Financing Your Franchise: The Five C’s of Obtaining Credit

from Joseph Pisani, Director of National Franchising Services, Bank of Montreal.

If you are in the process of buying a franchise or have plans to expand your existing location, chances are you will seek some level of financial assistance. In most situations, this scenario would require that you submit an application for financing to your local banker. What is important to know in advance is what will the banker expect to see in your application and what evaluation criteria will the banker use in assessing your application?

Quite often a business owner will experience some hesitation or even frustration when preparing their financing request. Some are simply not sure as to how to go about it. How do you communicate what is needed? What should the application include? Where does one even start? The answer lies in knowing who to speak to and in the creation of a well developed financing proposal which addresses the key points as often communicated by the banks to the marketplace through various brochures and publications.

What exactly is a “Bank Financing Proposal?”

In very general terms, a bank financing proposal is a business plan/ presentation that a potential borrower will use to convey the following to the banker:

An outline of the business activity
The amount of money required and from what sources
How the money will be used
How it will be repaid
What financial return to the business the banker may expect
What security will be provided

All the major financial institutions provide publications on this very subject and in some material even provide examples of what should be included and how to present it. There is no need for you to guess and there are no excuses for you to not be aware of what the banks are expecting.

Keep it Simple

While all business proposals are addressed as soon as possible, it is likely that your banker is dealing with a number of concurrent proposals. Keep your proposal simple and factual, and honestly recognize any risk/downside the application may entail (the latter will illustrate that you are aware of the relevant risks and how to manage them). Including a succinct one or two-page summary that briefly describes your business, its history, where its future lies and the money you require to get it there, can make a strong initial impression on your banker and help to set your proposal apart.

Your proposal should include/address:

Business name, address, key contact names
Table of contents (including page numbers)
Summary
Industry overview (key drivers, demographics, trends)
Management structure (background, qualifications, responsibilities)
Product / service offering
The market (size, competition, supply, overall standing)
Financing outline (emphasize the use of requested funds)
Basic corporate information (shareholders, lawyer, accountant)
Appendices (biographies, product literature, historical financial statements, forecast income and cash flow statements)

Having presented this information to the banker, it is equally important that you understand how your proposal will be assessed and what areas in particular will the banker focus on. Your banker will be keenly interested in all areas that touch on the six points mentioned earlier. These key elements will be specifically considered as the banker conducts their due diligence – their assessment – with both observations and questions likely emanating from one or more of the following “5C’s of Credit”:

Character

Probably the most important part of the overall assessment process and decision to extend credit is the stability and commitment to the business from the owner. The banker is looking to identify critical character traits such as trustworthiness, demonstrated good judgement, credibility, honesty and reliability. Business experience or previous employment, stability, education and overall integrity are also considered. In your proposal, and particularly if you are a new customer to the bank, it would not be unreasonable for you to also include two or three personal or business references.

Capacity

Does the business proposal seem realistic and consequently does it appear that the business will generate sufficient net earnings to service both their day to day and longer term credit obligations. The assessment would include an evaluation of various business ratios, sales assumptions, operational obligations and carrying costs. In addition, what possible financial reserves may be necessary should the need arise. Be as accurate and realistic as possible – even to the extent of being conservative. Any exaggeration of expectations may be to your disadvantage in the long run. The banker’s assessment would also look at owner salaries and what personal debt servicing obligations exist. In summary, will the borrower have the capacity to repay their debt obligations over an acceptable timeline?

Credit

This is simple enough to evaluate as it primarily involves an assessment of the borrower’s credit history. This would include both a review of the owner’s personal credit history as well as the business’s track record. Needless to say, it is important to maintain a good credit rating and to divulge all credit obligations (again both business and personal) to the bank as part of your proposal. Not conveying or trying to conceal financial problems (both previous and current) may eventually be to your detriment when it comes to receiving a favourable response from the bank.

Capital

This deals with the owner’s personal financial commitment to the business. Notwithstanding how convincing the business proposal may be, banks generally expect owners to provide a reasonable level of their own cash into the business. In addition this element deals with the financial stability of the business; being adequately capitalized at the outset and having a reasonable cushion to fall back on – a reserve for contingencies. Other reasons for having owners provide a reasonable level of their own capital into the business include:

It represents a tangible commitment on behalf of the owner and to some extent is an indication to the banker of their confidence level in the proposal.
In new/start-up situations and particularly in franchising businesses, there are often certain capital requirements that the banks normally do not finance. These would include items such as the franchise fee, training expenses, pre-opening expenses, security deposits – often referred to as intangibles.
Banks also have fairly rigid criteria in terms of the maximum level of financing available for certain business assets such as equipment, leasehold improvements, inventory and accounts receivable.
In more simple terms, the business simply cannot afford to be 100% financed at the outset as this would place significant strain on the business in terms of meeting its debt obligations and maintaining enough reserve for its daily working capital needs.

Collateral

Collateral is simply the value of assets available to support the various loan facilities requested. For example:

Operating loans are often supported by a pledge to the bank of all inventory and receivables but the extent to which the bank finances and accords a lending value to these assets is limited and will vary with individual circumstances.
Term financing is usually provided to support capital purchases such as equipment, vehicles and leasehold expenditures. While these assets certainly have a tangible value, the lending value of these assets and corresponding loan availability would be less than the actual cost – hence the need for owner equity as a down payment towards these assets.
Important to note that there are certain loan facilities such as financing arrangements under the Canada Small Business Loans (often referred to as the Government Guaranteed Loans program) that would permit a higher level of financing and corresponding collateral support to the Bank.
For new borrowers where there is no financial history or limited track record or where the bank requires an additional level of security to support the application such as, a collateral charge on real estate. It is not unreasonable for the banker to request personal guarantees from the owners.

It is important to understand that in terms of business banking, the bank does not look to their security as the primary source of loan repayment. Business profits and surplus cash, repay bank debt. Therefore, it is imperative that your business proposal be realistic and convincing in order to establish financing arrangements that are reasonable and attainable from your perspective and that of the banker. One of your primary objectives in both your written proposal and in your subsequent discussions with the banker is to present a “sound” business case as opposed to one that is more focused on safety – the safety of the bank’s funds.

During your initial discussions with the banker, and regardless of the results of your negotiations, you should pay particular attention to the terminology that apparently is important to the banker as they review your proposal. Often you will hear terms such as liquidity, leverage, debt to equity, debt servicing capabilities, just to name a few. Your awareness of these key points, and ensuring that they are addressed in any subsequent loan applications or at time of your next business review, will definitely improve your chances of receiving a favourable reply.

In most business banking situations it is likely that banking arrangements, including credit lines, will be subject to review on an annual basis. In this regard, and as your business moves forward, demonstrating profitability and building tangible net worth, the banker should be in a position each subsequent year to more easily complete their assessment of the business as per the “5C’s”- probably resulting in an even stronger overall assessment – which will be to your long term benefit.

Joseph Pisani has been in Commercial Banking for over 12 years. Joseph joined the Bank of Montreal’s Franchising Services Department in 2006. His past experiences include roles as Commercial Banking Account Manager, and operating a small business. Based out of Toronto, Joseph’s role as National Manager Franchising Services consists of identifying, developing and managing a portfolio of financial service programs aimed at facilitating financing and cash management products for selected franchise networks.

Phone: (416) 927-6025
Email: joseph.pisani@bmo.com

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