companies out there. It is important to ask for references and to Google the name of the factoring company you select to see what, if any, complaints are out there. Many factoring companies are run by long-time veterans of the business and are often the best choice with which to develop a financing relationship.

While many business owners fear what they do not understanding, the truth is that factoring can provide businesses which cannot yet qualify traditional bank financing with the working capital bridge they need until they can meet the standards for traditional business credit lines.

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Chris Lehnes is a 20 year veteran of the small business lending industry. He has held positions in commercial loan documentation, credit analysis, operations management and business development at one of the country's largest small business lenders. Currently, Chris is a Business Development Officer at Versant Funding where he provides non-recourse factoring to businesses in a wide variety of industries with annual revenue from $1 - $50 Million. You can reach Chris at 203-493-1663, [email protected], or

The restaurant space will be interesting in 2013. Sales issues, cost issues, expansion issues, franchisee issues. There are still too many restaurants in the US and x-US markets sales increases have slowed. The two industry leaders, McDonald's (MCD) and Darden (DRI), are both somewhat in the penalty box and under pressure. Here are our thoughts on 2013 issues and opportunities.

Comps Cliff Coming: In looking at 2013, it is likely restaurants will get off to a bad start. In Q4 and Q1 2013, the restaurant space will fall off a cliff of sorts: the comps bulge generated last winter. Driven then both by warmer weather, price increases, a bit lower sales of discounted items and the peak of the 2010-2011 restaurant recovery, the January-March 2012 number will be hard to beat.

The following chains will likely have the hardest sales comp comparisons in Q1. Every single chain had lower comps most recently reported than the Q1 peak, versus the most recent quarter or monthly update:

Company/symbol FY 2012, Latest Trend 2012 Q1 Jan-March Comp
McDonald's +2.4% +7.3%
Starbucks +7.0% +9.0%
YUM (YUM(1) -6.0% +14.0%
Jack in Box (JACK) +3.1% +5.6%
Chipotle, (CMG) +4.8% +12.7%
Texas Roadhouse (TXRH) +3.6% +5.8%
Blooming Brands (BLMN) +3.6% +5.3%
Buffalo Wild Wings (BWLD) +6.0% +9.1%
Panera (PNRA) +5.8% +7.7%

(1) China Division only

More sales news. Traffic throughout the sector has eroded since fall 2012. In the QSR space generally, traffic now is very marginally positive and average check is 2-3% favorable, but in the overall casual dining space, traffic is negative and totally offsets about a 2.5% check increase. A few positive standouts exist, however: Texas Roadhous ,Panera, Starbucks (SBUXand Popeye's (AFCE).

One question is why was investor disclose so poor at YUM? The China same store sales trend is so stunningly negative - large sequential decreases from +19% in FY-11 to -6% just noted this week for Q4 2012, perhaps the largest decline anywhere over such a short time.

Extreme discounting is the newest news but is really an old story. The current price spectrum of restaurant TV ads runs from $.99 grillers at Taco Bell to $11.99 thirty piece shrimp at Red Lobster. This does not portend positive for the average check. The comps cliff has affected marketing strategies everywhere via low price marketing.

Earnings standouts: Texas RoadhousePanera, Starbucks and Popeye's were Q3 (and Q2) positive standouts: positive sales and traffic, sales and earnings beat $.01 or more over estimate. Does prior performance guarantee future results?

Dividends are the goal. Dividends will be important in a low growth, low return world. The US restaurant market is way overdeveloped and worldwide development takes time and proper store level economics. We will be glad to see companies like Dunkin Brands (DNKN,1.80% yield), Burger King (BKW,.90% yield), and Blooming Brands (BLMN, zero yield) finally work their way out of private equity positions so that more substantial dividends can be paid. THI, another pure play 100% "capital light" franchisor, is also low at 1.70%. That there are two coffee sector players in this group is interesting. Lower coffee commodity costs advantage will accrue to the franchisees, not the corporate entities.

Some IPOs and M&A will happen. We still wonder when Noodles will be ready for its IPO. Fast casual is "hot." Another fast casual brand, Pei Wei, could be a candidate once its lower newer unit open sales problem is fixed. Jamba (JMBA) seems to be of value for those strategic buyers who need an established beverage platform.

It was clear from the 2012 SBUX and DRI transactions that the path to a rich M&A valuation is to develop a unique but mainstream product that well-heeled restaurant majors can buy for entry at rich multiples. There will be continued private equity churn, they always have fresh powder to deploy. The wave of 2006-2008 PE acquisitions will soon come due to sell.

Several Turn Arounds should be watched. Interesting that the two worldwide restaurant leaders, MCD and DRI, are both challenged. No surprise that MCD went into a new product new news tempo decline as it changed CEOs in 2012. New products news yields sales.

It will be fascinating to watch Darden work out of its current tight cash position caused by lagging big brands and resulting profit shortfall, big remodeling capital expenditure (CAPEX) requirements and now debt service for its 2012 acquisitions. Of necessity, they will look for another acquisition in 2014, once its free cash flow position improves. We wonder if BKW has the worldwide AUV sales base potential anywhere except Latin America for franchisees to expand profitably.

Restaurants must more creatively test revenue and expense solutions: Restaurants can offset negative cost pressure and difficult comps pressure by looking at revenue increases beyond price increases and cost reductions beyond food portion cuts and labor hour savings. Unique store level pricing tiers and dual wage tiers to offset Obamacare are but two examples. The industry needs to test aggressively new ideas.

Defrancising v. Refranchising company strategy divergence will continue. Those who can operate restaurants well will continue to do so, those who cannot will refranchise. Panera, Texas Roadhouse and Qdoba are building new units, converting franchisees to company operation.

Franchisors still need to improve investor reporting and franchisee disclosure if they hope the franchising "capital light" business model will be sustained. How can DineEquity (DIN), now 100% franchised, be properly analyzed if there is no franchisee profitability reporting?

Is there room for optimism? Yes. Commodity cost forecasts have come in at the low end of forecasts. Some restaurants, such as Sonic (SONC), have finally sorted out their marketing focus.

Investor Recommendations. Look for a rough first half. Be ready for and go light or short the nine companies noted above that will have a negative same store sales cliff In Q1. Restaurant space investor attractiveness will be better second half 2013. Look for potential dividend upside effects at BKW, BLMN and DNKN late in 2013. DRI likely must cut its dividend so react light/short accordingly.

If you're considering funding a startup or franchise, then you may already be ready for the huge gamble of turning a 401(k) into capital investment for a business: potentially losing the retirement account altogether. But are you committed?

The method described above -- called a Rollover as Business Startup (ROBS) -- injects capital into a business from your 401(k) account. Part of the Employee Retirement Income Security Act of 1974 (ERISA), the ROBS has been popular for years.


The potential payoff is tantalizing, which is why so many aspiring entrepreneurs are willing to put all their chips on the table. Unfortunately, few realize just how difficult it is claw those chips back if they're dealt a bad hand.

A mishandled ROBS is fraught with tax pitfalls. What's more, the mere act of initiating a ROBS may draw unwanted attention: this type of capital investment is immediately suspicious in the eyes of the IRS. And then you remember that it's your retirement you're betting.

That retirement risk brought a longtime business client of mine to my door seeking help to unwind his ROBS. After struggling with the ROBS' administrative hassle (which is often underestimated), the reality that his entire financial future was dependent on a new business in a sputtering economy was just too much.

If you're feeling the heat from a ROBS that you might want to unwind, remember that our door is always open. We'll talk you through the issues and get you where you want to go. If you're not sure, call us anyway and we'll connect you to one of the clients who we've helped out of this ERISA nightmare. They'll show you the path down from the cliff.

Before signing off, I'll leave you with some background on the ROBS, pulled from a 2009 small business guide that my clients have found helpful.

Let's start with ROBS 101

ROBS: For the investor in need of a green thumb.

ROBS plans are touted by business brokers and franchise sellers all over the Internet and arranged by investment firms specializing in capital investment.

ROBS firms charge a fee to walk clients through the process of creating a C corporation. The new corporation starts its own 401(k) plan or profit sharing plan, which must offer employees the option to purchase stock in the company. The new business owner then rolls over funds from an existing 401(k) into the newly created corporation's plan.

Because the assets are moved from one tax-exempt vehicle to another, business owners avoid taxes and penalties.

The sole participant in the plan (e.g., the owner of a new company) can then direct the investment of the 401(k) account balance into a purchase of employer stock in the new corporation. The transferred funds are used to either purchase a franchise or fund the new business -- essentially creating tax-free working capital.

But is it too good to be true?

A ROBS may be legal, but it operates in a grey area of IRS codes and regulations. To keep a ROBS transaction legal, the business owner must heed a slew of IRS regulations and avoid making certain prohibited transactions. The penalties for not complying with the rules are staggering.

For example, if the IRS determines the deal is a prohibited transaction, it can trigger excise taxes. If you run afoul of these prohibited transactions, you can run up 110 percent -- or more -- in penalties.

ROBS deals must be done very carefully and no two cases are exactly the same. This is not something to try with internet software or any law firm that simply "prepares documents at your specific direction," as they say. You want an attorney who is well-versed in ERISA law before venturing into any ROBS deals.

It can also become expensive money. Clients who have used these usually need to hire a "plan administrator", someone to be sure that all I's are dotted and T's crossed. That is an ongoing fee. It also could complicate recruitment of new talent. Anyone added to the payroll has to be given the right to access to the profit sharing plan. Remember: it was funded with your money.

So what does the IRS think?

A memo issued by the IRS on Oct. 1, 2008, appears to cast a chill on the ROBS strategy. The 13-page memo concludes that:

"ROBS transactions may violate the law in several regards. First this scheme might create a prohibited transaction between the plan and its sponsor. . . . Additionally this scheme may not satisfy the benefits, rights and features requirement of the Regulations. . . . For this reason employee plans specialists are directed to open ROBS cases as described herein."

The IRS looks closely at each case for different things, such as to make sure companies that use ROBS funding offer stock ownership to all employees of the business. Failure for that to happen would violate nondiscrimination rules.

Another red flag is when the rollover amount equals the business' stock value. Such math, in the view of the IRS, usually indicates the rollover's intent is to be used as business seed money only, rather than to be used as a bona fide employee retirement vehicle.

ROBS proponents insist that rollovers performed by reputable companies operate under IRS guidelines and will not raise agency suspicions. In any case, ROBS is not a strategy to be taken lightly. It requires careful thought and scrutiny because you're putting your retirement plan at risk. It also takes work to get out.

As always, good luck, good hunting and call us if you need us.

Many communities are still feeling the effects of Superstorm Sandy, including power outages and flooding.

The importance of listening to instructions and safety information from your local officials and FEMA cannot be understated.

Federal response teams are already providing assistance to affected communities. SBA is closely coordinating with our federal partners to share information in the immediate aftermath of the storm.

For the latest on the Federal government's response to Sandy, you can read FEMA's blog or follow updates on Twitter.

If you need emergency shelter, you can download the Red Cross Hurricane app, visit the Red Cross web site, or check your local media outlets.

You should also register on the Red Cross Safe and Well website, a secure and easy-to-use online tool that helps families connect during emergencies.

Finally, you can download the FEMA smartphone app or text SHELTER and your Zip Code to 43362 (4FEMA). Standard rates apply

If you're not in an affected area, please consider donating blood, because numerous blood drives have been canceled as a result of the storm. To schedule a blood donation or for more information about giving blood or platelets, visit or call 1-800-RED CROSS (1-800-733-2767).

SBA plays an important role in disaster recovery efforts for businesses and homeowners.

As disaster assessments and declarations are made, various SBA disaster recovery loan programs become available to eligible applicants. We will continue to highlight these programs as communities turn to longer-term recovery efforts.

For more information about SBA's disaster assistance programs, visit or call our disaster assistance center at 1-800-659-2955.

Panera and 5 Others to Watch

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In watching the Q2 2012 restaurant space earnings, six brands interested us by exhibiting what we define as standout operating tempo-what we term OPTEMPO.

These six posted not only significant EPS beats of $.02 or more (meets or a penny over doesn't excite us much), but also positive traffic and positive early peek Q3 trends-that early Q3 trend prerelease info that some companies give. This quarter's entire group has performed well recently: Brinker (EAT),Texas Roadhouse (TXRH), Ruth Chris (RUTH), Popeye's (AFCE), Panera (PNRA), Papa John's (PZZA)

Common Denominators: Two casual dining operators, one fine dine operator, one bakery/café, one QSR pizza, one Chicken QSR operator were the group. Two of the six are steak centric (RUTH, TXRH), with one other making inroads into higher steak menu mix . Brand focus matters: four of the six were single concept restaurant operators, and two with two brands under the holding company structure (EAT, RUTH). There, one brand greatly predominates over the other (EAT: Chill's versus Maggiano's) and RUTH (Ruth Chris versus Mitchell's).

Steak centric: we noted in 2011 that steak centric operators did well, no doubt by the improving travel/expense account traffic. RUTH's peer, Del Frisco (DFRG) via its first call since its IPO noted positive same store sales (SSS)of plus 5.1% and traffic of +2.2% at the flagship Double Eagle units.

Positive traffic and early peek looks: All had positive traffic-RUTH greatest at +3.9%; AFCE and PZZA don't reveal traffic/check but one can deduce from the magnitude of the numbers it was positive).

All had consensus earnings move up $.02 or more over the last 90 days-PNRA highest at +$.11, PZZA +$.09, EAT +$.07. Three of the six had 5 analysts or less providing estimates, with PNRA, TXRH and EAT well in double digit analyst coverage territory.

None of these chains had eyeball high debt. Interestingly, none of the chains was actively refranchising, all were growing company units, with even franchisee heavy AFCE planning a significant slug of new company units.

Four of the six chains (RUTH, AFCE, PNRA, PZZA) had positive free cash flow increases from quarter to quarter. EAT and TXRH free cash flow was off from prior year but EAT is doing heavy duty remodels (and is still a huge cash generator) and TXRH is building new units.

Price/earnings ratios: only RUTH cheap but…

This group of restaurants, other than RUTH are not cheap. PNRA is the most expensive, but EAT and TXRH aren't nosebleed high valuation yet.

The SBA has made it a priority to improve quality control and scrutinize defaulted loans, especially early-defaulted loan for fraud, waste and abuse.

The Office of Inspector General ("OIG") has released several reports detailing areas of repeated patterns found in early-defaulted loans.  


Loan agent and borrower fraud, eligibility, and use of proceeds are just some areas where material deficiencies have been found in early defaulting SBA loans.


Early defaulting loans are reviewed carefully for material deficiencies at the National Guaranty Purchase Center. Lenders should be aware of the most common reasons for SBA loan early-defaults and implement policies and controls to protect against those issues in their own SBA lending practice.


Loan Agent Fraud. If you are using loan agents, make sure you have a Lender Service Provider agreement in effect, approved by the SBA. Before you start working with a new loan agent, get references from other lenders to determine if the agent has a history of early defaulted loans. While almost all loan agents are ethical, OIG findings on early-defaulted loans found loan agent fraud to be a factor in many cases.


Issues to consider when working with loan agents in order to minimize fraud include: control of communications by the loan agent; whether a loan agent threatens to "shop" the loan elsewhere in an attempt to pressure the lender to close the loan; submission of a high number of "qualified" borrowers in a short period of time; difficult questions/issues are easily resolved (i.e., missing documents are quickly generated as the result of an inquiry or ledgers created to document a pre-existing debt); the loan agent wants to use specific appraisers or title companies; and whether the loan agent charges excessive fees.


Prudent lending practices when dealing with loan agents include tracking the loan agent's participation in the lender's portfolio to determine whether that individual is bringing in an unusually high number of early-defaulted loans or the loans have other material issues.


Borrower Fraud. Examples of borrower fraud include misrepresentation regarding the original purpose and use of refinanced debt; false equity injection, gift letters or affidavits, promissory notes and standby agreements (i.e. no intention of putting the obligation on standby), false financial statements; overvaluation of assets; failure to disclose outstanding debts; overstating income, failing to disclose true ownership of a business or common ownership between a seller and buyer; submitting altered tax returns; and misrepresentations regarding affiliate size.


OIG found many instances of fraud in Change in Ownership transactions. Lender due diligence must include obtaining copies of all relevant purchase documents. For example, in a stock redemption transaction, obtain a copy of the stock ledger and copies of all issued stocks pre and post closing. The stock certificates should be redeemed and retired, and not transferred or reissued to an individual. Selling shareholders should resign as an employee/officer/director of the company. Resolutions are also required showing the appointment of any new officers/directors.


Lenders are expected to comply with the equity injection verification requirements contained in SOP 50-10-5(E) Chapter 4 and SOP 50-51(C) Chapter 13. OIG investigations have repeatedly found that the cash injection was actually borrowed. Further, Lenders should verify gift money with at least two (2) months prior bank statements from the giftor. Lender should also obtain evidence of the transfer of the funds to the Borrower and an affidavit that no repayment is due to the giftor.


Fraud by loan officers and other lender employees. The SBA has recommended Lenders implement internal controls to both deter and detect suspicious lending activity, including: development of sufficient management oversight of loan approvals; policies (such as a Code of Conduct) to require business development officers and other lender personnel to disclose the involvement of brokers and loan agents in generating or packaging loans; limits on commissions and other internal inducement that incentivize loan officers to concentrate on loan volume rather than loan quality; internal review and auditing functions to analyze patterns of early defaulted loans or other material issues and the personnel involved; and policies to require a higher level of review on change of ownership transactions.


By originating and closing loans in accordance with the SOP, and using prudent lending standards applicable in any commercial transaction, a lender's risk of processing a fraudulent or early defaulting loan can be greatly reduced. 


 All instances of fraud should be reported to IG immediately. Contact the OIG hotline at 1-800-767-0385 or[email protected].

This July, 401k participants will receive more disclosures about the fees they are paying inside their 401k plans.

The Department of Labor wants more transparency and more disclosure on what kind of fees employees are paying inside their 401ks. Why? Because many employees have no idea how much they are paying in mutual fund fees. A recent survey by AARP said that 71% of people saving for retirement thought they didn't pay any investment fees whatsoever.

The fees inside a 401k are either paid by the plan sponsor (you - the employer) or by the participants, which are the employees. Over the last few years more of the fees have been paid by the employees. According to a report issued by the Investment Company Institute and Deloitte, employers are moving more of the plan charges onto their employees. For instance, employees are now paying for 91% of plan expenses, which is a substantial increase from 2009 when they paid 78% of such charges.

How does this happen? Here is an example. An employer wants to start a 401k and calls a bunch of mutual fund families to get some pricing to see how much it will cost to set up and administer. Most of the bids come back at $5000 a year. But one comes back at $1000 a year. Why is this one so much cheaper? Because the fund is making the money on the back end - higher mutual fund fees. So the employer goes with the cheaper option, and the little guy ends up paying more in fees.

A report issued last month by the U.S. Government Accountability Office highlighted that many employers aren't really aware about the fees charged by retirement plan providers (the mutual funds). The most obvious fee is the expense ratio inside the mutual funds offered inside the 401k plans. Many 401ks do not offer enough low cost mutual funds such as index funds. That's because they are usually not as profitable (to the fund company) as an actively managed fund is. For an explanation of index funds vs. actively managed funds, click here

Some Perspective

In the 1990s, when the average stock mutual fund was making 10% year after year, no one was complaining about mutual fund expenses inside 401k plans. Everyone was making money. But today, stock market returns have averaged 3.77% for the past 10 years. Mutual fund fees inside 401ks have decreased over the past 10 years. According to the Investment Company Institute, the average expense ratio for a stock fund in 1997 was 1.04%. In 2011, the average fee was 0.93%.

Higher fees mean lower returns for 401k participants.

If the average investor made 3.77% net of fees and the average fee paid by the investor was 0.94%, the average investor paid nearly 20% of his/her profits in fees.

Things to Consider If You Are an Employer and You Offer a 401k

1. Offer index funds inside your 401k plan.

2. Be proactive. Tell your employees about the upcoming information they will receive about the fees they are paying.

3. Calculate the average expense ratios of the funds in your 401k. Shop your pan and see how competitive your current 401k is.

4. Remember that if you are most likely a plan fiduciary, which means you are personally liable if you breach your duty as a fiduciary to the plan participants and beneficiaries.

5. Consult with 3rd party professionals like plan administrators and ERISA attorneys to make sure your 401k plan is compliant.

The trend is for more transparency in 401k fees that people will pay. Get in front of this and be proactive.

Remember what Wayne Gretsky said. "A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be."

This has been a guest post by Justin Krane, CFP®, CIMA® President/Principal. Justin Krane, is a Certified Financial PlannerTM professional and the President of Krane Financial Solutions. His savvy, holistic approach to financial planning allows clients to unite their money with their lives and businesses with sound financial decisions. Using a unique system developed from his studies of financial psychology, Justin partners with entrepreneurs to create a bigger vision for their business with education and financial modeling.

This is one of the most important and difficult questions for any business owner to answer. The value of a business is based on its future cash flow, which usually can be predicted from historical results of sales and profitability.

And, buyers don't care how much you spent yesterday, they care how much they can make tomorrow.

Ultimately your business is worth what someone will willingly pay.

A common mistake owners make is that they believe their business is worth what they have invested in it, that is rarely true.

If you are a franchisee, you are part of a system and usually are not so unique to lack comparable statistics. Talk to your franchisor to see if they have historical data on what other units have sold for. You also can see if other units in your system are listed for sale and what their asking price is relative to their revenue and profitability.

The next step is to talk to local business brokers and ask them what they believe the business is worth and what they could sell it for. In addition to referrals, the best way to find local brokers is to go to websites that list businesses for sale and see who the local brokers are with good listings. Remember that brokers primarily are compensated on a successful transaction. They won't want to list your business if you are asking an unrealistic price.

You might also want to consider a professional valuation. For businesses with revenues over $1 million this is money well spent. It will not only give you a realistic view of your value but it will help your buyer secure financing.

Always remember that your business is competing against all the other local businesses for sale. You need to take a realistic look at what others are asking and where your price should be relative to your revenue and profitability. If you can't live with the price you can get, then you need to wait to sell your business. If not, you will get frustrated and waste a lot of time, money and effort. If you can live with the price of what your business is worth to a buyer today, then you will be able to sell it.

What we have all realized, is whether we are Republican, Democrat, or Independent, we want to get the recovery going.

How are we going to do that? Small business creates 65% of the jobs in this country. That is where the jobs are created.

We need to get people back to work and people want to get back to work.

There is some good news. We are seeing deals getting done.

Yesterday we did a webinar for the hotel industry, and what they are seeing is transactions being made. Mom and Pop's are buying these hotels, they're buying these franchises, and there is a lot of activity in that.

It is very difficult for our small business bankers to lend money today, so the banks need to have some sort of inducement to reduce the risk.

90% of the deals beneath $5 million were done with an SBA guaranty.

So, deals are being done, and that is great news.

This is an intriguing snippet from the IFA's Small Business Lending Summit. I would have liked to seen the break-out of remodel and upgrade costs from Calderia. We are likely going to see remodel and upgrade "holidays" if the franchisees cannot get the financing.

The housing market is going to take probably a generation before it becomes accessible as an ATM again. I don't see what the new sources of collateral are, and where they are coming from.

The basic problem for franchisees is that many of them are not seeing their usual loyal customers - they have become price shoppers. Loans cannot fix that supply problem.

In 2010 Carmen M. Reinhart and Kenneth S. Rogoff wrote a book entitled "This Time is Different: Eight Centuries of Financial Folly". Writing on the heels of the Great Recession the book's message was a simple one: no matter how different the latest financial crisis always appears, there are remarkable similarities with past experiences from other countries and from history.

We have been here before.

Other nations and other leaders---notwithstanding the hubris, or maybe because of the hubris--always think that this time is different.

The vast range of crisis considered and analyzed in This Time is Different demonstrates that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater risks than it seems during the boom. "Debt fueled booms all too often provide false affirmation of a governments policies, a financial institution's ability to make outsized profits, or a country's standard of living. Most of these booms end badly."

Almost two years after the Great Recession officially ended the franchise market writ large is still struggling to cope with the boom that ended badly.

The International Franchise Association reported that 2012 will be the year that franchising rebounds. Last month the IFA released its Franchise Business Economic Outlook for 2012.

In short it stated, "after three years of restrained growth, due to the recession and its lingering effects, franchise businesses show signs of recovery in the year ahead." The IFA went on to state that "franchise business growth has been restrained over the past three years due to underlying factors, such as the weak rebound in consumer spending, that have been a drag on the economy as a whole.

In addition, tighter credit standards have limited the formation of new franchise small businesses and the expansion of existing businesses." (I think it important to keep in mind that the IFA has been forecasting for the last 2-3 years that this year will be the recovery year. In fact, the IFA has restated its numbers for the previous year's franchise unit growth in each of the last three years. For example, the 2012 report said that the number of franchise establishments in 2008 was 774,000; the report in 2011 stated that the number of franchise establishments in 2008 was 791,000; and the 2009 report claimed that the number in 2008 was 864,000. )

But in light of This Time is Different what struck me as particularly interesting about this latest pronouncement from the IFA was the statement by Stephen Caldeira, President of the IFA, in which he said in referring to 2012 "the rate of growth is far below the growth trends we experienced before the recession."

Most individuals understand that the growth that franchising experienced in the 4-5 years prior to the recession was fueled by the exact same economic and financial factors that gave rise to the larger American macro-economic bubble--and it subsequent collapse.

Thus I think the most important question that we in the franchising industry must ask is what growth rate do we want and what growth rate should we expect? If we expect a growth trajectory similar to the 4-5 years prior to the recession how do we plan to achieve that without a similar type economic environment? Or, do we care how we get there just so long as we do?

Toward that end, recently I had an executive remark to me that he hopes that we experience another liquidity bubble because it would return the franchise market to its pre-recession days. But is that what we really need and/or want as a country or as an industry?

Turning again to This Time is Different, the book reminds us that the boom we experienced in America was powered by a liquidity bubble--a bubble that was destined to burst--and was fueled in large part by the sub-prime mortgage market. "In the end run-up to the sub-prime crisis, standard indicators for the United States, such as asset price inflation, rising leverage, large sustained current account deficits, and a slowing trajectory of economic growth, exhibited virtually all the signs of a county on the very of a financial crisis--indeed a severe one."

A severe one indeed. We have millions out of work still, and those that are employed have seen their wages stagnate and their home value drop precipitously and not recover. But that is exactly what history has shown always occurred after a financial crisis. Reinhart and Rogoff state: "an examination of the aftermath of severe postwar financial crises shows that these crises have had a deep and lasting effect on asset prices, output, and employment. Unemployment increase and house price declines have extended for five and six years, respectively.

Real government debt has increased by an average of 86 percent after three year....Historical experience is that V-shaped recoveries in equity prices are far more common than V-shaped recoveries in real housing prices or employment. Overall the analysis of the post crisis outcomes for unemployment, output, and government debt provides sobering benchmark numbers for how deep financial crises can unfold."

Notwithstanding the remark of the executive I reference above, I do not think most in the franchise industry--nor the country--consciously want another liquidity bubble. The out-sized short term profits fueled by a large amount of liquidity in the system appear to be Faustian bargain that few in the franchise industry want to engage in again.

What the executive likely meant was that he wanted another great macro-liquidity event in our Nation's economy, he just did not want to have it become a "bubble". In that case, he, as well as most in American business today, is eagerly awaiting the next economic boom. And if that boom is to be fueled by complicated financial instruments and unrestrained access to the debt markets then "this time will be different" is the refrain that is soon to be repeated.

But as Reinhart and Rogoff detail with much precision it is unlikely from a historical perspective that the next time will be different. "The fading memories of borrowers and lenders, policy makers and academics, and the public at large do not seem to improve over time, so the policy lessons on how to avoid the next blow up are at best limited. Technology has changed, the height of humans has changed, and fashions have changed.

Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a constant." Franchising touches all segments of our economic society--technology, labor, finance, consumer, etc. Franchising will wax and wane depending on the over-all economic health of our country.

The question that must be answered is this: will franchising plot a course that is complimentary too, but not dependent on, the next banking and finance led American boom? Or, will franchising as a industry continue to aim for, and the IFA continue to lobby for, the good 'ole days of "outsized profits" and rapid franchise unit growth fueled as it was by what we now know to be an excess of debt accumulation both on the micro- and macro level of our economy?

My guess is that few are even thinking about the future of franchising in these terms. Most simply want growth, and they care not how that growth comes about. (Of course this is how most in our country feel and is the emotional genesis for the boom and bust cycles examined in This Time is Different.)

Every six months the IFA puts out a statement about how the tight lending standards are retarding the growth of franchising. While that is undoubtedly true, it would be helpful to learn exactly what the IFA deems as the optimal level of liquidity in the system. If by loosening the IFA is silently longing for the loose credit standards that reigned supreme in the middle of the last decade then that perhaps is the wrong path down which to proceed. If it is not, then it is incumbent upon the leadership to set forth with more particularity the goals because liquidity in the system is inextricably linked to the franchise growth projections.

In order to assure that we in franchising do not repeat the mistakes of the past, the franchising industry needs perhaps a different approach. The industry needs leadership that does not repeat nor countenance the thread-bare and statistically suspect mantra of "franchises do better in recessions."

We need leadership that understands that while prospective franchisees are more difficult to come by now then they were in 2007 that may not necessarily be a bad thing. In the same way that it is now settled wisdom that there were many who were allowed to take out a mortgage five years ago that should not have been permitted to do so, so too must the leadership in franchising state unequivocally that there were franchisees that should not have been awarded franchises and business that should not have been franchises as well.

And if that be the case, then the growth rate that was experienced in the years leading up to the Great Recession cannot be the benchmark for growth in the next decade.

The economic outlook published for 2012 projects an increase of 1.9% in franchise establishments. But as stated above, the one constant with the economic outlooks produced by the IFA over the last four years is that each year the reports change many of the figures stated in the previous years report.

The reports do have a convenient escape mechanism in that all of the reports state that the numbers are "estimates". In other words, neither the IFA nor the high powered accounting and consulting firms commisioned to compile the reports know conclusively how many franchise establishments exist today--and if you read the reports carefully you will see that the PWC reports state that 2007 was the first time that there was enough data to even put forth a sound estimate.

So while 1.9% may well be the appropriate and realistic growth rate for 2012, given the track record of the reports put forth by the IFA we must be more than a little skeptical about the numbers set forth.

All of us with a stake in franchising want to see franchising grow again. We all believe in the fundamentals that under-gird its special place in our economy. In order to achieve a prudent and sound franchise growth rate we need "tough love" leadership and sober, intelligent responses to the challenging times in which we live.

Doing so, however, requires an honest appraisal of how we got here and whether the good 'ole days were really that good. Simply running the same plays out of the same playbook, and using statistically suspect boom year expectations of growth is not a game plan for long-term success.

We have read this book before. We know how it ends. And no, this time will not be different.

This has been a guest post by Garth Snider, CEO of Franchise Opportunities Network. At FranchiseOpportunities Network we identify, create and distribute valuable information regarding franchising and small business opportunities. The FranchiseOpportunities Network lead generation network was created in order to high-quality franchising and business resources in a secure, collegial, professional and ethical business environment. As the web's largest directory of franchise opportunities, we aspire to continue giving potential franchisees simple and easy search practices, as well as thorough franchise and business resources.

What is Factoring?

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Not many know what Factoring is and if they do... they usually think it is overly complicated and don't bother with it.

Let me simplify this.

Basically what you are doing is paying a discount so you can get money today instead of waiting.

Sometimes this makes sense and sometimes it doesn't.

As we all know in business it comes down to CASH FLOW.

And if a lack of CASH will lose you a SALE you may want to entertain this OPTION.

Allow me to illustrate.

Let's say you are a manufacturer or a distributor and you receive a PO from a credit worthy entity who will pay you 30 days after install which is fine HOWEVER you don't have the CASH to fill the order.

FACTORING can get you the CASH so you can fill the order.

Or you have filled the order, invoiced your credit worthy customer and it is going to be 30 days before they pay you or longer. Well you really can't wait this long to get paid as it disrupts your CASH FLOW. Factoring can buy the invoice from you for a small discount. Now you don't get all your money but you will get most of it.

Again it all comes down to CASH FLOW and the TIME VALUE OF MONEY.



Factoring can be a solution and this is the goal of Allstate Capital... to provide our clients financial options. There is no perfect financial tool. What is perfect is having a partner like Allstate Capital to provide you tools so when any given situation arises you are prepared and don't miss a SALE.

Please call me with any questions on factoring or any of our financial solutions

John Papadopoulos

800.949.0018 X 202


SBA Liar Loans

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We all know about the residential liar loans - no income and no asset.  Not surprisingly these loans took on the nature of a gamble, benefitting only the originators who took out their fees early on.  

Are there commercial liar loans - a loan based on projections of income that make no commercial sense?  Is the practice widespread?  If so, what is enabling it and how can we stop it?

In a very good three part investigation on SBA loan fraud, (the first part of the SBA loan fraud is here, and the second story on SBA liar loans is here, and the third part is forthcoming) Don Sniegowski, writes about the SBA liar loans as follows:

A major franchise lender, Banco Popular, has been rebuked by the Small Business Administration for participating in lending chicanery.

The censure has both the lending and franchise industries concerned that the investigation may spread beyond the Puerto Rico-based bank.


Bob Coleman, publisher of the Coleman Report for lenders and a consultant to small business bankers, thinks that the situation isn't limited to just Banco Popular.

Most lenders thought future projections were unimportant. "That was pretty much the whole industry that did it that way," he declares.

He thinks future financial estimates for a business were never a high priority for bankers in screening the viability of an SBA-guaranteed loan.

"Projections were seventeenth on the list," he emphasizes.

While one or two quotes from SBA authorities is not evidence of systemic failure, my personal view is that there is a good possibility of systemic SBA loan fraud.  (I am not complaining that projections are bad, but rather that the mechanisms to rein in or eliminate bad projections are being avoided.)

Here are my reasons why:

1. No bank would lend against any business plan that could be constructed only out from the information in the franchisor's the item 19's claim and whatever local operational information is also available. (There is, by definition, no local information for a new store.) Remember by FTC and State Policy all the earnings information has to be in the Item 19 statement, except for local store information.

2.  If an SBA loan is made then, there has to be "enhanced" earnings report given to the franchisee's bank by the franchisor. There are a number of consultants who will prepare this information, and they appear to be in a difficult conflict of interest being both the franchisor and franchisee's agent.  That conflict of interest is unbearable if the consultant gives the enhanced earnings report directly to the bank with minimal franchisee involvement, oversight or review.

3. The current game, though, is that these enhanced earnings reports will be substantially prepared in advance or before closing, but only given to the franchisee in support of their loan application after the franchisee has signed an agreement.  

In that agreement, the franchisee agrees that the franchisor did not give them any more earnings information than appeared in the item 19, and if the franchisors did so, then franchisee agrees not to rely upon it - despite the enhanced earnings report being prepared precisely so that the franchisee could get a SBA loan!

We could well be slipping down the slope into the worst feature of Russian culture.

"You lie, your listeners know this and you know that they don't believe you...and they also know that you know they don't believe you. Everybody knows everything. The very lie no longer aspires to deceive anyone. From being a means of fooling people it has for some reason turned into an everyday way of life, a customary and obligatory rule for living." 

(Oddly, the current state regulators and state AG's find nothing in this practice to investigate despite all the predicate elements of a RICO fraud being in place.)

What is silly and pointless about this game, apparent from bringing a number of people uncomfortably close to a RICO claim, is that it is all a waste of time.

The franchisor should simply include the enhanced earnings report in the item 19 and avoid the entire problem - unless of course the expanded item 19 could not withstand scrutiny, and has to be rushed through in a pro forma manner.

From a game theoretic or strategic point of view, franchisors who do not include in the item 19 these enhanced earnings reports are signalling that these reports are inherently unreliable if given at a future date, after the closing.

The point here is simple.  After the closing, there is no legal liability to be found in the disclosure document for the information given after the sale.  

It is in the franchisor's strategic interest at that point to be "over enthusiastic" about the quality of future earnings.  It will be difficult right after closing for the franchisee to call the franchisor a liar or worse.  Bad projections will get accepted by both parties, which is bad for both of them - although much worse for the franchisee.

But the strategic franchisee who knows this can prepare a number of pre-closing responses to avoid being trapped.  Waiting until after closing is not a good option, however.

The takeaway for a prospective franchisee is this: if the bank would not lend against a business plan constructed only from the Item 19 information, then any further information from the franchisor is inherently unreliable and dangerous.

The IAFD cannot give you better leaders, but we can provide your future leaders better negotiation training in and mediation with our partnership with Mediation Works Inc.


Equipment finance facilitates the growth and expansion of the U.S. and global economies by providing multiple financing products for companies to acquire and employ plant, equipment and software, thereby enhancing business investment and capital formation.

The equipment finance sector is comprised of financial services companies and manufacturers, regional and community banks, and independent medium and small finance companies.

An important contribution of the industry lies in providing access to capital because equipment acquisition and utilization impacts goods-producing and service-providing industries - virtually all sectors of the economy. Watch the video below to learn more about the equipment leasing and finance industry. (Source ELFA Website)

Private Equity Firms and Restaurants: Motivations, Track Record

Recently, the press has been full of reports of private equity (PE) firms receiving outsized returns on prior restaurant investments. Examples include the reported Sun Capital 13 times return on its 2003 Bruegger's investment, Olympus' Partners reported 8 times return on its K-Mac predominantly Taco Bell franchisee group, Falfurrias selling Bojangles (unit counts up 30% since 2007). CKE Restaurant's is now working a dividend via new debt for its owners, as did Dunkin Brands in late 2010.

We are maintaining a log and count so far 62 separate and distinct chain restaurant brands owned by PE firms, from large to small. That count will soon equal the number of publicly traded restaurants. And three big chains, Arby's, Long John Silver's and A&W were put out for sale in January 2011, and could join the PE ranks.

PE Economic Motives: The age-old laws of economics and investing hold here: buy low, sell high. Take money out of the business when you can. Lever up, pay debt down, then lever up again. Try to make improvements in the business. Hold for a 4-7 year timeframe. Think exit strategy from the beginning. Use OPM (other people's money) if at all possible, hold your cash equity infusion as low as possible so long as the debt isn't too high.

PE firms hope to deliver a 25 % plus annual compounded return on capital invested.

The spate of 2010 and 2011 restaurant activity has to do with (1) a general reopening of lending after the 2008-2009 recession, (2) lower corporate debt rates, and (3) PE firms with funds that must be put to use. Larger cash on cash percentage returns seem possible for "older" deals, when the required equity infusion was lower, at 20-30%, versus now. But the returns depend and will change over time.

The private equity firm promotes operational improvement, and synergiesvia a "buy to sell" mentality to get their investment back and realize a trading profit. With a 4 to 7 year term focus, they utilize both operational value creation and leverage and financial engineering. The balance depends on the PE firm's own expertise and focus. PE firm ownership doesn't guarantee success, however.

Highly franchised businesses, especially national brands, command a valuation premium since the earnings is thought to be more predictable and there is less (but not no) capital expenditures associated with a franchised system. Multi-unit franchisees are valued a bit less as they have a smaller development universe typically.

Is this bad or good for the brands? We don't know yet. Not much data is available.

In 2010, we looked at 2003-2007 era private equity deals that failed. Since data for privately held restaurants aren't much accessible, we defined failure to be either Chapter 11 or 7 filing or where unit counts declined. About 30% seemed successful, 40% in some mid-state or not determinable yet and about 30% had failed.

Interestingly, the success factor seemed to vary based on the brand strength, and position in the marketplace. The purchase price multiple, a proxy for debt, didn't seem to be greatly associated with the success or failure.

What about the franchisees?

In all of these chains, franchisees do all the customer execution work; bear the expense of the initial investment, ongoing capital expenditures and new unit expansion. They pay the royalties, and borrow the bulk of the funds needed for expansion. They are highly affected by credit market conditions.

Franchisees want buy in, dedication, and culture, since they have bought in, often for life. PE firms might be smart to leave competent management in place that can further build the culture and promote franchisor- franchisee coordination and unified accountability.

In relating to the PE firms, franchisees must realize that the PE firm is using both "trader skills" via a so called "buy to sell" mentality as well as business management skills to get a good return. They certainly want to make the business better. But each PE firm is different and has different motives and capabilities.

Franchisees should figure that businesses would be held for some time to recover investments but trader, market conditions would rule the timing. The exit plan might not be re-entry to the public markets, but might be sale to another PE firm. As other PE firms raise money, they need to put the funds to work, too.

For the 5 Most Fascinating Stories in Franchising, a weekly report, click here & sign up.

Tax-exempt organizations, like franchisee trade associations,  that do not satisfy annual filing requirements for three consecutive years automatically lose their tax-exempt status.

The IRS is provided one-time relief for such organizations that have filing due dates on or after May 17 and before October 15, 2010. The list includes organizations for which the IRS does not have a record of a required annual filing for 2007 and 2008, and whose 2009 return, due on or after May 17 and before October 15, 2010, has not yet been received.

But that one time relief has ended and your association may be at risk,

Organizations should check their records and determine whether they are at risk of automatic revocation because they have not satisfied annual filing requirements. 


The U.S. Internal Revenue Service (IRS) is preparing to publish the Nonfiler Revocation List. This initial  publication may include as many as 321,000 nonprofits whose tax-exempt status has been revoked for failure to file an annual information return. 

We recently attended the 2010 Restaurant Finance and Development Conference, and  some relevant notes follow: 


  • More money is theoretically available but the lending standards are much practically not much has changed. 
  • Franchisors still have a valuation and debt capacity premium and can borrow more, at less, than even multi-unit franchisees. 
  • With maturing franchisee systems, the "renewal risk" of franchisor systems is becoming more visible. 
  • Associations should document and prepare. 
  • Some "lower tier" operators (recent example Dairy Queen) will have trouble refranchising and finding lenders for franchisees. 
  • Franchisors were promised a detailed "proctological like review'' of their franchise systems. 
  • Big Bank loan underwriting standards are tough and consider everything. 

Big Picture

A lot more franchisors attended. The theme of the conference was---it depends! (financing, brand, valuations, etc). 

Talk was that money was available to qualified borrowers (albeit very high standards), but many audience members didn't buy that. 

Macro economic conditions will be difficult in the US for some time. 

Loan underwriting standards VERY specific and detailed. 

Today's underwriting standards would have prevented many prior years' executed M&A actions from having much in future CAPEX, due to leverage. 

Restaurant Finance Availability, Rates, Terms and who Qualifies:

Much more liquidity/$ now present, but now looking for much greater equity (cash) infusion from operators. 

Max for senior debt, about 3 times EBITDA at LIBOR plus 350 to 500 bpts; 1.5 X for non-secured & mezzanine debt at12 to 18%. 

More capital available but fewer good prospects. Hard to find $ if most/all of system tied up as collateral to another lender. 

We examine each brand separately. Mixed opinion of the classical company versus franchisee mix argument. 

Some lenders not hung up on the same store sales increase test but look to see operator is operating as best possible. 

Lenders like restaurants that are voracious consumers of CAPEX. 

Look for franchisors to undergo extensive due diligence. In evaluating packages, lenders want dependable cash flow and definition of leverage to be clear. Specific concern about franchisor franchisee renewal rates noted (with many franchisees entering retirement zone).

Lenders want fixed cost coverage ratio to be 1.4 times zone (was 1.25). CIT has survived and GE Capital is back in the market too, but they want big transactions, over $10M EBITDA. 

Restaurant M&A Trends

Franchising Specific Notes Market conditions: lots of competition for deals now versus no demand last year. Investors view restaurants in a bond like relationship--should be low risk, it's a tangible, easily understood business (supposedly). 

Not a lot of distressed companies right now, but some coming. 90% of transactions from private equity, 10% strategic purchases. 

The numbers: One advisor is looking at franchisors at 9.5 times (X) EBITDA, casual dining at 7 X, upper end/fine dining at 7X. 

Franchisors have a premium over franchisees since they have a wider geographical area to expand. Typical leverage: 2.5 to 3.0 times EBITDA for senior debt, 1-2 times for mezzanine debt. Distressed company deals must be all equity. One saw QSR zees at 6-8 X EBITDA without real estate, a bit less for casual dining brands. 

There were questions whether the Burger King (BKC) buyout of appx. 9.2 X EBITDA set a new comparable price benchmark. Consensus not. 

It depends and it varies by brand: was often cited as the overall rule of thumb. All brands are not the same. The franchising premium (reliable cash flow and less CAPEX) remains. 

But franchisors should expect a detailed system diagnosis review of system health and prospects. 

A Purchasing co-op is a plus. 

One noted franchisor seller expectations were still too high, particularly if real estate was involved. 

Remodel economics; noted IHOP refreshes ($50 to $75K) with no sales lift, Pizza Hut $350K remodels at a 10% AUV lift, and a rescrape/redo ($600 to $700k) at a 30-35% AUV lift. 

Minimum standards PE firms want; increased equity, operational expertise and legacy financing. 

Outstanding or future CAPEX requirements (e.g., rundown restaurants) will affect the price multiple. 

Commercial Bank's Detailed Underwriting Standards: 

Little is not known or examined. Loan standards of all types exist and are tough. 

 ? EBITDA definition: maintenance CAPEX is subtracted from the traditional EBITDA definition. Typically 0- to $50K per unit/year. 

 ? Traditional Funded Debt to EBITDA metric: 2.75 X to 4.50 X ? Lease adjusted: total loans outstanding plus eight times rent expense, to EBITDA: between 5.25 to 5.50 for operators and 5.50 to 5.75 X for franchisees 

 ? Senior and Total Lease adjusted leverage: senior: 4.75 to 5.25X, total leverage 5.25 to 5.75X 

 ? Fixed Charge Coverage ratio: EBITDAR divided by Principal plus Interest: not less than 1.25 to 1.50 times for franchisees. 

 ? Cash EBITDA Standard: EBITDA -cash taxes-maintenance CAPEX divided by Interest plus principal: should be 1.15 to 1.25X 

 ? Capital Spending (CAPEX): per business plan except if lease adjusted leverage ratio is 5.25 or higher, new CAPEX likely limited. 

 ? EBITDA add backs: yes, the lender will listen if there are large non-recurring or extraordinary EBITDA effects. 

Generally, focus is on business cash flow before owners compensation. 

Private Equity and Restaurants: 

Market Conditions; debt is coming back in vogue but still scarce for small companies.  

Targets: multimarket successful operation, strong brands, $10M and up EBITDA. CFOs Panel 

The most interesting exchange here was the Chipotle perspective, that they didn't need to do franchising as they had the capital, the people, the expansion plan and the unit economics already in place, while Five Guys noted the US was "sold out" but that they were looking to do 30 company stores and 200 franchisee units next year. Interestingly, Five Guys likes small franchisees, as they feel multi-concept operators won't follow the Five Guys way. 

Heartland/BKC noted how reliant they were on the BKC brand and that they were looking to Canadian but no US expansion. 

Scouring the P&L for savings: Budgeting has become more sophisticated, with both internal (stretch) and external forecasts being developed. 

Cost savings targets; service provided contract costs, too much outsourcing is not cost effective (internal training), challenging tax assessments, implementing new labor guides via POS technology. 

Marketing: direct mail, elimination of low volume menu offerings, sees social networking as high marketing ROI. 

Financial Returns: 30% cash on cash or 3.3 year ROI still best in class standard, but franchisees were in the high teens. 5 year return or 20% cash on cash seen as realistic.
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YUM Brands reveals its Quarter Three earnings tonight, with the earnings call tomorrow, October 6 2010.

The Wall Street Journal noted today the fact that YUM may hit the symbolic benchmark of 50% of earnings generated outside of the United States, either this quarter or next. 

Their international focus is great and smart; YUM certainly looks smart developing and working its success in the China Market over the last decade. As we know, developing nations will have higher population and likely economic growth than the US/ Europe.

Yum Brands also is right at the 80% franchised units world-wide threshold, too.

KFC and Pizza Hut struggled greatly in the US since 2008, although they will say the Pizza Hut $10/any/any focus and its menu reengineering helps its sales trend. Since 2006, YUM has resisted per brand sales and margin breakouts, preferring instead to show combined world sector sales and margin trends.

We urge YUM and the security analysts that cover it to disclose and ask for per brand, US and outside of US franchisee and franchisor sales and restaurant margin data for both company and franchisee owned operations.

It's material enough of an issue, with 80% of the units franchisee operated, and will enhance worldwide decision making and analysis. YUM is a very complicated worldwide company.

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Since February, 2010, there has been a spate of chain restaurant merger and acquisition action underway: CKR (Carl's/Hardees's), Papa Murphy's,  Rubio's , On the Border, Lubys buying Fuddruckers, just announced today, via Chapter 11 auction results, for $60M); and rumored , Nelson Peltz selling Wendy's/Arby's.  Some of the prices paid have been pretty low (CKR) and some much higher.

This was all somewhat predictable. And all of these transactions involve franchisees, in the mix.

In some cases, private equity (PE) firms are eager to rebalance their portfolios and sell their concepts outright, or to buy the chains for later turnaround/later initial public offering (IPO).  And Denny' recently had the battle royale of proxy contests, where an outside, dissident force hoping to get board seats was narrowly turned back.  

How the debt is done, what the leverage and interest costs are what the plans for management, supply chain and future business expansion matters to franchisees.

For most of these chains, about 80% of the stores are franchised, and the franchisee owners collectively have more money invested in the current total enterprise value than does the company.

Just today, I saw a prominent restaurant security analyst's report that valued franchise earnings (company franchise operational profit, the royalty stream) at twice the multiplier rate of company owned's a lot of money for that fairly predictable piece of the top line that the franchisor receives in royalties.

Of course, associations aren't consulted nor have much information about this. The company views the buyout deal as complicated enough without involving franchisees.

Here are some suggestions for franchise associations:

(1)    Buy some company stock. That elevates the franchisee associations a bit, and gives access to stockholder meetings, and other communications.

(2)    Monitor the news, and include articles in your newsletters. Both the International Association of Franchisees and Dealers and have daily news clips and columns touching on these topics.

(3)    Document and come to agreement on your business strengths and weaknesses. And how to respond. You may need this information someday.    

John A. Gordon is a restaurant financial analyst and management consultant, and can be reached via (619) 379-5561, or [email protected]. 



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The franchisor is obligated to give a prospective franchisee financial disclosure of the franchisor's business.

One of my concerns is that this financial disclosure is less than what a shareholder gets in a public company.  

A shareholder can exist relatively quickly, but a franchisee is usually stuck for the term of the franchise contract - a situation that calls for more disclosure and not less.

Here is the type of example that should be of concern, from the franchisor 1-800 Radiator's 2009 filing.


A number of questions spring to mind, especially since this is buried in the footnote of the financials.

1.  Is Radiator Express really the franchisor, if it is doing all the collection and operational functions?  If so, where are its financials - it being the "parent company"?

2.  How much additional funds does the Parent need?  Is it in danger of no longer being an going concern?  What will happen to the franchisee operational support being provided?

3. It is now the middle of 2010 and there has been nothing filed on Caleasi which answers question 1 or 2.  Is Radiator Express insolvent, preparing a receivership, or preparing for bankruptcy.  Franchisees really need to know this.

4.  Radiator Express, in this note, appears to be charging the franchisor a sum equal to most of the franchisor's revenue.  But where is the explanation of what forms the basis of these charges - we don't have any information in the FDD about Radiator Express.

I could be way off base on this questions, and maybe there is a simple answer.  Does anyone from 1-800 Radiator have an explanation?

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Fascinating to see the disconnect between
what Washington is saying to th public, and what is
happening on the ground regarding small business loans.

"The bank examination climate today is perhaps the most severe in two generations at least," says Cam Fine, CEO of Independent Community Bankers of America (ICBA).   


"It's like a reign of terror, particularly on the community banks," which serve a disproportionate number of small firms.

In public statements and interviews, regulators say they've repeatedly told their examiners to encourage banks to lend to creditworthy borrowers. 

Examiners, they say, are generally fair, affording bankers ample leeway to make their own judgments.

Yet, officials acknowledge that examiners are more vigilant in light of the lax credit standards that triggered steep downturns in housing and commercial real estate and a continuing rise in the number of loan defaults and bank failures. Since early 2009, 177 banks have shut down, and more than 700 are on the FDIC's "problem bank" list.

Commercial real estate -- which makes up nearly a third of community banks' loan portfolios -- continues to be plagued by rising vacancies and plummeting value.

Still, officials concede, examiners may go too far sometimes.

Read the entire article on small business loans, by clicking here.


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Almost seven months ago, Direct Capital was concerned about a FRANdata report which projected a 40% reduction in available credit to franchisees over the coming year.

Robyn Gault, Direct Capital's Director of Strategic Accounts, said it is a critical time to get behind the franchise space. 

 "The retreat of many lenders from the market over the last several months has left franchisees with very few options," said Gault. "Growing concern over access to financing to support growth and upgrade initiatives has driven several leading brands to take an active role in securing lending for their franchisees to protect the growth and health of their systems. We have the financial strength to support franchisors and the companies that sell equipment to them." 

Gault said that Direct Capital's offering has peaked the interest of many businesses involved in the franchise industry, including franchisors, vendors, and associations. The company recently announced an exclusive partnership with the National Franchisee Association, an association of BURGER KING? franchisees, to launch a finance program created to support various equipment upgrades.

Recently, Direct Capital, a leading nationwide lender to the franchise industry for nearly 20 years, announced today that it will increase its funding commitment to the franchise industry and will continue to build new programs that alleviate the challenges faced by franchisees

Paul Ringuette, Vice President of Sales for Direct Capital, found an overwhelming need for credit and very few lenders willing to meet that demand.

 "We knew there was a large and growing gap in franchise capital needs but witnessing it first hand at the IFA convention was eye opening," said Ringuette. "This industry needs major support and we are committed to the effort."
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