What just happened in America? What will be the impact on franchising?

This is certainly going to be a challenging period for our economy, and this recession will be different than those that took place over the last thirty years. During past downturns we could rely on at least one of the three major economic supports (housing, employment or banking) to be strong, and the impact was frequently more localized that what we will see now. Different from the banking or the dot-com problems of the 80s and 90s, this recession has none of the major fail-safes working, and it is more broad-based. Despite Congress’ bailout of the banking industry, this turnaround will still take some time to work through. We have yet to see whether Paulson has a workable plan for the money, and no one is really expecting Congress to make the necessary changes in their social engineering that caused this problem in the first place. Small business growth and stability will again, as in past recessions, be an important part of the solution.

I am a true believer in the economic power of franchising. For those of us who worked through the economic downturns of the past, the one bright note is that by the fourth quarter of 2009 and early in 2010 we will likely begin to see a return to franchise system growth. There is an inherent strength in entrepreneurship in the United States, and a well-justified belief that being part of a quality franchise system creates a relatively safe and sustainable investment for franchisors and franchisees. In past downturns, as more passive investments either did not create reasonable returns or the ups and downs of Wall Street proved to be too volatile and risky, people looked to other investment vehicles, and franchising was their safe harbor. Similarly, as jobs disappeared and workers were asked to do more, people turned to small business ownership; becoming franchisees gave them the skills and support to strike out on their own. Franchising tends to be counter-cyclical in that way. As passive investments falter, active investments into franchising tend to grow. But this recession, as I said earlier, is a bit different.

In past downturns, individuals could turn to the value of their homes for collateral to invest in franchises. Today, home values are down, many people are unable to borrow against their largest asset, and the days of open lending at the banks is gone. Current home values and a reluctance of lenders, including some like GE Capital who traditionally provide franchisee financing, to make loans will keep franchise sales sluggish. But banks by their nature make money by lending it to responsible borrowers, and franchising provides a “safe” place for them. Franchisee loans will come back simply because banks need to use their cash to stay alive and franchising is a responsible place for them to take credit risks.

While multi-unit sales will also be depressed, multi-unit growth should be impacted somewhat less than single-unit sales. However, initial long-term growth expectations for multi-unit developers will likely need to be scaled back and franchisors are going to have to deal with the problem of existing multi-unit development schedules that will slip. Many of our clients have already been in discussion with their multi-unit developers about their contractual pipeline commitments for some time. Working through the lending crisis will require a review of franchisee growth commitments so that realistic growth projections can be developed and conflicts avoided.

Similarly, investments in modernization by franchisees will prove to be difficult. Credit is the oil of our economy and with same-store sales also impacted as consumer spending slows, major investments in modernization, new equipment, and point of sales systems may need to be postponed.

Even with companies like GE backing away from franchising, loans will still be available as the credit crunch begins to subside. However, lenders are going to require more skin-in-the game from franchisees than they did in the past and are going to look closer at the health of the franchise system they are joining. The franchisees you want to look for will need to be economically stronger, as they will need to invest more of their own capital into the business to be eligible for loans. Interest rates will likely be higher and franchise systems that will grow are going to need to show strong performance. Franchisors need to now look at the profile of franchisee they are targeting and modify their recruitment process and marketing materials to the right audience of available candidates. For franchisors that have historically not included a Financial Performance Representation in their Franchise Disclosure Documents, now may be a good time to discuss doing so with your lawyers and other advisors. Expect some pushback from your lawyers in doing so now, but discussing an Item 19 disclosure should be on your agenda.

The period will, though, have some major benefits as all downturns do. The available labor pool for franchisees will get a bit more robust as companies lay off workers and some businesses close. And, as we saw with the 600 units made available by Starbucks, as weaker independent retailers close their doors prime locations will become available. We are already seeing landlords using words that I had thought they had long forgot. Terms like “build-out allowances” and “free rent” are started to return to the lexicon. For those able to attract franchisees with capital to invest, the time it takes from signing the franchise agreement to opening the location will be reduced. Also, contractors will be looking for work to keep their crews active and even with the higher costs for raw materials, the costs for build-out should soften somewhat.

Lower-than-projected franchise sales and system revenue will create some opportunities and enable some franchisors and stronger franchisees to grow through acquisitions. Equity investors will take advantage of these opportunities, and we have been seeing this trend in our own practice for some time. For those of us involved in mergers and acquisitions, 2009 and 2010 should be an active period.

So what should franchisors be doing now?

With slower new unit growth, projected income from new franchise fees and royalties will be down. At the same time, consumer spending is expected to be lower, resulting in lower royalty receipts; lesser performing franchisees will likely be slower in sending in their royalty checks. Franchisors need to focus on their current system base and their own bottom line.

Several of our clients are looking overseas for franchise system growth. Many other countries will, however, also be affected by this money crisis, and you should examine each market carefully. Still, for those that can support an international expansion strategy while supporting their domestic operations, this may be a time to consider doing so. But again you need to take care in selecting your target countries. Most of our clients, though, will be focusing in on the health of their domestic units, as keeping their current system strong reduces the number of locations that could close, lessening the need for them to be replaced to stay even. MSA’s practice has always had a major focus on working with established franchisors in strategic and tactical planning, and we have noticed a dramatic uptick by our clients in looking at ways to work with franchisees to improve their bottom-line performance. Franchisors will also need to examine their internal costs and planned investments.

Anticipating continued robust franchise sales growth through 2009 is unrealistic. Conservatively, many franchisors should reduce their expected franchise growth in 2009 by as much as 50% if not more. Keeping the pressure on your development personnel will likely result in accepting candidates that do not meet your qualification standards. That is never a workable strategy in the short or long term. That is how the banks got us into this global economic mess in the first place. Brokers will likely provide some additional sales opportunities but as always, the needs of the brokers for you to close a deal may conflict with your sensible evaluation of the candidates they bring to the table. The best approach is to recognize that franchise sales and system growth in the short term will need to take a back seat to improving the performance of your existing operations. Do not sacrifice your standards of franchisee approval to meet inflated growth goals. Make sure your growth targets are realistic.

Now is the time to work closely with your current operators if you have not been doing so in the past. Creatively looking together at opportunities for new products or services that can be added to the system at a lower retail price and cost of sales, while always important, is something to really focus on now. While many of your suppliers are already under pressure with higher costs, including transportation, their active involvement in helping you develop retail and supply chain strategies can create a win-win situation for both of you. For franchisors that focus their efforts on improving system performance and their franchisee’s bottom line, once the opportunities for growth reappear, they will be extraordinarily well positioned to take advantage of the flood of new prospective franchisees, since their system validation will be higher than those franchisors that didn’t.

Looking internally at their own cost structure will be important for all franchisors, but you need to be cautious on where cuts are made and how deep those cuts are. There is certainly no reason to panic. Companies should always be looking at ways to be more efficient and effective with less, even in the best of times, and getting your internal house in fiscal order is essential when revenue may not be as high as you originally projected. At the same time, anticipate some opportunities coming your way and when they do, make certain you have the resources, capabilities, and confidence to take advantage of them.

Fortunes are made when times are hard. Franchising is inherently a solid method of business growth and wealth creation in good times and in bad, but you need to start by making realistic evaluations of the current business and, together with your franchisees, adjust to the market opportunities presented to you. Those who excel will not be afraid to challenge their core assumptions and look for the opportunities. Those who think the bailout of the banks is going to quickly solve all of their problems and return them to the world of 2007 will wish they had.