A.J. Jafrey, founder and owner of Scoops N’ Scoops in Irvine, already had many of the elements needed to operate a franchise. He’d worked in a few franchises that his extended family owns, and he has an entrepreneurial education.
It wasn’t as simple as he’d hoped, though, when it came time to seek financing for his own venture.
Jafrey said he’d prepared many of the documents and information required to obtain a $300,000 bank loan to open the store. He conducted market research and considered possible products and services, competitors, a potential client base, costs of production and labor, site locations and real estate development costs.
“Banks were really hesitant to offer startup financing” to open the 800-square-foot store, Jafrey said. “They said that they wanted to see me in about a year.”
So the budding entrepreneur, like a lot of new owners of small businesses, pitched his idea to friends and family to get the store up and running. Such sources of startup money have long been the means people like Jafrey begin to realize their business dreams, though new options have emerged since the Great Recession tightened traditional lending.
A couple of years earlier he’d earned a degree in business with an emphasis in entrepreneurship from Chapman University in Orange, and three times a week as a student he’d had to conceive a company and present a venture capital financing pitch.
“I was already used to the rigor of that process,” he remembered.
He approached seven banks and pitched the idea for the brand, which offers nitrogen-cooled ice cream tailored to international palates. The flavors are subtle, less sugary and appeal to Orange County’s diverse population, Jafrey said. The shop would offer flavors from the Middle East, China, Korea, Pakistan, the Philippines and the United Kingdom.
He also market tested customers’ opinions of the products for 18 months, he said.
“We brought the ice creams to fairs and festivals, opened a stand, gave out samples, and asked people if the ice cream was too sweet or too fruity or too rich,” Jafrey said. “Then we adjusted the recipe.”
After banks turned Jafrey away for the time being, friends and family decided to back the venture, which opened last May and exceeded first-year projections by 7%, he said, while declining to provide sales figures.
The store has had such good business, Jafrey said, that he and co-investors decided to open a second 1,100-square-foot location in Chino Hills with profits from the first site.
Money to the Table
Friends, family and personal savings typically are the initial sources of franchise financing in Orange County, according to small-business lenders.
It’s important for an aspiring franchisee to invest some of his or her own money in a new business because banks and nonbank lenders will finance about 75% to 80% of the entire venture, said Stacy Sanchez, an Orange County small-business loan expert at Irvine-based CDC Small Business Finance, a nonprofit lender that administers Small Business Administration loans.
The federal government created new nonprofit lending programs after the real estate downturn because banks were reluctant to issue small-business loans or startup financing needed to start businesses and create jobs, Sanchez said.
Nonprofit lenders like hers are more flexible than banks when issuing small-business loans used by franchisees, though the nonprofit institutions charge higher interest rates, she said.
“Nonprofit lenders do not have government guarantees for our loans, so we’re completely responsible for any bad loans.”
CDC Small Business Finance can provide up to $10 million in financing to OC businesses at various stages of growth, from startups to mature companies that are expanding, Sanchez said.
“A lot of banks will refer clients to me because they want to help an entrepreneur, but the bank is unable to issue a loan based on projected cash flow,” she said. She also said most banks don’t want a client to go to a competitor.
Sanchez said she’s not a competitor to traditional financing institutions. Such borrowers end up turning to lenders like CDC Small Business Finance after striking out at traditional lenders. They don’t want to pay the higher rates but need startup financing.
“I’m usually the last person that can talk to small-business owners about financing,” she said.
Most banks issue financing based on a combination of an applicant’s credit history, available collateral, and whether their brand is on a list of road-tested companies, including ones with reliable cash flows, she said.
Sanchez said she and other nonprofit lenders differ from banks because they can issue financing based on cash flows entrepreneurs expect to generate after they receive the loan.
CDC Small Business Finance offers three types of financial products: micro loans worth $5,000 to $50,000; larger loans under the Community Advantage SBA-7(a) program that can be worth up to $250,000; and loans of up to $10 million under the SBA-504 program.
Microloans typically are used to purchase inventory, supplies, furniture, machinery or equipment. Most lenders require applicants to provide collateral in exchange for the loans, which can’t be used to acquire real estate or to pay business debts.
The larger 7(a) loans can be used for the above items and to purchase real estate or construct a building.
“These loans are also variable-rate loans that are mainly used to launch a new company,” Sanchez said.
Most franchisees will use the loans to customize a building or retail space, expand existing operations, acquire another franchise, or purchase inventory.
The largest loans that nonprofit lenders can offer, SBA-504 products, are fixed-interest-rate loans reserved to acquire real estate, modernize or convert facilities, or purchase capital goods with a 20-year depreciation. A franchise owner can’t use those loans to purchase a commercial-grade stove or oven because those items don’t depreciate over 20 years, Sanchez said.
“These (SBA-504) loans must be used with traditional bank loans,” she said. A bank will provide 50% of the financing to purchase a building, for example. The CDC Small Business Finance nonprofit will provide 40% of the transaction up to $10 million in some situations, and the franchise owner must invest 10% of the value of the purchase.
Sanchez said her institution won’t issue an SBA-504 loan if the client has a second bank loan in lieu of the required 10% payment. The franchise owner must have personal responsibility in the business venture.
Nonprofit and for-profit lenders require that their loans be used exclusively for developing the franchise, Sanchez said, so applicants can’t use the loans to pay themselves a salary. Applicants’ business plans must show that the franchisee can pay for life expenses without using the funds from the loan, she said.
“We want to know that the proposed franchises will generate enough money to pay for the loan.”
Recipe for Revenue
Craig Hirson, a senior bank executive and market executive for the Orange County office of Bank of America Merrill Lynch, said the best franchise owners have prior experience in the industry and have increased revenues at their respective stores.
“Franchise owners sometimes get caught up in thinking that they have purchased a business in a box,” he said. Prospective owners should understand that success takes a lot of manual labor and the ability to train new staff and manage a variety of people.
Hirson said that an established brand can make it easier for a franchisee by determining business guidelines, providing trusted suppliers, and issuing marketing and advertising support, though franchisees must have a passion for the industry and its daily operations.
He said he usually deals with two types of applicants: current franchise owners who want to buy other franchises or someone who wants to open a franchise with an established brand.
There’s less risk to finance a more mature entrepreneur supported by a well-recognized brand, he said.
He and his team of lenders will scrutinize the business plan, visit all of the proposed stores, evaluate traffic patterns and parking, and ask the entrepreneur to explain business strategies. First-time and experienced franchise owners get the same level of scrutiny.
Applicants who provide well thought-out plans supported by evidence, run by experienced managers, and supported by established brands will receive funding.
“There’s little contact with those franchisees after underwriting the loan,” Hirson said.
Prospective franchise owners in Orange County should be excited about their prospects, said Cristin M. O’Hara, managing director of Bank of America Merrill Lynch’s restaurant group. She supports Hirson’s Orange County office.
“A new franchise that is successful in Southern California is more likely to be successful elsewhere,” she said, because California customers usually determine the nation’s eating preferences. Californians demand healthy foods, for example, that are tasty, locally sourced and affordable.
California also has high standards for its businesses.
“So if a brand-new franchisee can be successful in California, they have a good chance of being successful in the rest of the country,” O’Hara said.
Jafrey’s business celebrates its one-year anniversary this month, and he plans to visit with the banks again.
“I’m looking forward to what they think about our business this year.”
