FINANCING THE PURCHASE OF A FRANCHISE: EQUITY FINANCING OPTIONS
By Andrew J. Sherman, Esq.

One of the most difficult tasks faced by the management team of a growing company is the development and maintenance of an optimal capital structure for the organization. This generally involves a balancing of one or more of the following five central components: (1) long-term debt; (2) preferred stock; (3) common stock; (4) hybrid securities; and (5) retained earnings.

The challenge for the management team is to find the appropriate combination of these five components at any given moment in time that will serve as an effective capital structure to help fuel, rather than impede, the company's growth. Each of these five components carries with it certain advantages and disadvantages to the growing company. Each element of the capital structure also involves certain direct and indirect costs, which the company must be prepared to meet before it can select a capital formation alternative.

Before turning to a discussion of the legal issues surrounding capital formation alternatives, the following preliminary strategic issues should be considered:

• What are the immediate and projected capital needs of the corporation?
• Who are the current stakeholders (e.g., creditors, bondholders and stockholders) in the corporation and what are their expectations with respect to ownership, control and rate of return? What perceptions (and misperceptions) will these stakeholders have regarding your capital formation efforts?
• Who are the projected stakeholders in the company and what are their projected expectations with respect to rate of return?
• How will the capital raised be allocated? How and when will the assets acquired begin to generate income to repay the costs of the capital utilized for the project?
• If debt financing is selected:
  1. What collateral is available to secure the loan?
  2. What assurances can be offered to the lender as to the company's ability to meet its debt-service obligations?
  3. What additional risks of financial distress and/or failure will be placed on the corporation as a result of these debt-service obligations?
  4. What are the direct (principal and interest) and indirect (restrictive covenants in loan agreements) costs of this additional leverage?
• If equity financing is selected:
  1. What are the expectations of the current equity holders with respect to ownership and control? To what extent will current equity holders suffer dilution as a result of the offering? Are there any contractual restrictions on dilution?
  2. What are the relative risks involved in the deployment of the capital to be raised? How will prospective investors assess this risk in determining their expected rates of return?
  3. What are the projected profits to be generated by the deployment of the capital to be raised? How and when will these profits be divided and distributed among the holders of the company's equity securities?
  4. What tax advantages are lost as a result of the choice of equity over debt? Do the benefits of not being obligated to repay the holders of the equity securities outweigh the benefit of deductibility of interest payments on the debt?

There is almost always some component of debt financing in the development or acquisition of a franchise. Whether it is a small loan from family or friends at the outset of the business or a sophisticated term loan and operating line of credit from a regional commercial lender, most franchisees end up borrowing some amount of capital along their path to growth. The use of debt in the capital structure (commonly known as "leverage" ) will affect both the valuation of the company as well as its overall cost of capital. The determination of the proper debt-to-equity ratio in any given entity will depend on a wide variety of factors, which include among other things:

• the risk of business distress/failure created by the contractual obligation to meet debt-service payments;
• the direct and indirect costs to the company of obtaining the capital;
• the need for flexibility in the capital structure in order to respond to changing economic or market conditions;
• the ability of the company to get access to various sources of financing (access to capital issues);
• the nature and extent of the tangible (or intangible) assets of the company which are available to serve as collateral to secure the loan;
• the level of dilution of ownership and control that the shareholders (and managers) of the company are willing to tolerate; and
• certain tax considerations (interest payments are a deductible expense whereas dividends are not).

The maximum debt capacity that a franchise will ultimately be able to handle will usually involve the balancing of the costs and risks of defaulting a debt obligation against the desire of the owners and managers to maintain control. Some franchisees prefer preservation of control over the affairs of the company in exchange for the higher level of risk that is inherent in taking on additional debt obligations. The ability to meet debt-service payments must be carefully considered in the company's financial projections.

If the forecasted projections and analysis reveals that the ability to meet debt-service obligations will put a strain on the corporation's cash-flow (or that insufficient collateral is available), or may effect the ability to pay royalties to the franchiser, then equity alternatives should be explored. It is simply not worth driving a company into voluntary (or involuntary) bankruptcy solely to maintain a maximum level of control. As it is often said, 60% of something is worth a whole lot more than 100% of nothing. Also, the level of debt financing selected by the franchisee should be compared against key business ratios for the particular industry (such as those published by Robert Morris Associates or Dun & Bradstreet). Once the optimum debt-to-equity ratio is determined, you must be aware of the various sources of debt financing as well as the business and legal issues involved in borrowing funds from a commercial lender.

SOURCES OF DEBT FINANCING

Although most small companies turn to term loans and operating lines of credit (the traditional form of financing from commercial lenders), there exists a wide variety of alternative sources of debt financing such as (a) trade credit; (b) equipment leasing; (c) factoring; and (d) other sources of non-bank financing.

(a) Trade Credit - The use of credit with key suppliers is often a means of survival for rapidly growing companies. When a company has established a good credit rating with its suppliers, but as a result of rapid growth tends to require resources faster than it is able to pay for them, trade credit becomes the only way that growth can be sustained. A key supplier has a real economic incentive for helping the growth and prosperity of a loyal customer and, therefore, may be more willing to negotiate credit terms that are mutually acceptable.

(b) Equipment Leasing - Most rapidly growing companies are desperately in need of the use but not necessarily the ownership of certain key resources to fuel and maintain growth. Therefore, equipment leasing offers an alternative to ownership of the asset. Monthly lease payments are made in lieu of debt-service payments. There are many forms of equipment leasing, such as operating leases (which are generally shorter in term and include repair and maintenance services) or capital leases (which are generally longer in term, do not include ancillary services and virtually transfer ownership to the lessee, due in part to the attractive terms of the option to purchase the asset at the end of the lease term).

(c) Factoring - Under the traditional factoring arrangement, a company sells its accounts receivables to a third party in exchange for immediate cash. The third party or "factor" assumes the risk of collection in exchange for the ability to purchase the accounts receivable at a discount. The amount of the discount is usually determined by the level of risk that debtors will default and the prevailing interest rates. Once notice has been provided to debtors of their obligation to pay the factor directly, the seller of the accounts receivables is no longer liable to the factor in the event of a default. As factoring has become more commonplace in a variety of industries, less traditional forms of factoring have emerged (which are more akin to pure accounts receivable financing), whereby (i) the lender does not assume the credit risk; (ii) the accounts are assigned to the lender without notice to the debtors; and (iii) the accounts receivable merely become the principal source of collateral to secure the loan agreement.

(d) Miscellaneous Sources of Non-Bank Debt Financing - Debt securities (such as bonds, notes and debentures) may be offered to venture capitalists, private investors, friends, family, employees, insurance companies, and related financial institutions. Many smaller companies turn to traditional sources of consumer credit (such as home equity loans, credit cards and commercial finance companies) to finance the growth of their business. In addition to the loan programs offered by the Small Business Administration (SBA), many state and local governments have created direct loan programs for small businesses.

Although all available alternative sources of debt financing should be strongly considered, traditional bank loans from commercial lenders are the most common source of capital for small growing companies. Before attempting to understand the types of loans available from commercial banks, it is important to understand the perspective of the average commercial bank when it analyzes the company's loan proposal.