Small Business Lending Matrix and Analysis

Transcription

1 Small Business Lending Matrix and Analysis The Impact of the Credit Crisis on the Franchise Sector Prepared for the International Franchise Association Educational Foundation Volume IV April FRANdata N. Fort Myer Drive, Suite 410, Arlington, VA 22314

2 Small Business Lending Matrix and Analysis The Impact of the Credit Crisis on the Franchise Sector Volume IV 2 Source Material Information for this report is based on SBA data, the Economic Impact of Franchised Businesses Study (Volume 1 and 2) and additional third party data such as government agencies. Additional information in this report was compiled from FDDs received and registered by state franchise examiners. Franchisors are required under state and federal laws to produce and deliver FDDs to prospective franchisees. As part of this disclosure process, certain state regulatory agencies require complete and updated FDDs to be filed and approved before a franchisor is permitted to sell franchising rights within their jurisdictions. These documents must be accurate by law. More information concerning FDD disclosure guidelines is available at the North American Securities Administration Association (NASAA) website: Regulatory_Resources/Corporation_Finance/588.cfm 2012 Franchise Information Systems, Inc. (all rights reserved) FRANDATA HAS NOT CONDUCTED ANY INDEPENDENT INVESTIGATION WITH RESPECT TO THE INFORMATION COMPILED BY FRANDATA FOR INCLUSION IN THIS REPORT, AND FRANDATA DOES NOT WARRANT THE ACCURACY OR COMPLETENESS OF THE INFORMATION CONTAINED IN THIS REPORT. FRANDATA HEREBY DISCLAIMS ALL EXPRESS, IMPLIED AND STATUTORY WARRANTIES, INCLUDING, WITHOUT LIMITATION, WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. FRANdata may be contacted at: FRANdata 4300 Wilson Blvd, Suite 480 Arlington, VA FRANdata TM and the FRANdata logo are registered trademarks of Franchise Information Services, Inc.

3 3 TABLE OF CONTENTS EXECUTIVE SUMMARY... 4 OVERVIEW... 5 INTRODUCTION PROJECTED FRANCHISED UNIT TRANSACTIONS FOR Factors Affecting Unit Transactions: Franchisor Capacity Factors Affecting Unit Transactions: Investor Willingness and Ability Willingness Ability Projected Franchised Unit Transactions ESTIMATED CAPITAL REQUIREMENTS FOR UNIT TRANSACTIONS ESTIMATED CAPITAL REQUIREMENTS FOR UNIT TRANSACTIONS Estimated Average Initial Investment Advance Rates The Lending Environment Ability to Lend Willingness to Lend SHORTFALL IN LENDING FRANCHISE ECONOMIC IMPACT IN ECONOMIC IMPACT DUE TO SHORTFALL IN LENDING IN BANK LENDING SCENARIOS Aggressive Scenario Conservative Scenario APPENDIX Factors Affecting Prospective and Existing Operator Willingness Factors Affecting Prospective and Existing Operator Ability Bank Ability to Lend Bank Willingness to Lend... 41

4 4 EXECUTIVE SUMMARY The franchise business climate is improving for the third consecutive year there is greater demand for new units and transfers, increased franchisor capacity for growth, greater bank willingness and ability to lend and an economy that is slowly improving. Demand by new prospects and existing franchise owners is expected to increase significantly in FRANdata projections indicate demand for more than 44,200 unit transactions this year, including both new units and transfers. Collectively, this represents an 8 percent increase in demand over 2011 and a 22 percent increase over If achieved, these new franchise businesses would provide more than 522,400 jobs to the U.S. economy. There are multiple factors contributing to the increasing demand. Historically, the number of prospective new franchisees increases when the unemployment rate is high. In addition, existing franchisor staff and resources will not limit investment or expansion ability in 2012, as was the case during the recession. To satisfy demand completely, franchises will require $11.72 billion in new lending capital. If capital is supplied at this level, these franchise businesses would generate an additional $70 billion in economic output. Obtaining needed financing depends on two factors, bank willingness and bank ability to lend. Both factors will improve in 2012 and bank willingness will be at its highest level since before the recession. Nevertheless, banks will not fully meet franchise borrowing requirements. We estimate that although $11.72 billion will be sought, banks will make only $9.5 billion available. This 18.6 percent shortfall in the supply of loans for franchises will result in 8,230 fewer unit transactions. A shortfall in lending has limited franchise growth since the start of the recession. The lending gap is slightly smaller this year, down 5 percent (and 1 percentage point) from the 19.6 percent shortfall in 2011 and 22.8 percent shortfall in This year s gap between demand for financing and the supply of capital will result in fewer unit transactions, nearly 94,000 jobs not created, and $12.9 billion in economic output lost. The Small Business Lending Matrix, Vol. 4 describes the reasons demand has increased and outpaced the supply of credit in detail by presenting and analyzing Factors contributing to increased demand for unit transactions; Estimated capital requirements; Factors contributing the lending shortfall; and The economic impact caused by the lending crisis. Additionally the report provides continuous comparisons to the changes in lending supply and demand over the last three years and concludes with analysis of lending scenarios that are more conservative or aggressive than the scenario on which the Small Business Lending projections are based.

5 5 OVERVIEW FRANdata projects that the franchise climate will improve in 2012, as a continuation of the positive trend since The main factors that shaped the franchise business environment in 2011 will to take effect in 2012, including Higher demand for franchise unit transactions, both new units and transfers Unconstrained franchisor capacity for growth Increased lending ability by banks to franchisees Increased willingness for both SBA guaranteed and conventional loans by banks to lend to franchisees Slow to moderate pace of economic recovery through 2012 and beyond In 2012, franchise activity is projected to increase thanks to the improving economy. Nonetheless, capital access will remain a challenge. Despite the fact that this year s lender willingness to provide financing is projected to be the highest since the recession, FRANdata predicts that banks will still not meet prospective and existing franchisees borrowing requirements. We project a shortfall of nearly $2.2 billion in lending to franchise businesses in Franchises will require $11.7 billion in new lending capital to fulfill 100 percent of the forecasted demand for new and transfer units in However, banks are projected to make only $9.5 billion available. FRANdata projects that with access to $9.5 billion in lending, 35,997 franchise unit transactions will be financed. These new and transfer units will create or maintain 425,187 jobs and generate $56.7 billion of annual economic output. Over the last three years, the gap in lending has been continuously shrinking from an estimated 22.8 percent in 2010 to 19.6 percent in 2011 and a projected 18.6 percent in Nonetheless, the $2.2 billion shortfall will result in a loss of 8,230 unit transactions, both new and transfers, more than 97,200 jobs not created or protected and a loss of $12.96 billion in annual economic output in The Small Business Lending Matrix and Analysis, Volume 4, provides a framework to estimate how the lending environment will impact the demand for and supply of capital to finance franchised unit transactions, both new and transfer units, excluding lodging. The report examines the main factors noted above and their interrelationships. The connection between sufficient capital for franchise transactions, job creation, and sustained economic recovery is a critical one. Historically, as unemployment rises, the pool of prospective franchisees increases. Franchising as a business model has shown extraordinary resilience to economic slowdowns. In past recessionary and post recessionary periods, franchise units have grown by 6 percent (between 1999 and 2006) and 5 percent (during the Tech Bubble). Because franchising represents an opportunity for individuals to change careers or expand their business, it has helped spur the pace of economic growth and also the recovery from economic downturns. The potential pool of people willing to start franchising has been sustained at high levels since the recession, due to the high levels of unemployment since During the economic recession, however, banks have been left with limited funds after accounting for declines in their home real estate loans. As a result, entrepreneurs access to capital has been limited, constraining franchise growth and slowing down the recovery. Thus, lending has a direct effect on franchise small business jobs and economic output, and consequently, on economic recovery.

6 6 Increased Investor Demand for Franchises FRANdata predicts that investor demand for franchise unit transactions will increase to 44,226 in 2012, a 22 percent rise from the estimated demand of 36,345 transactions in 2010 and an 8 percent increase from the 2011 estimate of 41,001. With the overall improvement of the economy, the demand for new unit transactions has started to surpass the demand for transfer units. In 2012, FRANdata projects that demand for new units will increase by 10 percent to 25,858 while the demand for transfer units will increase by 5 percent to 18,368. These transactions will require capital of nearly $17.7 billion, an 11 percent increase from the total required capital of $16 billion in Of the total required capital in 2012, $11.7 billion will need to be borrowed to meet the full demand for transactions, representing an increase of 12 percent from $10.4 billion in Unconstrained Franchisor Capacity for Growth Franchisor capacity, including staff and resources to support franchisee recruitment efforts, will not be a limiting factor in During the recession, franchisors capacity to grow was curtailed. The overall improving economic and business climate over the last two years has helped franchisors invest in their franchise development capabilities again and strengthened their capacity to grow. Lending Environment Ability and Willingness In an improving economy, banks will continue to have sufficient funds available to meet the demand for franchise unit transactions in 2012, as they did in the previous two years. FRANdata predicts that bank willingness to lend will also improve during the year, mostly for SBA guaranteed loans, but also, to a small extent, for conventional loans. Economic growth, certain improvements in delinquency rates, more upbeat employment data and positive trends in the commercial property market will somewhat ease banks lending standards and terms in FRANdata predicts that banks willingness to provide SBA guaranteed loans will increase by 30 percent while their willingness to provide conventional loans will rise by 5 percent. Even with the improvement in willingness, however, banks willingness to lend will not be high enough to meet all borrowing requirements for franchise unit transactions. Banks continue to be cautious lenders to small businesses and remain ready to tighten their standards at any signs of economic distress. In January 2012 for example, amid global economic uncertainty triggered by the Greek sovereign debt crisis, over 94 percent of U.S. banks reported that their lending standards had changed little over the past three months. At the same time, the net fraction of banks reporting increased demand from small firms rose to its highest level since The SBA announced an all time lending record in its 60 year history, with over $30 billion in lending supporting over 60,000 small businesses in fiscal year The boost was driven by a combination of governmentenforced provisions, such as the Recovery Act, the Small Business Jobs Act, raising the guarantee on SBA loans to 90 percent and eliminating or reducing fees, and the 2.5 times increase in the cap for SBA guaranteed loans. FRANdata estimates that from 15 percent to 20 percent of SBA loans are made to franchisees. The SBA will continue to be a major driver in small business lending in 2012 and after. FRANdata estimates that between 15 percent and 20 percent of SBA guaranteed loans are provided to new and existing franchisees. Based on the increase in SBA lending, the overall economic improvement, and lender and franchisor feedback, FRANdata predicts that SBA guaranteed lending to franchisees will constitute an even larger portion of their financing, increasing from 35 percent in 2011 to 40 percent in Based on our assessment of SBA lending activities, business and economic trends and the lending environment as a whole, FRANdata projects that lenders will have a pool of more than $13.2 billion available to finance franchise transactions in This represents a 10 percent increase from the $12 billion FRANdata estimated

7 7 for 2011, reflecting economic growth and strengthening of banks balance sheets. At the same, however, banks will only be willing to provide a total of $9.5 billion in SBA guaranteed and conventional lending to new and existing franchisees. Even though this represents a nearly 14 percent increase from the lending volume banks were willing to provide in 2011, it will not be sufficient to meet the borrowing needs of all transactions projected to be demanded in Competition for financing will remain tight in 2012, since lenders remain risk averse and credit standards have not significantly changed since For applicants to merely qualify will not be sufficient in the banks view. Instead, lenders will assess creditworthiness by evaluating unit economics, system performance and franchisor performance. Since 2008, entrepreneurs' access to capital has been limited, constraining franchise growth and slowing down the U.S. economic recovery. As a result, lending has a direct effect on franchise small business jobs and economic output and consequently, on economic recovery. Effect of Lending Shortfall in 2012 In 2012, FRANdata projects that banks will lend $3.8 billion through SBA guaranteed and $5.7 billion through conventional loans or a total of $9.5 billion to new and prospective franchisees. The difference between the lending required to fund 100 percent of the demanded franchise transactions and the lending capital banks will be willing to make available represents a shortfall of nearly $2.2 billion, or 18.6 percent. The shortfall in lending is projected to result in 8,230 unit transactions, both new units and transfer units, which will not be completed due to restrictive lending policies. The following graph presents the effect the projected lending shortfall will have on the number of new and transfer unit transactions. The yellow area defines the shortfall in lending due to the difference between bank willingness to lend, presented by the Supply of Funds line, and franchise capital borrowing requirements, presented by the Demand Requirement line. Figure 1. Effect of Lending Shortfall. New Units FRANdata estimates that in 2012, the 25,858 possible new unit transactions would create 504,475 direct and indirect jobs and add $67.2 billion in annual economic output. This also means that the shortfall in lending will cost the economy 4,812 new units, 93,872 jobs not created, and $12.5 billion in annual economic output.

8 Table 1. Base Scenario, Effect of Lending Shortfall on New Units. Base Scenario New Units 8 Total Jobs Created thru Financing Total Annual Economic Output Created thru Financing Maximum Level 25, ,475 $67,240,078,812 Effect of Shortfall (4,812) (93,872) ($12,511,906,779) Reduced Level 21, ,603 $54,728,172,033 Transfer Units The lending shortfall has a similar but more muted effect on transfer units. FRANdata assumes that if a unit that needs to transfer is unable to get funding, in 95 percent of cases it will continue to operate for the next year, while 5 percent of the units would be unsustainable. This means that demand for 18,368 transfer unit transactions would maintain 17,918 direct and indirect jobs and $2.39 billion in annual economic output. However, due to the shortfall in lending, FRANdata estimates that 3,418 transfer unit transactions will not occur. Consequently, 3,334 total jobs and $444.4 million in annual economic output will not be protected. Table 2. Base Scenario, Effect of Lending Shortfall on Transfer Units. Base Scenario Transfer Units Total Jobs Maintained Total Annual Economic Output Transaction thru Financing* Maintained thru Financing* Maximum Level 18,368 17,918 $2,388,231,129 Effect of Shortfall (3,418) (3,334) ($444,397,535) Reduced Level 14,950 14,584 $1,943,833,594 *The number of jobs maintained was calculated by taking the 18,368 total demanded transfer unit transactions and multiplying them by the estimated 19.5 (direct and indirect) jobs. The product is multiplied by 5 percent to calculate the number of jobs not protected by the units that will close without financing. The same methodology was applied to estimate the economic output. Total Units New and Transfers In 2012, the 44,226 unit transactions seeking capital could create or maintain 522,393 total direct and indirect jobs and create or maintain $69.6 billion in total direct and indirect annual economic output. However, due to banks unwillingness to lend, 8,230 unit transactions will not be able to obtain funding. As a result 97,206 direct and indirect jobs will not be created or maintained and nearly $13 billion in economic output will be lost. Table 3. Base Scenario, Effect of Lending Shortfall on New and Transfer Units Combined. Base Scenario Number of New and Transfer Unit Transactions Total Jobs Created or Maintained thru Financing Total Annual Economic Output Created or Maintained thru Financing Percent of Maximum Level Maximum Level 44, ,393 69,628,309, % Effect of Shortfall (8,230) (97,206) ($12,956,304,314) 18.6% Reduced Level 35, ,187 $56,672,005, % More Aggressive Lending Scenario The above estimates are based on FRANdata s analysis of a combination of factors that affect bank lending to small businesses in different ways. In addition to the projected 30 percent increase in SBA guaranteed and 5 percent in conventional loans, it is worth examining the effects on the economy that would result if banks took a more aggressive or a more conservative approach to lending than the base scenario discussed above. Under an aggressive lending scenario, banks will increase their lending to $10.95 billion (from $9.54 billion under the base scenario). This scenario could occur if the positive signs of growth and stabilization continue at an

9 9 accelerated pace throughout the year and SBA guaranteed lending continues to increase as a result of the provisions in support of lending to small businesses. Over 62,600 more jobs and over $8.3 billion more economic output will be maintained if banks took the aggressive approach to lending as compared to the base approach. This represents a 15 percent increase from the base scenario in both jobs and economic output created or maintained. Table 4. Aggressive Scenario, Effect of Lending Shortfall on New and Transfer Units Combined. Aggressive Scenario Number of New and Transfer Unit Transactions Total Jobs Created or Maintained thru Financing Total Annual Economic Output Created or Maintained thru Financing Percent of Maximum Level Maximum Level 44, ,393 69,628,309, % Effect of Shortfall (2,929) (34,595) ($4,611,021,001) 7% Reduced Level 41, ,798 $65,017,288,941 93% More Conservative Lending Scenario On the other hand, banks may take a more conservative approach to lending than projected under the base scenario and tighten their lending again in case of global economic distress, rising gas prices and political uncertainties. Under the conservative scenario, total lending available will be reduced to $8.1 billion. This shortfall will result in an additional 5,381 unit transactions that will not obtain financing. Consequently, an additional 63,561 direct and indirect jobs and $8.4 billion in economic output will not be created or maintained. The total jobs and economic input that will fail to be created or maintained will be more than 160,000 and $21.4 billion, respectively. Table 5. Conservative Scenario, Effect of Lending Shortfall on New and Transfer Units Combined. Conservative Scenario New and Transfer Unit Transactions Total Jobs Created or Maintained thru Financing Total Annual Economic Output Created or Maintained thru Financing Percent of Maximum Level Maximum Level 44, ,393 69,628,309, % Effect of Shortfall (13,611) (160,766) ($21,428,122,463) 31% Reduced Level 30, ,626 $48,200,187,478 69%

10 10 INTRODUCTION This is the fourth volume of the Small Business Lending Matrix a report series designed to estimate how the current lending environment will impact the demand for and supply of lending capital to franchising in the year ahead. The combined unit transactions (defined as an investment in a new unit or a unit transfer for all industries except lodging) have a huge impact on the U.S. economy. Each franchised unit accounts for an estimated average 19.5 direct and indirect jobs and $2.6 million in direct and indirect annual economic output. The ability to create and protect jobs is paramount as the U.S. economy slowly regains its footing, and franchising plays an important role in ensuring the continued recovery after the worst recession since the 1930s. Since 2009, FRANdata s Small Business and Lending Matrix and Analyses have projected lending capital requirements for franchise systems across all industries (excluding lodging) based on the following factors: 1. Average initial investment for a unit transaction 2. The number of unit transactions, defined as both new units and transfers 3. Distinctions between prospective franchisee and experienced operator franchisee willingness and ability to start new units and acquire existing units 4. Bank s willingness and ability to lend 5. Bank loan terms In 2011, the lending environment showed the first signs of improvement since the recession. Based on the Federal Reserve Board Senior Loan Officer Opinion Survey on Bank Lending Practices, some banks reported somewhat eased lending standards, although loans to smaller firms remained relatively low. The economy continued to grow throughout 2011, even though at a slower pace than during the previous year 1.7 percent vs. 3 percent, respectively. It is projected to accelerate modestly at 2.3 percent in The unemployment rate fell to a three year low of 8.3 percent in February Rebounding stock markets have also started to stabilize Americans balance sheets. In February 2012, the Dow Jones industrial average crossed above 13,000 for the first time since May After fluctuating levels of confidence in 2011, consumers are more optimistic and expect business conditions to improve over the next six months. In 2011, monthly retail and food services sales (seasonally adjusted) grew by an average of 7.7 percent over the previous year s monthly sales, which compares to a growth of 6.4 percent in In January 2012, sales reached $401,400 million, which represented a 5.8 percent increase over sales in January However, this was below the 8 percent increase in January 2011 over January Same store sales for 23 chains tracked by Retail Sales increased 3.6 percent from a year ago. This was the 28th month of gains, after 12 consecutive months of declines. Retail sales have increased 7.8 percent over the last year and now stand 0.4 percent above pre recession levels. Additionally, same store sales have also increased compared to decreases in 2009 and In 2011, the SBA reached a record in small business lending: over $30 billion in lending supported more than 60,000 small businesses in the fiscal year ending September This boost was driven by a combination of government provisions, such as the Recovery Act, the Small Business Jobs Act, raising the guarantee on SBA loans to 90 percent and eliminating or reducing fees, and the 2.5 times increase in the cap for SBA guaranteed loans. On the downside, U.S. home prices, which significantly affect prospective and existing franchisees willingness and ability to invest in transactions and banks ability and willingness to lend, continue to decline. The Federal 1 Based on the average of different projections for economic growth, presented in the Appendix.

11 11 Housing Finance Agency (FHFA) announced that even though about half of all U.S. states saw price increases in the last quarter of 2011, its national index declined by 2 percentage points over the last four quarters. According to some forecasts, average U.S. home prices are not expected to rise until the third quarter of The number of failed financial institutions has dropped significantly to 92 in 2011 and to 12 in the first two months of However, it must be remembered that a total of 436 banks failed since the onset of the financial crisis in 2008, causing a total estimated loss of $74 billion. In addition, prominent bank failures, such as Lehman Brothers and CIT, took place only three to four years ago. As a result, banks small business lending standards and terms remain generally conservative With hindsight, the optimism in early 2011 was exaggerated. The economic recovery was choppy and world events such as the European crisis, the Arab Spring and tensions with Iran created uncertainty. However, the recovery continued throughout 2011 and the economic data for the last months in 2011 showed a continuous trend upwards. As a result, FRANdata forecasts that new and prospective franchisees willingness and ability to invest in franchised unit transactions will increase in Banks willingness and ability to lend will also see marked improvements from their levels in 2011 and the years before. This increase in demand for unit transactions will also raise the demand for borrowing capital. As in previous years, we project that this demand will still not be met in In fact, there will be a lending gap of 18.6 percent between the funds demanded for unit transaction financing and the capital lenders are willing to make available. This gap, however, will be smaller than the estimated 19.6 percent in 2011, reflecting an overall improvement of the lending environment. For the 2012 projections, FRANdata used the same methodology as in its previous studies, but made changes to some underlying assumptions. The most significant changes include the following: Based on data analysis and market feedback, FRANdata believes that the backlog of transfer units accumulated in the downward economy has started to clear out. A significant portion of the units that needed to be closed due to cash flow problems during the recession have already been transferred or closed. At the same time, rising same store sales, consumer optimism and overall improving economic conditions decrease the supply of transfers as operators have less motivation to sell. This results in three main factors that affect the lending matrix: o The price of a transfer is back to the level of the price of a new unit, up from its slightly suppressed 2011 level. FRANdata expects that after 2012, as the economy continues to improve, the price of transfers will rise above the price of a new unit to reflect the additional value a transfers existing sales performance brings. o Along with the improvement of the economy, the demand of new units started to grow faster than the demand for transfers in FRANdata forecasts that the demand for new units will continue to be higher than that of transfers in o In 2011, FRANdata concluded from an analysis of turnover and closure data that nearly 10 percent of transfer unit transactions that did not happen due to capital constraints resulted in a closure, because the relatively large number of franchisees who had waited for better economic conditions to achieve higher multiples found it hard to remain in business. With the overall economic growth and clearing of the backlog, FRANdata predicts the number of transfers that will result in closure rates will be closer to the previous 5 percent trend levels in 2012.

12 12 In the previous lending matrices, for simplicity purposes, FRANdata assumed that an equal number of transfer and new unit transactions will not take place due to the lending gap. In this matrix, FRANdata allocates the unit transactions that will not take place relative to their share of the total demanded transfer and new units. The change in the assumption more closely reflects the smaller demand for transfers as compared to new unit transactions and its effect on franchise jobs and economic output. 2 As in the previous studies, potential new unit owners were divided into two groups, first time owners and experienced franchisees. FRANdata took into consideration possible changes in both the ability and the willingness to invest in a unit transaction for each group separately. It was assumed that both had decreased due to the effects of the economy on housing prices, the unemployment rate and investment portfolio losses. In 2012, operators willingness and ability to invest in franchised unit transactions will improve further from their 2011 levels. New franchisee s ability to invest will rise for the first time since the recession, due to the gradual growth of the economy, 401Ks, and the stock and labor markets, which will help strengthen balance sheets. Existing operator ability to invest also continues to grow, boosted by gains from the rise in the same store sales of their existing franchised units, and will surpass the change experienced in Overall, although willingness and ability for both experienced and new operators will increase, any such increases will be at a lower rate than in 2011, when the economy had just started to pick up from the nearrecession levels of This reflects the overall slow down of economic growth in 2011 and the fact that this year s increases are from a relatively high base in In 2012, FRANdata projects existing operator willingness and ability to increase by an average of 11 percent, which compares to an estimated average of 18 percent in For new franchisees, FRANdata projects an average increase of 4 percent as opposed to an average of 8 percent in Table 6 presents the change in willingness and ability since Table 6. Estimated and Projected Operator Willingness and Ability. Operator Willingness and Ability Estimated Projected Existing Operator Willingness 30% 20% 28% 13% Existing Operator Ability 35% 5% 8% 10% New Operator Willingness 18% 15% 15% 5% New Operator Ability 25% 5% 0% 3% Figure 2 presents the change in willingness and ability to invest in a franchised unit transaction by operator type with 2008 as the starting point. Both willingness and ability have grown since their initial drop in Willingness rose faster than ability as optimism improved quicker than capacity at the first signs of a growing economy. Also, existing franchisees ability to invest dropped deeper than new franchisees ability because existing operators incurred higher losses when the economy crashed. They were, however, also quicker to regain their assets and improve their outlook with the rise in same store sales and overall business and consumer optimism. 2 In 2011, FRANdata estimated that lending shortage would result into a total of 7,985 unit transactions failing allocated between 3,993 new and 3,993 transfer units. In 2012, we project that the gap will result in 8,230 transactions failing, allocated as 4,812 new units (18.6 percent of the demand for new units) and 3,418 transfers (18.6 percent of the demand for transfers).allocated between 3,993 new and 3,993 transfer units. In 2012, we project that the gap will result in 8,230 transactions failing, allocated as 4,812 new units (18.6 percent of the demand for new units) and 3,418 transfers (18.6 percent of the demand for transfers).

13 13 Figure 2. New and Existing Franchisee Willingness and Ability to Invest in Franchised Unit Transactions Based on these assumptions, FRANdata projects a total demand for 44,226 unit transactions in This represents a 7.9 percent increase in demand from 2011 but is below the 12.8 percent increase in demand from This reflects the somewhat suppressed economic growth in 2011 as well as the higher base on which the change is applied. Scenario Units Unit Shortfall Dollars Dollar Shortfall As with the previous studies, FRANdata relied on actual data, sample data, industry knowledge, franchisor interviews, and discussions with lenders to assess lender willingness and ability. FRANdata forecasts that 5 percent of the transfer units projected not to find financing will not be able to continue operations throughout These 5 percent are included in the total jobs and economic output not protected through financing. The table below shows the different scenarios FRANdata projects for 2012, based on the above considerations. The Maximum Level presents the total demand for unit transactions and the number of jobs and economic output that would be created or protected if total demand for financing was met. In other words, the Maximum Level outputs are only constrained by the investor willingness and ability to invest into a unit transaction but not by the lending environment. The Base Scenario presents the outcomes that FRANdata considers most likely to occur based on the current economic situation. It shows an 18.6 percent gap from the maximum possible level of outputs. The Aggressive Scenario could occur if the economy strengthened and banks eased their lending standards further from the current expectations. This would reduce the lending gap from 18.6 percent to 7 percent. The Conservative Scenario could occur if the economy worsened and banks tightened their lending standards in Under these circumstances, there would be a 31 percent gap.

14 14 Table 7. Scenarios Comparison. Scenario New Units Transfer Units Total Jobs Created or Maintained thru Financing Total Annual Economic Output Created or Maintained thru Financing Percent of Maximum Level Maximum Level 25,858 18, ,393 $69,628,309, % Base Scenario 21,046 14, ,187 $56,672,005,628 81% Aggressive Scenario 24,146 17, ,798 $65,017,288,941 93% Conservative Scenario 17,900 12, ,626 $48,200,187,478 69% Note: The jobs created or maintained through financing include the jobs created by opening a new unit and the jobs maintained through financing a transfer unit that would have closed without lending funds. FRANdata estimates that 5 percent of the transfers that do not receive financing will close in FRANdata assumes 19.5 (indirect and direct) jobs per unit to estimate the number of jobs that would be created or maintained dependent on receiving financing. Every new unit transaction that does not occur because of financing constraints results in 19.5 of these jobs not created. Conversely, 5 percent transfer units without financing will result in 19.5 jobs not protected. The same methodology was applied to estimate the economic output. The projected demand of 44,226 franchised unit transactions reflects an increase at a compound annual growth rate (CAGR) of nearly 10 percent from its 2009 level of 33,302. Over the same period, demand for capital increased at a CAGR of 11.7 percent from $12.7 billion to $17.8 billion. The total borrowing required will increase at a CAGR of 11.3 percent from $8.5 billion in 2009 to $11.7 billion in Actual lending is projected to improve steadily at a CAGR of 10.8 percent, from $7 billion in 2009 to $9.5 billion in The gap between demand for and the supply of lending capital was highest in 2010 over the examined period. We project it to fall further to 18.6 percent in 2012, the lowest since The following table summarizes FRANdata s estimates and projections for the lending environment from 2009 to Table 7. Small Business Lending Capital Needs Estimated Projected 2009* 2010* 2011* 2012** Total Capital Requirements $12.7 $13.6 $16 $17.8 Total Borrowing Requirements $8.4 $10 $10.4 $11.7 New Unit Demand 12,695 13,655 15,191 25,858 Unit Transfer Demand 20,338 22,690 25,810 18,368 Actual Lending for Unit Transactions $7 $7.8 $8.4 $9.5 Gap in Lending 21% 23% 20% 19% Note: All $ amounts in billions The following figure summarizes the projected development of the franchise lending environment from 2009 to 2012.

15 15 Figure 3. Franchise Lending Environment Under FRANdata s base scenario projection for 2012, a lending gap of $2.2 billion will occur. Due to this shortfall, a total 8,230 unit transactions will not occur resulting in a total of 97,206 direct and indirect jobs not created or not maintained and nearly $13 billion in direct and indirect economic output not generated or not maintained.

16 16 PROJECTED FRANCHISED UNIT TRANSACTIONS FOR 2012 FRANdata determines the projected number of franchise unit transactions that would occur if there were no constraining factors in the market by using the estimates for 2011 as a baseline. These estimates are used to project demand based on assumptions about franchisor and franchisee willingness and ability to develop new units or to invest in a transfer unit. For the purpose of this analysis, the lodging industry is removed as an outlier. The lodging industry is highly capital intensive and its financing comes primarily from capital markets activities that are not often available to other franchise segments. The main factors impacting the likelihood for a unit transaction to take place are franchisor capacity, investor willingness, and investor ability to open or purchase a unit. Economic indicators, such as GDP growth, the unemployment rate, personal income, confidence levels, and standard of living perceptions have improved since the end of the recession. The outlook is generally better than twelve or six months ago. The overall economy picked up pace in the final quarter of Economic indices had an overall upward trend: the employment trends index (ETI) improved rapidly for four straight months, 3 economic activity in the manufacturing sector expanded for the 30th consecutive month and the overall economy continued its growth for the 32nd consecutive month. 4 Unemployment decreased to 8.3 percent in January 2012, down from 9.1 percent a year earlier. This trend continued in February and the unemployment rate remained at 8.3 percent. Through the year at hand, the economic trends are expected to continue to be positive. However, many observers expect only a slight quickening of the recovery pace due to worries over sluggish improvement of the unemployment rate, consistently high gasoline prices, possible tightening of lending conditions, potential aggravations of the financial crisis in Europe, political uncertainty in an election year, and healthcare legislation related concerns. These factors will continue to influence franchisors capacity to grow, as well as investor ability and willingness for new unit transactions throughout Factors Affecting Unit Transactions: Franchisor Capacity In 2008 and 2009, franchisors adjusted to the weak economic conditions by reducing their capacity to develop and support franchise unit transactions. With the slow improvement of the economy, franchisors started to rebuild their growth capacity as they resumed hiring the training and development staff needed for successful expansion of their systems. Businesses have remained cautiously optimistic throughout 2011 and at the start of 2012, despite the slow pace of the recovery. Based on CEO satisfaction surveys, most firms are expected to increase, or at least retain, the number of their employees and fixed investment expenditures in anticipation of higher revenues and profits during the year ahead. 5 Based on such indicators and primary research, FRANdata expects that franchisors will continue a cautious hiring pace. Since franchisor capacity for growth depends primarily on employing an adequate workforce rather than capital investment, FRANdata believes that, as in 2011, franchisor growth capacity will not be a limiting factor for growth in board.org/press/pressdetail.cfm?pressid= index/pdf/flierconfindex_q411.pdf

17 17 Factors Affecting Unit Transactions: Investor Willingness and Ability Besides franchisor capacity, the two main factors affecting the demand for unit transactions are investor ability and willingness to develop new or to acquire transfer units. Investor ability is determined by the investors access to credit and personal financial position. However, in addition to the availability of capital, the demand for a unit transaction will be affected by the investors willingness to do so, which is based on intangible factors, such as perception of the economy, forecasts, risk aversion, and other individual emotional and psychological factors. Demand for unit transactions is also influenced by the type of prospective investor. FRANdata distinguishes between new owners and experienced franchisees adding another unit to their existing one(s). For these two types, ability and willingness to invest may differ. As in the previous Small Business Lending Matrix reports, in order to assess the change in investor willingness and ability for unit transactions in 2012, FRANdata has developed the following matrix, based on the factors discussed below. The change in investor willingness and ability for unit transactions was used to determine the demand for new and transferred units assuming that franchisor growth capacity is not a constraining factor. Table 8. Existing Operator and New Franchisee Changes in Willingness and Ability. Changes in Willingness and Ability Franchisee Type New Unit Transfer Transactions Transactions Existing Operator Willingness 15% 10% Existing Operator Ability 10% 10% New Franchisee Willingness 10% 0% New Franchisee Ability 5% 0% Willingness In 2011, FRANdata projected that existing operator willingness to invest in new and transfer unit transactions increased by 25 percent and 30 percent, respectively. New franchisee willingness was also projected to increase, although to a smaller extent 15 percent for both new and transfer units. These predictions were based on the optimistic economic indicators, such as rising consumer and business confidence, supported by growth in retail and same store sales. In 2012, FRANdata expects that new and existing franchisees willingness will grow further from their 2011 levels. However, the increase in willingness is slightly lower than the increase in the previous year, since expectations for 2012 have been affected by the slow and choppy progress made during FRANdata forecasts that, in 2012, existing operator willingness to develop new units will increase by 15 percent, while their willingness to acquire transfers will increase by 10 percent. The demand for new units is more susceptible to economic turns and levels of optimism than the demand for transfers. When the economy underperforms, the development of new units slows down considerably, while that of transfers remains less affected. This is driven by the lower risk of transfer units due to their existing performance history. When the economy starts to improve and entrepreneurs become more optimistic, new units become attractive options again while the demand for transfers is more stable. Thus, in economic upturns, the demand for new units surpasses that for transfers. The overall improvement of the economy in 2012 will cause the demand for both new and transfer units to increase. However, the increase in the demand for new units will be higher than that for transfers. New franchisee willingness will modestly increase over its 2011 level to10 percent for new units. Their willingness to invest in transfer transactions will remain unchanged. New operators willingness will pick up

18 18 slowly due to their lack of franchise business experience. Based on interviews with prospective new franchisees, their willingness to develop a transfer unit will increase by a slightly lower percentage than to open a new unit. Prospective franchisees consider transfer units in good shape to be more expensive to purchase while the more affordable ones would not be an attractive deal due to their challenges to survive prolonged and difficult economic conditions. Existing franchisees, on the other hand, do not consider transfer units potential issues as challenging because of their experience operating similar businesses. For this reason, they are no less willing to develop a transfer unit than a new one. The main business and economic factors affecting franchisee willingness to develop new and transfer units are discussed below. For more details, please refer to the Appendix. As the economy is moving further away from the recession, existing and new franchisees gain more confidence in the business and economic environment and become more willing to develop franchised units. At the same time, yet another year of slow to come recovery has made them a little more cautious about their expectations for 2012 than they were for Standard of living perceptions and consumer confidence fluctuated during 2011 as the U.S. debt ceiling crisis and the European financial crisis exacerbated the degree of uncertainty but finished on a high note at the end of the year. Gallup's standard of living index was at 31 in December 2011, the highest since June and up slightly from 30 in December It remained below the pre recession level of 36 in January In January 2012, the consumer confidence index dropped slightly to 61.1 from its large gains in the last two months of 2011 when it reached January 2011 levels At the start of this year, consumers were more upbeat about employment, but less optimistic about business conditions and their income prospects. Growth in sales, an indicator of higher potential profitability, also has a strong positive effect on existing and new franchisee willingness to develop franchise units. In 2011, monthly retail and food services sales (seasonally adjusted) grew by an average of 7.7 percent over the previous year s monthly sales, which compares to 2010 s growth of 6.4 percent. In January 2012, sales reached $401,400 million, which represented a 5.8 percent increase over sales in January This was a smaller growth than January 2011 s increase of 8 percent over January 2010, however. 8 Same store sales for 23 chains tracked by Retail Sales increased 3.6 percent from a year ago. This was the 28th month of gains, after 12 consecutive months of declines. 9 Some of these improvements are, however, contributed to aggressive discounting by retailers that created a better buying climate and bolstered consumer confidence. Doubts remain about the sustainability of such gains and their impact on the economy, especially in combination with slow improvements in the labor market and rising gas prices. Over the last year, retail sales have increased 7.8 percent and now stand 0.4 percent above pre recession levels. Additionally, same store sales have also increased compared to decreases in 2008 and As a result, actual new unit and transfer data tracked by FRANdata has been trending upward since late Ability In 2011, FRANdata forecasted that existing operators ability would improve by 5 percent for new units and by 10 percent for existing units. New franchisee ability was expected to stop its downward trend from 2010 and to 6 standard living perceptions best june.aspx 7 board.org/press/pressdetail.cfm?pressid=

19 19 remain flat in These predictions were based on marginal economic growth, recoveries in the stock market and personal investment portfolios, a rise in retail sales, as well as a high unemployment rate and a weak housing market. With the overall strengthening of the economy since the end of the recession, existing and new franchisees ability to develop new and transfer units has increased further from their 2011 levels. FRANdata forecasts that, in 2012, existing operators ability to develop new and transfer units will rise by 10 percent over last year s. New franchisees ability to open a transfer will remain the same as the previous year but their ability to open a new unit will increase by 5 percent. The overall rise in ability to open new and acquire transfer units represents a significant improvement over recession levels, when ability plunged in all categories. At the same time, however, the projected rise in ability in 2012 will be somewhat subdued in comparison to the projected rise in 2011, due to the suppressed growth rate of economic recovery we saw in 2011 and expect to continue in Unlike previous years, in 2012, operators ability to acquire transfers will be equal (for existing operators) or lower (for new operators) than their ability to develop a new unit. Transfer transactions will be somewhat constrained by the lower availability of attractive transfer deals as many weak units have already closed during the prolonged economic downturn and, at the same time, fewer current operators will be willing to offer their unit for a transfer when they see their outcomes gradually improving with the strengthening of the economy. The health of the economy is one of the main indicators of the investment ability of new and existing franchisees was marked by intense market volatility and a sluggish recovery. The economy slowed down its growth of 3.0 percent in 2010 to 1.7 percent in Based on the 2011 and early 2012 economic environment, economists expect GDP growth of about 2.3 percent in This estimate was revised down from last year s expectations of 3.5 percent economic growth in New and existing operators ability to develop franchised units is affected by multiple factors. Personal income, which is a direct factor in entrepreneurs ability to open new units and acquire transfers, increased at an average quarterly rate of 1 percent in 2011 to $13,062 billion in December, with most of the gains occurring in the first quarter of the year. Personal income growth slowed down a bit from its 2010 average quarterly rate of 1.3 percent. It does, however, represent a marked improvement from the negative rate in 2009, testifying that current and prospective franchisees have been gradually regaining strength in their investment abilities, even if at a somewhat slower pace in 2011 as compared to the previous year. 12 Average 401(k) balances are another source of investment capital and borrowing collateral, especially for new franchisees. At the end of 2011, 401(k) accounts remained virtually unchanged over their average value a year ago, down to $69,100 from $69,400 a year earlier. Workers and businesses made slightly higher contributions, but these were offset by factors including investment performance, and fees paid to manage the money and to administer plans. Still, 401(k) balances in 2010 and 2011 remained significantly above their recession levels at year end 2008, the average 401(k) account balance was $48, Rebounds in the stock markets have also started to stabilize Americans balance sheets. In February 2012, the Dow Jones industrial average crossed above 13,000 for the first time since May 2008 as Greece secured a bailout to avoid a disorderly default. Except for a weak third quarter, the index has grown steadily from a little over 11,500 in December 2010 to over 12,200 in December 2011 and followed a generally upward trend in the Average of different economic forecasts. See Appendix

20 20 beginning of The S&P index had a choppy growth throughout 2011, with further uneven gains in the first two months of The index reached above 1,360 in February This compares to 735 at the deepest point of the recession in However, it has yet to reach the pre recession heights of above 1,500 in Even though existing home sales rose in January 2012, marking three gains in the past four months, home prices are still falling, nearing a six year downward trend. Single family home prices ended 2011 on a downbeat note as a drop in December prices sent the seasonally adjusted index to its lowest level since Home prices overall are down more than a third since the housing market peaked in Prices are expected to decrease at a slow rate in 2012 before starting to rise modestly in The decline in home prices has a negative impact on prospective franchisees ability to invest in new units or transfers because it limits the potential to use their properties as collateral for business loans a practice that funded much of the economic expansion of the last decade. Based on these factors, new and existing franchisees ability to invest in franchised units in 2012 will marginally improve from 2011 levels. The economic recovery will, however, continue to be vulnerable, and concerns about both the domestic outlook and developments in Europe will slow down the pace of business investments. For more details on the factors affecting investor ability to invest in franchise unit transactions, please refer to the Appendix. Projected Franchised Unit Transactions Based on the economic factors discussed in the previous two sections, FRANdata projects that, despite certain small economic gains in 2011, the ability to purchase a new or existing unit will continue to be a more limiting factor than the willingness to do so in Along with the improvement of the economy, the demand of new units grew faster than the demand for transfers. Based on FRANdata s internal unit database and interviews with prospective franchisees, in 2011, transfer units represented an estimated 41 percent of total demand, or 23,507, while new units represented 59 percent, or 17,494. FRANdata forecasts that the demand for new units will continue to be higher than that of transfers in We project that demand for new unit transactions will increase by 10 percent to 25,858 in The demand for transfer unit transactions will increase by 5 percent to 18,368 in Both figures exclude demand for lodging units. This increase in demand will result in a total of 44,226 projected unit transactions in 2012, up 7.9 percent from 41,001 in This means that 44,226 new and transfer unit transactions, excluding lodging, will seek financing in In our previous Lending Matrix reports, FRANdata assumed that an equal number of new franchisees and existing operators were involved in unit transactions in a year. In this report, FRANdata revisited these assumptions. Based on our comprehensive franchisee database and interviews with franchise development executives, we estimate that about 90 percent of transfer units are acquired by existing franchisees, who have the experience and expertise to do so. These franchisees also become aware of units for sale in the system faster than others. On the other hand, new unit openings are, on average, split equally between new and prices tumble december p html 17