Traditional bank lending will remain the single greatest source of finance for franchising for many years to come, but alternative forms of financing are becoming more common and in particular, borrowing from the Bank of Mum and Dad (BOMAD).
Borrowing from BOMAD has been a common form of financing ever since money was invented, but today takes on a new importance due to a variety of factors.
First among these is that the borrower will most likely have already been rejected by a bank in their application for a “traditional” loan.
Despite all the hurdles involved in borrowing money from a bank, the process boils down to an assessment of whether or not the bank believes the borrower can repay the principal and interest on their loan in the timeframe required and, if not, has sufficient assets that can be sold to cover any shortfall.
If a bank does not approve a loan, it will generally be for one of two reasons: There is a fundamental concern that the principal and interest can’t be repaid in the required timeframe (this is known as a servicing requirement), and/or the borrower does not have enough assets that can be sold if the loan goes bad (this is known as a securitisation requirement).
To balance its portfolio of loans and to offset the risk profile of different types of borrowers, a bank will vary its servicing and securitisation requirements from time to time for new borrowers, and also for existing borrowers.
When this occurs for new borrowers, it means that two identical loan applications may receive two entirely different outcomes if there has been a change in servicing or securitisation requirements in the meantime.
Likewise, an existing borrower may be called upon to increase their repayments, decrease their loan balance, or increase the amount of assets offered as security during the term of a loan as a result of changing servicing or securitisation requirements.
But, unlike mainstream lenders for whom servicing and securitisation is everything, the bank of Mum and Dad will assess the creditworthiness of their son or daughter based on their life experiences together, the child’s latent talents, and the BOMAD’s own liquidity or capacity to raise funds.
It is unlikely that many BOMAD loans are struck on the same kind of commercial terms as those of real banks, and therefore the consequence of default are usually less severe. If the borrower fails to repay the loan, then BOMAD will probably write it off as an advance on their inheritance, and family gatherings thereafter will be a little tense and uncomfortable.
Unfortunately BOMAD will become an increasingly common feature on the franchise financing landscape as more borrowers fail to meet bank servicing and securitisation requirements.
While it stands to reason that the servicing of any franchise loan should be determined by the performance of the business itself, many franchise candidates who seek finance for a new outlet are not able to demonstrate a history of cash flow. The next best thing is for the lender to assess cash flows across the entire chain, and determine serviceability from that.
But despite more than 1,100 franchise systems operating in Australia, it is estimated that less than 15% would have had their cash flows assessed by the major banks in order to determine if this meets their servicing requirements.
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Where serviceability has not been established by a bank assessment, then a greater focus will be placed on securitisation, and this is potentially the greatest driver of borrowing from BOMAD. Why? Because many borrowers will not have enough assets to meet a traditional lender’s securitisation criteria, and this is unlikely to change any time soon.
The reasons for this securitisation dilemma are rooted in the saving habits (or lack thereof) of the up and coming generation of franchise buyers, and the bursting bubble of the Australian property market.
Australian franchising surveys over the years have consistently shown that the overwhelming majority of franchisees are aged between 35 and 55. This means that people who are approaching the age of 35 and are now looking for franchises will increasingly be drawn from Generation Y (those born in between 1980 and 2000), compared to Generation X (1965-1980) and Baby Boomers (1945-1965).
Unlike Baby Boomers and, to a certain extent, Generation X, which have both been conditioned to save for the future, Generation Y is often characterised as the “spend it now” generation.
The upshot is that Generation Y has not accumulated assets in the same way that Baby Boomers and Generation X have done.
In acquiring few (if any) assets, particularly real estate, Generation Y franchise candidates can easily fail the securitisation requirements of major lenders.
Generation X isn’t doing much better currently, for despite being older and more disciplined in their saving habits, they have started families and bought homes over the last 10 years or so as the property market has boomed and prices have become more and more expensive.
But since the GFC, real estate prices in Australia generally have been slowly going down, meaning that primarily Generation X buyers are now saddled with record levels of housing debt they are struggling to pay off. (While Generation Y buyers are in the same boat, though not in the same numbers.)
Indeed recent data from property information company RP Data indicates that as many as 5% of mortgages are now greater than the price originally paid for the home, leaving their owners with negative equity.
This downshift in the property market has quietly eroded the security that many potential franchise buyers could offer traditional lenders, and consequently BOMAD again emerges as the financier of choice.
What are the implications for franchisors for BOMAD financing?
When suitable franchise candidates are financed by the bank of Mum and Dad, there is a greater likelihood that the franchisor can take a general security agreement over the business as this may not have been considered in a family financing arrangement, which may be poorly documented at best. (Banks on the other hand will commonly take general security agreements over the business, meaning that franchisors are less capable of exercising security provisions if the business runs off the rails).
Additionally, franchisors might enter a franchise agreement with a suitable candidate, who for whatever reason may fold and then Mum and Dad are forced to step in to keep the business operating in order to protect their investment. In other words, the franchisor might start out with one franchisee, and to all intents and purposes, “inherit” another.
This can provide more than just a few management challenges.
On occasion, the Golden Rule may also apply, meaning that the person operating the business in the role of the franchisee tries to follow the system laid down by the franchisor, and then is forced to circumvent the system because the parents who have provided the gold decide that the business should be operated by a different set of rules.
Consequently franchisors might find themselves dealing with two different types of franchisee for the same outlet, and struggle to create a management approach that will satisfy both types of franchisee as well as deliver the outlet performance expected by the franchisor.
As mentioned earlier, a loan from BOMAD can subconsciously be considered by the borrower as an advance on their inheritance, which means that the consequences of defaulting on the loan are not as severe as defaulting on a bank loan.
Where there are fewer and less severe consequences for failure, it follows that the determination to succeed may not be as great, therefore family-financed franchises may even be more prone to poor performance than bank-funded franchises.
If this theory holds true (and it is certainly worth more detailed research), it also follows that another franchisor challenge in managing BOMAD franchisees is actually keeping them in their businesses, rather than the franchisee abandoning when times get tough.
While it makes sense to think that someone will work through the tough times to preserve the value of their investment, this logic is based on the assumption that the loss of their money will hurt them. The whole purpose of “hurt money” in franchising is somewhat undermined when it’s someone else’s money, and it doesn’t really hurt quite as much to lose it.
Franchisors will have to accept that franchisees funded by BOMAD will become more common during the current economic cycle.
However, that doesn’t mean that BOMAD-funded franchisees will behave and react the same as those funded by traditional lenders. Franchisors who understand the difference may be able to reach their growth targets accordingly. Franchisor’s who don’t understand the difference may live to regret accepting BOMAD-funded franchisees.
Jason Gehrke is the director of the Franchise Advisory Centre and has been involved in franchising for nearly 20 years at franchisee, franchisor and advisor level.
He advises both potential and existing franchisors and franchisees, and conducts franchise education programs throughout Australia, and publishes Franchise News & Events, a fortnightly email news bulletin on franchising issues and trends.