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FRANdata - 800.485.9570 - www.frandata.com 1655 N. Fort Myer Drive, Suite 410, Arlington, VA 22314

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 2012

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FRANdata | 800.485.9570 | www.frandata.com | 4300 Wilson Blvd, Suite 480, Arlington, VA 22314

Small Business Lending Matrix and Analysis The Impact of the Credit Crisis on the Franchise Sector Volume IV 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: http://www.nasaa.org/Industry___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 22203 703.740.4700 FRANdata

TM and the FRANdata logo are registered trademarks of Franchise Information Services, Inc.

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TABLE OF CONTENTS

EXECUTIVE SUMMARY .................................................................................................................... 4 OVERVIEW ....................................................................................................................................... 5 INTRODUCTION ............................................................................................................................. 10 PROJECTED FRANCHISED UNIT TRANSACTIONS FOR 2012 .......................................................... 16

Factors Affecting Unit Transactions: Franchisor Capacity ................................................... 16 Factors Affecting Unit Transactions: Investor Willingness and Ability ................................ 17

Willingness .................................................................................................................. 17 Ability .......................................................................................................................... 18

Projected Franchised Unit Transactions .............................................................................. 20 ESTIMATED CAPITAL REQUIREMENTS FOR UNIT TRANSACTIONS ............................................... 22 ESTIMATED CAPITAL REQUIREMENTS FOR UNIT TRANSACTIONS ............................................... 22

Estimated Average Initial Investment .................................................................................. 22 Advance Rates ...................................................................................................................... 22 The Lending Environment .................................................................................................... 23

Ability to Lend ............................................................................................................. 23 Willingness to Lend ..................................................................................................... 25

SHORTFALL IN LENDING ................................................................................................................ 27 FRANCHISE ECONOMIC IMPACT IN 2012 ..................................................................................... 28 ECONOMIC IMPACT DUE TO SHORTFALL IN LENDING IN 2012 .................................................... 30 BANK LENDING SCENARIOS .......................................................................................................... 32

Aggressive Scenario ............................................................................................................. 32 Conservative Scenario .......................................................................................................... 34

APPENDIX ...................................................................................................................................... 36

Factors Affecting Prospective and Existing Operator Willingness ....................................... 36 Factors Affecting Prospective and Existing Operator Ability ............................................... 37 Bank Ability to Lend ............................................................................................................. 39 Bank Willingness to Lend ..................................................................................................... 41

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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 2012. 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 2010. 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 2010. 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.

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OVERVIEW FRANdata projects that the franchise climate will improve in 2012, as a continuation of the positive trend since 2010. 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 2012. Franchises will require $11.7 billion in new lending capital to fulfill 100 percent of the forecasted demand for new and transfer units in 2012. 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 2012. 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 2012. 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 inter‐relationships. 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 1999 – 2002 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 2009. 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.

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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 2011. 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 2011. Unconstrained Franchisor Capacity for Growth Franchisor capacity, including staff and resources to support franchisee recruitment efforts, will not be a limiting factor in 2012. 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 2012. 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 2005. 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 2011. The boost was driven by a combination of government‐enforced 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 2012. 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 2012. This represents a 10 percent increase from the $12 billion FRANdata estimated

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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 2012. Competition for financing will remain tight in 2012, since lenders remain risk averse and credit standards have not significantly changed since 2009. 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.

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Table 1. Base Scenario, Effect of Lending Shortfall on New Units.

Base Scenario New Units Total Jobs Created thru Financing

Total Annual Economic Output Created thru Financing

Maximum Level 25,858 504,475 $67,240,078,812

Effect of Shortfall (4,812) (93,872) ($12,511,906,779)

Reduced Level 21,046 410,603 $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 Transaction

Total Jobs Maintained thru Financing*

Total Annual Economic Output 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 44,226 522,393 69,628,309,941 100.0%

Effect of Shortfall (8,230) (97,206) ($12,956,304,314) ‐18.6%

Reduced Level 35,997 425,187 $56,672,005,628 81.4%

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

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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 Annual Economic Output Created or

Maintained thru Financing


Maximum Level 44,226 522,393 69,628,309,941 100%

Effect of Shortfall (2,929) (34,595) ($4,611,021,001) ‐7%

Reduced Level 41,298 487,798 $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




Percent of Maximum

Level

Maximum Level 44,226 522,393 69,628,309,941 100%


Reduced Level 30,616 361,626 $48,200,187,478 69%

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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 2012.1 The unemployment rate fell to a three‐year low of 8.3 percent in February 2012. 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 2008. 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 2010. In January 2012, sales reached $401,400 million, which represented a 5.8 percent increase over sales in January 2011. However, this was below the 8 percent increase in January 2011 over January 2010. 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 2008. 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 2011. 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.

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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 2013. The number of failed financial institutions has dropped significantly to 92 in 2011 and to 12 in the first two months of 2012. 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 2012. 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 2012. 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 2011. FRANdata forecasts that the demand for new units will continue to be higher than that of transfers in 2012.

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.

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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 2011. 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 near‐recession levels of 2010. 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 2011. 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 2011. For new franchisees, FRANdata projects an average increase of 4 percent as opposed to an average of 8 percent in 2011. Table 6 presents the change in willingness and ability since 2009. Table 6. Estimated and Projected Operator Willingness and Ability.

Operator Willingness and Ability Estimated Projected

2009 2010 2011 2012

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 2009. 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.

2In 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).

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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 2012. This represents a 7.9 percent increase in demand from 2011 but is below the 12.8 percent increase in demand from 2010. 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 2012. 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 2012. Under these circumstances, there would be a 31 percent gap.

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Table 7. Scenarios Comparison.

Scenario New Units

Transfer Units





Maximum Level 25,858 18,368 522,393 $69,628,309,941 100%

Base Scenario 21,046 14,950 425,187 $56,672,005,628 81%

Aggressive Scenario 24,146 17,152 487,798 $65,017,288,941 93%

Conservative Scenario 17,900 12,716 361,626 $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 2012. 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 2012. Actual lending is projected to improve steadily at a CAGR of 10.8 percent, from $7 billion in 2009 to $9.5 billion in 2012. 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 2009. The following table summarizes FRANdata’s estimates and projections for the lending environment from 2009 to 2012. Table 7. Small Business Lending Capital Needs 2009 ‐ 2012.

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.

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Figure 3. Franchise Lending Environment 2009 ‐ 2012.

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.

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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 2011. Economic indices had an overall upward trend: the employment trends index (ETI) improved rapidly for four straight months, 3economic 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 2012.

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 2012.

3 www.conference‐board.org/press/pressdetail.cfm?pressid=4400 4 www.ism.ws/ismreport/mfgrob.cfm 5 www.vistage.com/media/confidence‐index/pdf/FlierConfIndex_Q411.pdf

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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

Transactions Transfer

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 2011. 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

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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 2011. 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 2010. It remained below the pre‐recession level of 36 in January 2008.6 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 – 64.8.7 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 2011. 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 2009. As a result, actual new unit and transfer data tracked by FRANdata has been trending upward since late 2009.

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 www.gallup.com/poll/152000/americans‐standard‐living‐perceptions‐best‐june.aspx

7www.conference‐board.org/press/pressdetail.cfm?pressid=4394

8www.census.gov

9www.retailsails.com

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remain flat in 2011. 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 2012. 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. 2011 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 2011.10 Based on the 2011 and early 2012 economic environment, economists expect GDP growth of about 2.3 percent in 2012.11 This estimate was revised down from last year’s expectations of 3.5 percent economic growth in 2012. 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 $48,900.13 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

10 www.bea.gov/newsreleases/national/gdp/2012/pdf/gdp4q11_adv.pdf 11 Average of different economic forecasts. See Appendix. 12 www.bea.gov/newsreleases/national/pi/pinewsrelease.htm 13 www.fidelity.com

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beginning of 2012.14 The S&P index had a choppy growth throughout 2011, with further uneven gains in the first two months of 2012. The index reached above 1,360 in February 2012. This compares to 735 at the deepest point of the recession in 2009. However, it has yet to reach the pre‐recession heights of above 1,500 in 2007.15 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 2003.16 Home prices overall are down more than a third since the housing market peaked in 2006. Prices are expected to decrease at a slow rate in 2012 before starting to rise modestly in 2013.17 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 2012. 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 2012. We project that demand for new unit transactions will increase by 10 percent to 25,858 in 2012. The demand for transfer unit transactions will increase by 5 percent to 18,368 in 2012. 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 2011. This means that 44,226 new and transfer unit transactions, excluding lodging, will seek financing in 2012. 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

14www.finance.yahoo.com/q?s=^dji

15 www.finance.yahoo.com/q?s=^gspc 16 www.finance.yahoo.com/news/home‐prices‐tumble‐december‐p‐141150377.html 17 www.realtor.org/press_room/news_releases/2012/02/ehs_jan

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existing franchisees. Thus, FRANdata projects that new franchisees will demand a total of 14,766 unit transactions, accounting for a third of the total demand for unit transactions in 2012. The table below presents the number and type of franchised unit transactions new and existing franchisees will demand to develop in 2012. Table 9. Number of franchised unit transactions by type and operators

Type of transaction New franchisees Existing franchisees Total units

New units 12,929 12,929 25,858

Transfer units 1,837 16,532 18,368

Total units 14,766 29,461 44,226

Percent of total 33% 67% 100%

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ESTIMATED CAPITAL REQUIREMENTS FOR UNIT TRANSACTIONS

Estimated Average Initial Investment In order to estimate the capital requirements for the projected 44,226 unit transactions in 2012, FRANdata examined the average initial investment per new and transfer units. Excluding lodging, we forecast that new and transfer units will have an average initial investment of $401,610. At the end of 2009, FRANdata assumed that transfer unit costs would be similar to the creation of a new unit in 2010. Any difference in price would be based on individual sales performance, which cannot be measured. At that point, the signs of economic recovery were yet to be felt, which caused current operators who wanted to transfer their units to wait for a more favorable economic environment to increase their unit’s sales price. In 2011, the increased number of units for sale temporarily decreased the average price for a transfer as compared to the average initial investment for a new unit due to an increased supply of transfers. Suppressed revenues and business valuations made many small business owners feel more open to selling their units when the economy started to pick up during that year. This year, FRANdata believes that this backlog of transfer units has started to clear out as the economy continues to improve. The price of a transfer will be back up to the level of initial investment in a new unit once again. Thus, FRANdata projects that the average initial investment for both new and transfer units will be $401,610. We believe that the price of a transfer will eventually surpass the price of a new unit. However, that is unlikely to happen by the end of 2012, due to the relatively slow economic growth expected throughout the year. To determine the average initial investment level for 2012, FRANdata calculated the average initial investment in 2011 based on a set of 1,010 franchise brands, applying the assumptions discussed previously. Based on recent trends for initial investment and projected price increases for 2012, FRANdata estimates that the average initial investment for new units will increase by an average of 0.8 percent during 2012, thus arriving at the projected $401,610 for both new and transfer units. The calculations of the average initial investment excludes units with initial investment levels of less than $50,000, as in FRANdata’s previous Small Business Lending Matrix and Analysis studies. The assumption holds that these businesses will be financed through non‐institutional sources or will not require any debt to start. The lodging industry is excluded as an outlier because the industry is highly capital intensive and its financing comes primarily from capital markets activities. Using the projected average initial investment of $401,610 for new units and transfers and the respective number of units transactions, excluding lodging, FRANdata projects that investors will require capital of nearly $10.4 billion for new and nearly $7.4 billion for transfer units. This leads to a total of nearly $17.8 billion in total capital needed for the projected total demand for 44,226 unit transactions in 2012. This represents a 11 percent increase from the nearly $16 billion estimated for 2011.

Advance Rates Of the calculated $17.8 billion in required capital in 2012, excluding lodging, only a part will come from lenders. Lenders require borrowers to provide a portion of the capital themselves. The advance rate banks expect on franchise transactions is based on the type of transaction. Since SBA loan transactions have a government guarantee of 90 percent protecting the bank from default, they often have a higher advance rate than conventional loans. This means franchisees have to provide a smaller cash piece to qualify for a loan.

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In 2012, based on lender and franchisor feedback, as well as some minor easing of lending standards reported throughout 2011, FRANdata projects the upper range of the advance rates to be 80 percent for SBA and 70 percent for conventional loans. On average, however, the advance rates will remain largely unchanged from their 2011 and 2010 levels of 65 percent to 70 percent range for SBA and 55 percent to 65 percent range for conventional lending. The Federal Reserve Survey on Senior Bank Loan Officers showed a minor easing in lending standards throughout 2011. However, this applied mostly to large and middle market firms (i.e. with annual revenues over $50 million), which does not include most franchised businesses. Also in 2011, survey participants reported slightly increased loan demand. The majority of respondents that had eased standards and terms cited increased competition from other banks and nonbank lenders as the most important reasons for the easing. Some also pointed to a more favorable or less uncertain economic outlook. This trend still held in January 2012, as domestic banks reported that their lending standards had changed little.18 At the start of 2011, FRANdata projected that SBA‐guaranteed loans would account for 35 percent of the total loans to franchisees. We also predicted that the percentage would rise further in the following years. For the fiscal year ending September 2011, the SBA hit a record in small business lending: over $30 billion in lending supported over 60,000 small businesses.19 The boost was driven by a combination of government‐enforced 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. Based on the increase in SBA lending, overall economic improvement, and lender and franchisor feedback, FRANdata predicts that in 2012, SBA‐guaranteed lending to franchisees will constitute an even larger portion of their financing – about 40 percent. FRANdata predicts that in the following years, the percentage of SBA loans will rise further. FRANdata projects that total borrowings required to meet demand in 2012 will be $11.7 billion, up by 12 percent from $10.4 billion in 2011 and by 16 percent from $10.1 billion in 2010. The significant increase in borrowing requirements in 2012 is driven by two main factors. First, an increase in demand for unit transactions, due to an improving economy. Second, as described above, an increase in price of transfer units due to clearing of the transfer backlog created during the recession.

The Lending Environment The lending environment is determined by the amount of money banks have available to lend,how much of that money they are willing to lend, and the rate at which they will lend it. This section examines both the banks’ ability and willingness to lend.

Ability to Lend

FRANdata projects that banking ability to lend will continue to surpass the capital required to satisfy the projected demand for unit transactions during 2012. This is a continuation from 2010 and 2011. The requested SBA budget of $985 million in 2012 guarantees $27 billion in loans to small businesses – a 3.7 percent decrease from the guaranteed $28 billion in 2011.20 FRANdata estimates that between 15 percent and 20 percent of SBA loans are made to franchisees, based on the assessment of SBA franchise activity sources. We further assume that about 40 percent of franchisees’ funding will come from SBA‐guaranteed loans. This is an increase from the 35 percent assumed in 2011, driven by the increase in SBA activity, as evidenced by the 2011 all‐time lending

18 www.federalreserve.gov/boarddocs/SnloanSurvey/ 19 www.sba.gov/community/blogs/official‐sba‐news‐and‐views/open‐business/all‐time‐sba‐loan‐volume‐record‐fiscal‐yea 20 www.sba.gov/content/fiscal‐year‐2012‐budget‐summary

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record in the nearly 60‐year history of the SBA. In addition, the organization reports that SBA loan levels are back to pre‐recession levels, even without the special provisions that helped fill the gap these past few years, and project another strong year ahead.21 With the overall economic improvement, conventional lending is likely to improve marginally from its 2011 level. Commercial Real Estate (CRE) values are important indicators for bank willingness and ability to lend. Larger, nationwide banks have traditionally had more CRE exposure than small community banks. An improvement in CRE values is likely to increase large banks’ ability and willingness to lend. According to CoStar’s January 2012 CRE Index, prices for commercial property were an average 1.8 percent higher in November 2011 than compared with the same period a year ago. Positive trends in the second half of the year suggested a stabilized recovery for the commercial property market.22 Business and consumer loan delinquency rates are also improving.23 Based on these developments, FRANdata projects a slight increase of up to 2 percent in conventional lending ability throughout 2012. This represents an improvement over the previous year’s projection of a slightly decreasing lenders’ ability for conventional loans due to high default rates and numerous business and personal bankruptcies. Based on these assumptions, FRANdata projects that in 2012, there will be a pool of over $13.2 billion of SBA and conventional funds to lend to franchisees. About $5.3 billion—or 40 percent – will be available from SBA‐guaranteed loans and the rest from conventional lending. Thus, the estimated bank lending ability will be well above the total borrowing requirements of $11.7 billion for the development of the projected demand of 44,226 unit transactions in 2012. As in the last two years, banks should have the ability to meet 100 percent of demand for funds. This means that 2012 is the third year in a row when banks’ lending ability outstrips small business loan demand. Even more importantly, the projected increase in the available supply of funds is a continuation of the increase that took place in 2010 and 2011. In 2008 and 2009, the available amount for small business lending was limited by the overall shaken state of the banking industry. Many banks did not have the ability to lend even if they wanted to, hampered by concerns about the collapse of the housing market and uncertainty related to the valuation of bank assets. The liquidation of Lehman Brothers in 2008 and CIT’s bankruptcy in 2009 were some of the most prominent bank failures. In 2009, total lending by U.S. banks fell 7.4 percent, the steepest drop since 1942. In response to these concerns, the government implemented a number of stimulus measures to protect the banking industry and to increase lending. The Recovery Act from 2010 set aside a $375 million funding pool to temporarily eliminate fees for SBA loans and to increase the government guarantee of loans to up to 90 percent. The provisions worked well and Congress provided funding five more times to keep up. The Small Business Jobs Act, also signed in 2010, has provided resources to help small businesses by extending the SBA enhanced loan provisions while offering billions more in lending support, tax cuts, and other opportunities for entrepreneurs and small business owners.24 In September 2011, President Barack Obama asked Congress to pass the American Jobs Act, helping small businesses grow and hire through provisions like reducing or eliminating certain payroll taxes, providing large tax credits for businesses that hire workers who have been unemployed for more than six months or veterans,

21 www.sba.gov/community/blogs/official‐sba‐news‐and‐views/open‐business/all‐time‐sba‐loan‐volume‐record‐fiscal‐yea 22 www.costar.com/about/article.aspx?id=10551 23 www.thomsonreuters.com 24 www.sba.gov/content/small‐business‐jobs‐act‐2010

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and other.25 In September 2011, 13 of the largest U.S. banks made $20 billion in new commitments to small business lending over the next three years.26 The effect of the 2010 and 2011 provisions will continue to support lending throughout 2012 and after. There is still significant room for improvement, however. For example, the SBA reports that loans under $250,000 are down. This affects more than two thirds of the franchise brands in the United States. U.S. home prices, which also affect lenders’ ability and willingness, continue to trend downwards. The Federal Housing Finance Agency (FHFA) announced that despite price increases in the latest quarter of 2011, half of all U.S. states nationally declined 2 percent points over the last four quarters.27 According to some forecasts, average U.S. home prices are not expected to rise until the third quarter of 2013.28 Willingness to Lend While banks are projected to be able to meet 100 percent of franchise demand for using capital, the limiting factor in 2012 will be their willingness to do so. This has been the case for three consecutive years now. FRANdata projects that the overall improving economic and business climate will affect positively banks’ willingness to lend and for the first time since the recession, the willingness for conventional loans will improve slightly. Banks’ willingness to provide conventional lending tightened drastically during the recession and did not improve even after it ended in mid‐2009. FRANdata believes that in 2012, conventional lending will increase by up to 5 percent, which is a significant change from the years before but only a marginal improvement when applied to its weak shape since the credit crunch. The willingness for SBA‐guaranteed lending will continue to increase in synchrony with the improving economy as a result of the SBA‐imposed provisions in support of small business lending. FRANdata projects an increase in banks’ willingness to provide SBA‐guaranteed lending of up to 30 percent. In 2011, FRANdata predicted a 25 percent increase in willingness and SBA‐guaranteed lending hit an all‐time record. Conventional lending was forecasted to stay unchanged. These projections were based on factorssuch as a continuation of the increase in overall SBA lending from the year before, an increase in the cap for SBA‐guaranteed loans, SBA incentives for increased, pressure to lend based on a prolonged period of suppressed lending, but also banks’ expectations for levels of lending to remain unchanged, continuous distress in the housing market, and an increased number of bank failures. In 2012, the SBA incentives will continue to support an upsurge in lending. Additionally, the improving economic and business conditions will provide a further boost to banks’ willingness to lend. Upbeat data on employment, manufacturing and overall growth are likely to have a positive effect in the lending environment. The Thomson Reuters/PayNet Small Business Lending Index, which measures the overall volume of financing to U.S. small businesses, jumped 18 percent in January 2012 from a year earlier, marking its 18th consecutive double‐digit rise. Additionally, some marginal improvement in delinquency rates took place throughout 2011 and in early 2012. Accounts 90 days or more behind in payments fell to 0.37 percent in January, a record low, from 0.38 percent in December. Accounts behind 180 days or more fell to 0.51 percent in January, from 0.54 percent in December. Accounts in moderate delinquency, however, or those behind by 30 days or more, rose to 1.57 percent in January, from 1.55 percent in December. That is still far below the high of 4.42 percent reached in May 2009 and consistent with continued lower risk of default. 29

25 www.sba.gov/about‐sba‐services/199/23001 26 www.whitehouse.gov/the‐press‐office/2011/09/20/ohio‐vice‐president‐biden‐discusses‐importance‐american‐jobs‐act‐small‐b 27 www.dsnews.com/articles/home‐prices‐decline‐fourth‐quarter‐but‐for12‐states‐plus‐dc‐rose‐2012‐02‐23 |www.fhfa.gov/ 28 www.dsnews.com/articles/dont‐expect‐rise‐in‐national‐home‐prices‐until‐2013‐fiserv‐2012‐01‐30 29www.smallbusiness.foxbusiness.com/finance‐accounting/2012/03/01/small‐businesses‐borrow‐more‐signaling‐growth | www.thomsonreuters.com

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According to the Federal Reserve Board’s Senior Loan Officer Opinion Surveys on Bank Lending Practices, during 2011, an increased number of domestic lenders indicated that their lending standards and terms had eased somewhat as compared to the previous years. The most commonly cited reason for having eased standards or terms on C&I loans was increased competition from other lenders. In January 2012, loan officers reported that their lending standards had changed little over the past three months.30 Overall, some improvement in the lending environment is anticipated in 2012, but it will not be strong enough to help prospective and existing franchisees obtain adequate financing to meet their demand for franchise transactions during the year. As PayNet founder Bill Phelan told Reuters in an interview, "it's like a lukewarm cup of coffee – it's not bad, but it's not great. We're all looking for really strong growth, and I'm not sure when we are going to get it."31 During the recession and up until 2011, banks primarily focused on not losing money. As the recovery takes hold, banks will gradually start to consider ways of making money again. Because the economic downturn was precipitated by a financial crisis, the change in banking mindset will be gradual and will span the next several years. The key to lender willingness to lend in this environment centers on information. Lenders have created tighter credit qualification boxes after the recession. They will not apply more liberal terms quickly. However, qualifying under these terms is not sufficient in this economic period. As banks are only slowly changing from a mindset of not losing money to generating money, greater underwriting due diligence remains. As anyone who has applied for a home mortgage in the past two years can attest, much more analysis and paperwork is required. Franchised businesses have an advantage over independent small businesses from a lender’s perspective. That advantage is the ability to statistically and quantitatively measure the performance history across a brand’s many similar small businesses as compared to generalized data on independent small businesses. This provides franchisees looking for financing a competitive advantage as credit committees consider loan requests. In the case of franchising, the issue that must be addressed is the creditworthiness of the system, not just the borrower. A franchise system has historical performance attributes that suggest levels of risk to lenders. There are three areas that lenders want to assess in addressing system creditworthiness: unit economics; system performance; and franchisor performance. To the extent that franchise systems have good credit risk performance attributes, lender willingness to lend to such systems will be higher than for other franchise systems and especially for other independent businesses competing for loan dollars. Based on FRANdata’s assessment of these factors and assuming an increase in banks’ willingness to provide SBA‐guaranteed lending of up to 30 percent and conventional lending of up to 5 percent, FRANdata projects that banks will be willing to provide a total of $9.5 billion in lending capital in 2012. This is a 13.8 percent increase from the estimated $8.4 billion in 2011. The $9.5 billion will include over $3.8 billion of SBA‐guaranteed loans. The expected increase in bank willingness to lend is a continuation from the increase in 2011 but a big change from the previous matrix studies when FRANdata estimated a decrease in bank willingness to lend.

30 www.federalreserve.gov/boarddocs/SnLoanSurvey/ 31 www.boefly.com/blog/small‐business‐lending/small‐business‐lending‐rose‐slightly‐in‐january

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SHORTFALL IN LENDING The improvement in willingness will not be sufficient to meet new and existing franchisees’ demand for funds in 2012. FRANdata predicts a shortfall of nearly $2.2 billion, or 18.6 percent, in lending to franchise businesses during the year. Banks are forecasted to lend $9.5 billion to franchises in 2012 versus the $11.7 billion that would meet 100 percent of the demand. The 18.6 percent gap in lending, although significant, represents a 5 percent contraction from 2011’s 19.6 percent. In 2011, FRANdata forecasted that banks would be willing to lend $8.4 billion to franchises, $2 billion less than the estimated amount to meet 100 percent of the demand. The following graph presents the effect the projected lending shortfall has on the number of franchise unit transactions, including new and transfer units. 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 4. Effect of Lending Shortfall.

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FRANCHISE ECONOMIC IMPACT IN 2012 Based on the Economic Impact of Franchised Business Study, the average franchise unit provides approximately 10.3 direct jobs and 9.2 indirect jobs (excluding lodging) and creates $1,000,139 of direct economic output and $1,600,223 million in indirect economic output (excluding lodging) .32 This section examines the economic impact of franchising in 2012 if borrowing capital requirements were met by lenders. Table 10. Franchise Direct and Indirect Jobs and Economic Output per NAICS Code.

NAICS Code # of Direct

Jobs per Unit # of Indirect Jobs

per Unit Direct Economic Output per Unit

Indirect Economic Output

per Unit

Auto 6 5 $1,258,559 $2,013,695

Commercial and Residential 6 5 $836,052 $1,337,684

Quick Service Restaurants 20 18 $1,329,131 $2,126,610

Table Service 29 26 $1,626,264 $2,602,022

Retail Food 8 7 $621,647 $994,636

Lodging 27 25 $2,970,607 $4,752,971

Real Estate 3 3 $542,531 $868,050

Retail Products 5 5 $406,321 $650,113

Business Services 10 9 $1,571,322 $2,514,115

Personal Services 6 5 $809,427 $1,295,083

Average Excluding Lodging 10 9 $1,000,139 $1,600,223

The projected 25,858 new unit transactions for 2012 would create 265,513 new direct jobs and 238,962 indirect jobs33 — a total of 504,475 jobs. The new unit transactions projected for 2012 account for $25.86 billion in direct total annual economic output and $41.38 billion in indirect economic output, a total of $67.24 billion annual economic output. Transfer units do not generate new jobs or additional economic output because at existing units all employees have been hired and are already creating output. However, some units that are looking to transfer ownership might not find a buyer. While some franchisors may re‐acquire these units and ensure continued operations, others will be closed. FRANdata assumes that 5 percent of such units will be closed in 2012, which is a decrease from the 2011 level of 10 percent due to the reduced backlog in transfer units in an improving economy. Thus, the 18,368 transfer unit transactions that would occur without the limitation of lending sustain 9,430 direct jobs and 8,487 indirect jobs, resulting in a total of 17,918 jobs. These transfers also maintain $918.55 million of direct annual economic output and $1.47 billion in indirect economic output, resulting in total economic output of $2.39 billion. In total, FRANdata projects that unit transactions seeking capital in 2012 will account for 522,393 total direct and indirect jobs either created or protected and over $69.6 billion in total direct and indirect annual economic output either created or protected. In 2011, FRANdata estimated that unit transactions seeking capital during the year accounted for 333,170 total jobs created and protected and over $43 billion in total annual economic output created or protected. The

32 The Franchise Business Economic Outlook: 2012 report, published by the IFA Educational Foundation.

33 Jobs are defined as positions filled by part‐time and full‐time employees or by self‐employed individuals. Economic Output is defined as the gross value

of the goods and services it produces.

29


projections in 2012 represent a large increase from the 2011 levels — 57 percent in jobs and 61 percent in economic output. The significant increase in jobs and economic output created or maintained is driven by the projected unit transactions and is affected by two main factors: the increased projections for transactions demanded throughout the year and the shift of focus from the acquisition of transfers to the development of new units. The development of new units has a much stronger impact on the creation of jobs and economic output than the acquisition of transfer units. As a result, the demand for unit transactions will create a substantially higher number of jobs and amount of economic output.

30


ECONOMIC IMPACT DUE TO SHORTFALL IN LENDING IN 2012 FRANdata predicts that franchises will require $11.72 billion in new lending capital to fulfill 100 percent of the forecasted demand for unit transactions in 2012, excluding lodging. At the same time, FRANdata forecasts that banks will only make available $9.5 billion to lend to franchising. The estimated 18.6 percent shortfall in lending will result in 8,230 unit transactions that will not be completed. The following section examines the negative impact on economic output caused by the shortfall in lending capital. Lodging is excluded from this analysis. Each franchise unit, excluding lodging, is estimated to employ nearly 20 people (10.3 directly and 9.2 indirectly) and to create $2.6 million in annual economic output. Carrying this forward, the 25,858 new unit transactions possible in 2012 would create 504,475 total jobs and add $67.24 billion in annual economic output. This also means that the shortfall in lending would cost the economy 4,812 new units, 93,872 jobs not created, and $12.5 billion in annual economic output. Table 11. Base Scenario, Effect of Lending Shortfall on New Units.

Base Scenario New Units Total Jobs

Created thru Financing



Maximum Level 25,858 504,475 $67,240,078,812 100.0%


Reduced Level 21,046 410,603 $54,728,172,033 81.4%

From a lender’s perspective, transfer unit transactions involve less risk than new unit transactions. This is due to the availability of historical performance data. However, the exact way in which the shortfall in lending will affect transfer vs. new unit transactions is not possible to project because it depends on the banks’ individual underwriting considerations. For simplicity purposes, FRANdata assumes that an equal percentage of new and transfer unit transactions out of the respective projected units will not be developed due to the shortfall in lending. This means that 18.6 percent out of both new and transfer unit loan applications will not receive financing.

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 funds, 95 percent of the time the unit would continue to operate for the next year, while 5 percent would be unsustainable. The total number of demanded units would protect 17,918 jobs and $2.39 billion in annual economic output if funding were received.34 However, due to the shortfall in lending, FRANdata projects that 3,418 transfer unit transactions will not occur. The cost to the economy would be 3,334 total jobs and $444.4 million in annual economic output not maintained.35

34 The 18,368 transfer units projected to be demanded would result in 358,358 total direct and indirect jobs. 95 percent of them, however, would continue

to exist even if funding was not available. The remaining 5 percent, or17,918 jobs would be lost if funding were not available. The number of jobs maintained was calculated by taking the 18,368 total demanded unit transactions and multiplying them by the estimated 19.5 (direct and indirect) jobs. The product is then multiplied by 5 percent to get the number of jobs lost from the units that would have closed without financing. The same methodology was applied to estimate the economic output. 35 The number of jobs and economic output not maintained was calculated by multiplying 5 percent of the number of transfers that will not receive

financing by the number of jobs (indirect and direct) and the amount of economic output a unit maintains, respectively.

31


Table 12. Base Scenario, Effect of Lending Shortfall on Transfer Units.

Base Scenario Transfer Units Transaction

Total Jobs Maintained

thru Financing*

Total Annual Economic Output Maintained thru

Financing*


Maximum Level 18,368 17,918 $2,388,231,129 100.0%

Effect of Shortfall (3,418) (3,334) ($444,397,535) ‐18.6%

Reduced Level 14,950 14,584 $1,943,833,594 81.4% *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 then multiplied by 5 percent to calculate the number of jobs not created from the units that close without financing. The same methodology was applied to estimate the economic output.

To summarize, the shortfall of 8,230 unit transactions will cost the economy 97,206 total jobs not created or protected and $12.96 billion in annual economic output. Table 13. 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 44,226 522,393 69,628,309,941 100.0%


Reduced Level 35,997 425,187 $56,672,005,628 81.4%

These projections represent an increase in total jobs created or maintained of 18 percent and an increase in economic output created or maintained of 21 percent over the 2011 levels of 82,334 jobs and $10.67 billion in economic output.36

36 A comparison between the base scenarios of 2012 and 2011

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BANK LENDING SCENARIOS FRANdata projects that the constraints provided by bank willingness to lend throughout 2012 will reduce the number of jobs that could be created or maintained by 97,206 and the possible annual economic output by $12.96 billion. These estimates are based on FRANdata’s expected net effect of a combination of factors that affect bank lending to small businesses in different ways. Besides the expected increase of 30 percent 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, conversely, a more conservative approach to lending than the base scenario discussed above.

Aggressive Scenario Under an aggressive lending scenario, FRANdata assumes that in 2012, bank willingness to lend will continue to rise and SBA‐guaranteed as well as conventional loans will increase from their 2011 willingness levels by 50 percent and 20 percent respectively. This scenario represents the upper limit of an optimistic but reasonable case. This scenario can take place if the current level of growth and stabilization continue at an accelerated pace throughout the year. During the fiscal year 2011, the SBA lending peaked in its 60‐year history, with over $30 billion lent out to support over 60,000 small businesses. The effect of the provisions implemented since 2010, will increasingly be felt in 2012 and after. Loan delinquencies are also starting to improve. At the same time, the economy has further moved away from the recession and is growing. In addition, the unemployment rate is contracting, the stock market has started to stabilize, and household net worth has started to strengthen. In 2011, lenders began to ease their standards and terms for the first time since the recession. If these positive signs continue to take effect in a more systematic manner than the rather choppy recovery in 2011, banks are likely to start lending with more confidence in 2012. Based on the forecasted increases in lending, banks would be willing to provide $10.95 billion, an increase of 15 percent over the estimated funds projected in the base scenario. This reduces the number of unit transactions that will not be funded by 64 percent from 8,230 under the base scenario to 2,929 under the aggressive scenario. The additional unit transactions that will be financed under this aggressive scenario will also result in over 62,600 more jobs and over $8.3 billion more economic output created or protected. This represents a 15 percent increase from the base scenario in both jobs and economic output created or maintained. Under the aggressive scenario, 24,146 new franchise unit transactions will be funded, resulting in 471,067 new jobs and $62.8 billion in economic output. Table 14. Aggressive Scenario, Effect of Lending Shortfall on New Units.

Aggressive Scenario New Units Total Jobs Created thru Financing



Maximum Level 25,858 504,475 $67,240,078,812 100%


Reduced Level 24,146 471,067 $62,787,214,514 93%

Under the aggressive scenario, 17,152 transfer unit transactions will be funded, resulting in 16,731 jobs and $2.2 billion in economic output maintained.

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Table 15. Aggressive Scenario, Effect of Lending Shortfall on Transfer Units.

Aggressive Scenario Number of New and Transfer Unit Transactions

Total Jobs Created or Maintained thru Financing*


Maintained thru Financing*


Maximum Level 18,368 17,918 $2,388,231,129 100%

Effect of Shortfall (1,216) (1,187) ($158,156,702) ‐7%

Reduced Level 17,152 16,731 $2,230,074,427 93% *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 from the units that close without financing. The same methodology was applied to estimate the economic output.

In total, provided that banks increase their lending to franchisees aggressively, 487,798 jobs and $65 billion in economic output will be created or maintained in 2012. This represents 93 percent of the maximum possible jobs and economic output created or maintained if the full demand for lending capital for new and transfer unit transactions was met.

Table 16. 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*


Maintained thru Financing*


Maximum Level 44,226 522,393 69,628,309,941 100

percent

Effect of Shortfall (2,929) (34,595) ($4,611,021,001) ‐7 percent

Reduced Level 41,298 487,798 $65,017,288,941 93

percent *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 from the units that close without financing. The same methodology was applied to estimate the economic output.

The shortfall under the aggressive lending scenario is presented by the pink area on the graph below. The yellow area presents the difference between the base and the aggressive lending scenarios. Figure 5. Effect of Lending Shortfall, Aggressive Scenario.

34


Conservative Scenario Under a conservative case scenario, FRANdata assumes that bank willingness to lend will remain stagnant. In this scenario, willingness for SBA‐guaranteed loans will not change, while willingness for conventional loans will contract by 5 percent from the 2011 levels. This scenario represents the lower limit of a pessimistic but reasonable case. This scenario can take place if the U.S. economic growth slows down even further. In the midst of positive economic data in the first quarter of 2012, such a scenario seems unlikely. However, some economists state that the reported acceleration of economic activity may be “cooked” by the unusually warm winter in the country – the fourth warmest in history. The unusually warm weather makes it look like the economy is going into over‐drive. Some economies expect some “payback” in the form of a slower growing labor market and somewhat weaker consumption in the first quarter and the beginning of the second quarter of 2012.37 Continuously rising oil prices also pose a threat to the economy as they curtail consumers’ ability to spend on other goods and services, thus crippling business growth. The European debt crisis also has the potential to throw Europe into a recession, which will impact the global economy. The uncertainty around the U.S. presidential elections can also threaten the country’s smooth economic recovery. If these negative factors shape the economy in 2012, lenders may see little change in the level of SBA‐guaranteed lending and may even tighten their conventional loan standards and terms. Under this scenario, banks will be willing to lend $8.1 billion, 15 percent below the base scenario and 3 percent below the estimated funds for 2011. The total number of franchised unit transactions that will not be funded under the conservative scenario is 13,611. Under the conservative scenario, a total of 160,766 jobs (155,252 from unfunded new unit and 5,514 from unfunded transfer transactions) and $21.4 billion in output ($20.7 billion from unfunded new unit and $735 million from unfunded transfer transactions) would not be created or maintained in 2012. In total, 17,900 new franchise unit transactions will take place resulting in 349,223 jobs and $46.5 billion in economic output.

Table 17. Conservative Scenario, Effect of Lending Shortfall on New Units.

Conservative Scenario New Units Total Jobs Created thru Financing


Percent of Maximum

Level

Maximum Level 25,858 504,475 $67,240,078,812 100%


Reduced Level 17,900 349,223 $46,546,934,825 69%

Under the conservative scenario, 12,716 transfer unit transactions will be funded, resulting in 12,404 jobs and $1.7 billion in economic output maintained.

37 www.finance.yahoo.com

35


Table 18. Conservative Scenario, Effect of Lending Shortfall on Transfer Units.


Transfer Units Transaction

Total Jobs Maintained thru

Financing*

Total Annual Economic Output Maintained thru

Financing*

Percent of Maximum

Level

Maximum Level 18,368 17,918 $2,388,231,129 100%

Effect of Shortfall (5,653) (5,514) ($734,978,476) ‐31%

Reduced Level 12,716 12,404 $1,653,252,653 69% *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 lost from the units that close without financing. The same methodology was applied to estimate the economic output.

In total, provided that banks do not change their SBA lending and decrease their conventional lending by 5 percent from 2011 levels, 361,626 jobs and $48.2 billion in economic output will be created or maintained in 2012. This represents a 31 percent shortfall of the maximum possible jobs and economic output created or maintained by new unit and transfer unit transactions. Table 19. Conservative Scenario, Effect of Lending Shortfall on New and Transfer Units Combined.


Number of New and Transfer Unit Transactions




Percent of Maximum

Level

Maximum Level 44,226 522,393 69,628,309,941 100%


Reduced Level 30,616 361,626 $48,200,187,478 69%

The shortfall under the conservative lending scenario is presented by the total shaded area on the graph below — the sum of the pink, yellow and blue areas. The shortfall under the aggressive lending scenario is presented by the pink area on the graph below. The yellow area presents the difference between the base and the aggressive lending scenarios. The blue area presents the additional shortfall that would occur if banks were to tighten lending under the assumptions of the conservative lending scenario. Figure 6. Effect of Lending Shortfall, Aggressive and Conservative Scenarios Combined.

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Figure 7: Confidence Levels

Figure 8: Retail Sales

APPENDIX

Factors Affecting Prospective and Existing Operator Willingness As the economy continues to recover, franchisees’ willingness to participate in franchise unit transactions is expected to increase, albeit to a lesser degree compared to 2011. Several economic indicators point to a sluggish recovery in 2011 with a sizeable improvement only in the last quarter. The U.S. economy grew 1.7 percent in 2011, only half of the growth in 2010.38 Other factors, including tight financial lending conditions, rising gasoline prices, and the European crisis will provide challenges for the economy to rebound. Correspondingly, the nation’s top chief executives remain wary about the economic recovery. According to CEO

Economic Outlook, their confidence dropped over the course of 2011, only to

level off in the last quarter. The closely related Consumer Confidence Index fluctuated during 2011 as the U.S. debt ceiling crisis and the European financial crisis exacerbated the degree of uncertainty. The index reached its 28‐month low reading of 39.8 in October 2011 and regained its ground only over the fourth quarter. Consumer confidence further improved in February 2012 when consumers were considerably less pessimistic about current business as well

as the labor market conditions.39 They remain more optimistic about the short‐term outlook and expect business conditions to improve over the next six months. Small Business Optimism also improved during the fourth quarter in 2011 after a decline in the first eight months. Contributing the most to these improvements were reduced concerns regarding business conditions six months into the future.40 The overall sentiment in the market points to improved willingness at the beginning of 2012. Prospective and existing franchisees are relatively optimistic regarding business conditions and remain willing to invest in unit openings or transfers. Retail Sales Growth in retail and food sales indicate higher potential profitability. Holiday sales increased 6.3 percent from the same period the prior year. As a result, they had 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

38 U.S. Economy Grew 1.7 Percent in 2011: www.lamonitor.com/content/us‐economy‐grew‐17‐percent‐2011 39 The Conference Board Consumer Confidence Index Increases, www.conference‐board.org/data/consumerconfidence.cfm 40 NFIB Small Business Economic Trends, www.nfib.com/Portals/0/PDF/sbet/sbet201201.pdf

0

20

40

60

80

100

120

Aug‐10

Oct‐10

Dec‐10

Feb‐11

Apr‐11

Jun‐11

Aug‐11

Oct‐11

Dec‐11

Feb‐12

Confidence Levels

Consumer Confidence

Small Business Confidence

CEO Economic Outlook

37


over the previous year’s monthly sales. In January 2012, sales reached $401,400 million, which represented a 5.8 percent increase over sales in January 2011. This was a smaller growth than the increase of 8 percent in January 2011 over January 2010.41 The overall improved retail sales data point to altered consumer behavior where shoppers are adapting and coping with the economy conditions while responding more to sales and deals offered by stores.

Rising car sales are an indicator for further economic recovery. Of the $401,400 million of sales generated in January 2012, 17.6 percent were generated by motor vehicles and parts dealers. General merchandise, food and beverage stores, and gas station sales each accounted for 13.5 percent, 13.2 percent, and 11 percent of the sale.42 Compared to the same period in 2011, motor vehicles gained 14.8 percent, following building material, clothing and clothing accessories, and miscellaneous store retailers, which realized a 36.7 percent, 33.3 percent, and 18.7 percent growth, respectively.

The retail sales trends show that shoppers seemed to ignore many of the lingering economic warning signs and spend more. Same‐store‐sales for 23 chains tracked by Retail Sales increased 3.6 percent from 2010. This was the 28th month of gains, after 12 consecutive months of declines.43 Although some of these improvements are attributed to aggressive discounting by retailers, they 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. The improving economy, while far from robust, has brought hope to many small and medium sized businesses. Improving confidence indicators and the retail sales trends point to a better and healthier economic environment. Therefore, FRANdata projects a mildly improved willingness among prospective and existing franchisees.

Factors Affecting Prospective and Existing Operator Ability The stock markets were volatile in 2011, ending the year with a flat finish on S&P, a 5.5 percent gain on Dow, and a 1.8 percent decline on Nasdaq. Although markets showed some level of resilience during the first quarter of 2011, other factors, including the European debt crisis, the Arab Spring, and tensions with Iran hampered improvements. The markets tumbled even further as European policy makers struggled to contain the debt crisis. Many investors suspect that the U.S. stock market is geared for a better year. Some have argued that the late pickup in the last quarter of 2011 is likely to carry through 2012, especially with lagged growth and development in the previous year and the shifting momentum from bonds back to the stock market.44 This trend is somewhat confirmed by the rebounds in the stock markets in early 2012. In February 2012, the Dow average crossed above 13,000 for the first time since May 2008 as Greece secured a bailout to avoid a disorderly default. Although the

41 www.census.gov 42 U.S. Census Bureau News, www.census.gov/retail/marts/www/marts_current.pdf 43www.retailsails.com

44 All that Market Volatility for This?, WSJ, www.online.wsj.com/article/SB10001424052970204632204577128763787544458.html

Figure 9: Service Sales

38


Figure 10: Unemployment

S&P had uneven gains in the first two months of 2012, it reached above 1,360 in February, which is a marked improvement. However, the index has yet to reach its pre‐recession levels. Increases in the stock markets will positively impact franchisees’ ability to investment in franchises. If the continuing signs of economic recovery remain stable, they will further support the market. Traditional Sources of Financing 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 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 $48,900.45 Traditionally home equity has been an alternative to fund investments of prospective franchisees. However, with home values continuing to decline since the onset of the crisis, prospective franchisees may have lost an important source of financing. As of the end of 2011, 22 percent of homeowners with a mortgage owe more on the house than it is worth.46 This percentage has improved from 30 percent from the beginning of the year. Nevertheless, 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 2003.47 According to the S&P/Case‐Shiller Home Price Indices, all three composites ended 2011 at new index lows. The indices are at their lowest levels since the housing crisis began in mid‐2006.48 During the first month of 2012, the number of existing‐home sales edged up 3 percent to 4.4 million. With increasing inventory, low mortgages, and improving job prospects, homes remain affordable and prices are still on the decline, continuing a six‐year downward trend. Prices are expected to decline at a slower rate in 2012 before starting to rise modestly in 2013.49 Some economists believe that they may bottom in 2012 but will remain flat for three to four years before improving to a healthier level.50 Overall, the housing market is expected to build on the momentum from the end of 2011.

Unemployment Over the past two years, the U.S. unemployment rate settled at around 9 percent and only went below this threshold for the second time during the last quarter of 2011. This trend carried over to 2012. The economy has been creating more jobs since last fall, producing an average of 223,000 new jobs a month in December and January. According to the Bureau of Labor Statistics, payroll employment rose by 143,000 in January of 2012 and the

unemployment rate declined by 0.2 percentage points to 8.3 percent. Most of the job growth was generated by the private sector with large gains in professional and business services, leisure and hospitality, and

www.fidelity.com 46 USA Today, Home Prices Continue to Decline, but at a Slower Pace, www.usatoday.com/MONEY/usaedition/2011‐11‐30‐Home‐prices_ST_U.htm 47 finance.yahoo.com/news/home‐prices‐tumble‐december‐p‐141150377.html 48 S&P Indices Press Release: All Three Home Price Composites end 2011 at New Lows

49 www.realtor.org/press_room/news_releases/2012/02/ehs_jan 50 USA Today, Home Prices Continue to Decline, but at a Slower Pace, www.usatoday.com/MONEY/usaedition/2011‐11‐30‐Home‐prices_ST_U.htm

39


manufacturing.51 The unemployment rate is expected to hover around 8 percent during 2012 and eventually to decrease to 5.3 percent by 2016.52 Known as the lagging indicator, the unemployment rate is an important measure of the economy’s growth rate. The improved unemployment rate over the recent months may indicate a better economic environment. This is consistent with other economic indicators. As confidence is restored, new and prospective franchisees will gradually regain their abilities to invest in franchising activities.

Bank Ability to Lend FRANdata estimates banks will continue to have sufficient funds to finance the projected demand in 2012, continuing the trend from 2010 and 2011. With the overall economic recovery, conventional lending is also likely to improve marginally from its 2011 level. The ability to lend is influenced by three factors, commercial real estate values, the condition of financial institutions, and stimulus measures implemented by the government. Commercial Real Estate Value Commercial Real Estate (CRE) values are important indicators for bank willingness and ability to lend. Larger, nationwide banks have traditionally had more CRE exposure than small community banks. An improvement in CRE values is likely to increase large banks’ ability and willingness to lend. According to CoStar’s January 2012 CRE Index, prices for commercial property were an average 1.8 percent higher in November 2011 than compared with the same period a year ago. Positive trends in the second half of the year suggested a stabilized recovery for the commercial property market.53 Distress sales as a percentage of total sales continued to decline from a peak of 35.4 percent in March 2011 and accounted for 24.8 percent of all repeat sales by year end. Although distressed sales have declined gradually, the overall level was still high, suggesting that it continues to be a significant factor for CRE pricing.54 Moodys/REAL CPPI measures the change in actual transaction prices for CRE assets and shows similar trends. The transaction activity remains on par with the historical average and the process is expected to continue over the next two years. By August 2016, property prices should be just below where they were the same period in 2006, and 8.3 percent higher than in August 2011.55 Investment volume across the major U.S. property types is expected to grow by 50 percent to approximately $300 billion in 2012, according to Real Capital Analytics. Commercial real estate remains an attractive investment compared to other asset classes and is expected to pick up momentum especially in the second half

51 Bureau of Labor Statistics, Employment Situation Summary, http://www.bls.gov/news.release/empsit.nr0.htm 52 Congressional Budget Office, 2011 53 www.costar.com/about/article.aspx?id=10551 54 CoStar Commercial Repeat‐Sale Indices, Commercial Real Estate Prices Increase a Modest 1.1% in Fourth Quarter as Property Pricing Levels off in

December, www.costar.com/uploadedFiles/About_Costar/CCRSI/articles/pdfs/CCRSI‐February2012.pdf 55 Moody’s Investors Service, Moody’s/REAL Commercial Property Price Indices, November 2011, www.rcanalytics.com/Public/derivatives_index.aspx

Figure 11: Property Prices

40


of 2012. This will be in contrast to 2011 when the first half was marked by considerable momentum which then faded in the second half.56 The overall economy and the credit markets will also improve as a result. Condition of Financial Institutions Financial institutions were directly affected by the economic downturn. The liquidation of Lehman Brothers in 2008 and CIT’s bankruptcy in 2009 were some of the most prominent bank failures. Since the onset of the financial crisis in 2008, a total of 436 banks have failed with a total estimated loss of $74 billion. The number of failed institutions skyrocketed in 2009 and 2010 to a historical high with 148 and 154 failures, respectively. The total estimated loss reached $37 billion in 2009 alone. The number of failed financial institutions has dropped significantly to 92 in 2011 and to 12 in the first two months of 2012.57 With the slower than expected recovery, the banking system is likely to shrink, although at a slower rate. However, the failures have affected smaller banks more than larger ones. The number of large and financially sound institutions with more than $10 billion in assets remained virtually unchanged during the recession. On the other hand, smaller institutions with less than $1 billion in assets, which account for over 90 percent of the banking industry, have declined at a 4 percent annual rate since the beginning of the crisis. Even though many banks remain fragile, their position has improved over the previous years. In 2011, net income for the surviving institutions totaled $119.5 billion, an increase of almost 40 percent from full‐year 2010 earnings. This is the highest annual net income since 2006. Among the 7,357 FDIC‐insured institutions, 67 percent reported improved earnings in 2011 while 15.5 percent reported a net loss compared to a 22.1 percent reported loss in 2010. In March 2012, it was reported that the majority of banks that underwent a stress test to examine whether they would survive another downturn passed. Business and consumer loan delinquency rates are also declining.58 In the fourth quarter of 2011, the net charge‐offs totaled $25.4 billion, a decline of 40 percent from a year ago. This drop represents the sixth consecutive quarter in which charge‐offs posted a year over year decline. The charge‐off volume is also the lowest since the first quarter of 2008.59 These trends and developments point to a healthier and more stable financial environment. This will further facilitate banks’ improved ability to lend in 2012.

56 Real Capital Analytics, 2012 Predictions for the US Commercial Real Estate Capital Markets, www.rcanalytics.com/usct/1328/2012‐Predictions‐for‐the‐

US‐Commercial‐Real‐Estate‐Capital‐Markets.aspx 57 FDIC, www.fdic.gov 58 www.thomsonreuters.com 59 FDIC, Fourth Quarter 2011 Quarterly Banking Profile, http://www2.fdic.gov/qbp/2011dec/qbp.pdf

Figure 12: Bank Failures

Figure 13: Asset Distribution

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Stimulus Measures In 2008 and 2009, the available amount for small business lending was limited by the overall shaken state of the banking industry. Many banks did not have the ability to lend and were hampered by concerns about the collapse of the housing market and uncertainty related to the valuation of bank assets. The liquidation of Lehman Brothers in 2008 and CIT’s bankruptcy in 2009 were some of the most prominent bank failures. In 2009, total lending by U.S. banks fell 7.4 percent, the steepest drop since 1942. In response to these concerns, the government implemented a number of stimulus measures to protect the banking industry and to increase lending. The 2010 Recovery Act set aside a $375 million funding pool to temporarily eliminate fees for SBA loans and to increase the government guarantee of loans to up to 90 percent. Subsequently, Congress provided funding five more times to keep up. The Small Business Jobs Act, also signed in 2010, provided resources to help small businesses by extending the SBA enhanced loan provisions while offering billions more in lending support, tax cuts, and other opportunities for entrepreneurs and small business owners.60 In September 2011, President Barack Obama asked Congress to pass the American Jobs Act, helping small businesses grow and hire through reducing or eliminating certain payroll taxes, providing large tax credits for businesses that hire workers who have been unemployed for more than six months or veterans, and other.61 In September 2011, 13 of the largest U.S. banks made $20 billion in new commitments to small business lending over the next three years.62

Bank Willingness to Lend The lending world shut down in September 2008. It revived slowly in 2010 and started to come back in 2011. In 2012, banks are projected to be more willing to make loans than at any time in the past 17 years.63 According to Omega Performance, close to 64 percent of U.S. bankers surveyed expect slow increases in small business lending. Another 13 percent expect the lending environment to increase drastically. Overall, 77 percent indicate that their institutions are likely to increase lending to small business in 2012.64 With the improved economic condition and positive consumer sentiment, banks are slowly loosening their credit standards to make more funds available to support daily operations and activities. According to the Federal Reserve Board’s Senior Loan Officer Opinion Surveys on Bank Lending Practices, during 2011, an increased number of domestic lenders indicated that their lending standards and terms had eased somewhat during 2011 as compared to the previous years. The most commonly cited reason for having eased standards or

60 www.sba.gov/content/small‐business‐jobs‐act‐2010 61 www.sba.gov/about‐sba‐services/199/23001 62 www.whitehouse.gov/the‐press‐office/2011/09/20/ohio‐vice‐president‐biden‐discusses‐importance‐american‐jobs‐act‐small‐b 63 Banks Willingness to Lend at 17‐Year High: Fed, Market Wathc, The Wall Street Journal, http://articles.marketwatch.com/2011‐05‐

02/economy/30710819_1_industrial‐loans‐credit‐card‐loans‐business‐loans 64 Omega Performance, 2012 Banking Trends Outlook Survey, www.omega‐performance.com/media/2012_Q1_Survey_Results.pdf

Figure 14: Lending Practices

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terms on C&I loans was increased competition from other lenders. In January 2012, loan officers reported that their lending standards had changed little over the past three months.65

Unlike national banks that are still testing the water on large portfolios in new markets, local banks that typically do not have the exposure to the broader market have helped small businesses through the last few years. Local banks, limited by their resources, make loans to local businesses that they know. Another trend in small business lending is that alternative lenders such as community development financial institutions, accounts receivable financers, merchant cash advance, micro lenders, and others step in to provide financing. In January 2012, these alternative lenders approved 62.4 percent of funding requests, up from 62.2 percent in December.66 Loan approvals among small banks also improved.

The Thomson Reuters/PayNet Small Business Lending Index, which measures the overall volume of financing to U.S. small businesses, jumped 18 percent in January 2012 from January 2011, marking its 18th consecutive double‐digit rise. Additionally, some marginal improvement in delinquency rates took place throughout 2011 and in early 2012. Accounts 90 days or more behind in payments fell to 0.37 percent in January, a record low, from 0.38 percent in December. Accounts behind 180 days or more fell to 0.51 percent in January, from 0.54 percent in December. Accounts in moderate delinquency, however, or those behind by 30 days or more, rose to 1.57 percent in January, from 1.55 percent in December. That is still far below the high of 4.42 percent reached in May 2009 and consistent with continued lower risk of default. 67

Figure 16: Small Business Financing

65 www.federalreserve.gov/boarddocs/SnLoanSurvey/ 66 Biz2Credit, Biz2Credit Small Business Lending Index Reports Loan Approval Rate Increase, www.biz2credit.com/pressroom/biz2Credit‐small‐business‐

lending‐index‐january2012 67www.smallbusiness.foxbusiness.com/finance‐accounting/2012/03/01/small‐businesses‐borrow‐more‐signaling‐growth/ thomsonreuters.com

Figure15: Approval Rates

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In 2011, the SBA‐guaranteed loan amount reached record high with over $30 billion disbursed to 60,000 businesses.68 The same year, the agency approved $19.6 billion in 7(a) loans, and more than $1.5 billion of those were for franchise businesses, up 82 percent from $826 million the previous year. The percentage of 7(a) loans made to franchise concepts has increased steadily in the past several years, at an average of 5 percent year over year.69 The willingness for SBA‐guaranteed lending will continue to increase with the improving economy and as a result of the SBA‐implemented provisions in support of small business lending.

68 SBA.gov, All‐Time SBA Loan Volume Record in Fiscal Year 2011: Over $30 Billion in Small Business Loans to 60,000 Businesses,

www.sba.gov/community/blogs/official‐sba‐news‐and‐views/open‐business/all‐time‐sba‐loan‐volume‐record‐fiscal‐year 69 Entrepreneur, Tips for Finding a Franchise Loan, www.entrepreneur.com/article/222420

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