The Government Accountability Office (GAO) published a report identifying that loans to certain franchise companies failed at a higher rate. From 2003 to 2012, the SBA guaranteed loans for more than $10.6 billion to franchise businesses and was forced to make payments on about 28 percent of those loans.
Analysis of guaranteed loans to franchisees of a select franchise organization reviewed by GAO, approved from January 1, 2000, to December 31, 2011, showed the Small Business Administration (SBA) approved a total of about $38.4 million for 170 loans made by 54 lenders. SBA’s guaranteed portion on these loans was approximately $28.8 million.
Of the total population of 170 loans, 74 loans defaulted, 55 of which (74 percent) originated from four lenders that had the highest loan volume and default rates on loans to the franchisees. SBA made guarantee payments of around $11 million on the defaulted loans to franchisees, including about $8.5 million in guarantee payments on the 55 defaulted loans from these four lenders.
In comparison, 19 of the 82 loans (23 percent) that originated at the other 50 lenders to the franchisees defaulted. As part of GAO’s investigative work, GAO interviewed the owners of 22 franchisees of the franchise organization in GAO’s review, of which 16 defaulted on their loans and 10 filed for bankruptcy protection. Interviewed franchisees noted difficulties meeting anticipated revenue estimates and limited access to information that would aid in business planning.
GAO was unable to conclusively determine whether the loan agent referred to GAO for investigation intentionally provided exaggerated revenue projections to franchisees to help them qualify for SBA loans, and SBA has taken initial steps to enhance program oversight. The loan agent stated that she obtained the revenue projections from her employer and former clients, one of which she identified.
She then provided these revenue projections to clients. The employer and former client she identified denied providing the revenue projections to the loan agent. SBA’s Office of Credit Risk Management debarred the loan agent and her employer for encouraging false statements, among other things, making them ineligible to work with the federal government for a period of 3 years beginning in January 2012. According to GAO’s analysis, the first-year projected revenues on loan applications involving the loan agent or her employer were, on average, more than twice the amount of actual first-year revenue for 19 of the 24 franchisees reviewed
Potential franchisees should include first-year revenue estimates in their SBA loan applications. However, this information is not necessarily available to potential franchisees in the franchise organization’s disclosure document, which provides information about the organization’s financial performance representations and franchisees’ estimated initial investment, among other things. Further, federal regulations do not require franchise organizations to provide actual first-year average revenues for start-up businesses in their disclosure document. Thus, potential franchisees may have to conduct due diligence to identify this information from other sources, if available.
GAO also identified discrepancies and other issues in SBA’s franchise loan data with respect to fields used for risk-based oversight of its loans portfolio, such as default status, number of loans, and loan agent information.
Participating lenders should expect the SBA’s Office of the Inspector General to continue pressuring the agency to tighten standards and cancel more guarantees of lenders that fail to do their job.
The GAO Report identified many failures:
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Comments by Jim Coen, Executive Director, Maine Franchise Owners Association.
This reports identifies one of franchising dirty little secrets “lack of financial disclosure”. The FTC does not require franchisors to make a financial representation in item #19 of the Franchise Disclosure Document. With lack of financial representation how can a prospective franchisee create an accurate sales or expense proforma?
Here are the main failures the GAO report identified:
- New franchisees, frequently rely on others who have a financial incentive to win loan to prepare financial projections for a start-up business. Borrowers wind up with loans based on fictional expectations, defaulted loans and bankrupt companies.
- Since the loans are guaranteed lenders may accept financial projections without questioning their source and without challenging the loan applicant directly to substantiate the estimates.
- SBA guaranty may cause a disproportionate share of the loan loss when SOP guidelines and good bank underwriting are not followed by the lending partner.