February 2011

New Dealership Investment
The Effect Manufacturer Capital Policies Have on Your Balance Sheet

General Motors has recently changed their accounting policy, which actually eases some financial burden on new dealerships and existing dealers.

Starting a new dealership often requires an automotive franchise buyer to spend significant time and money negotiating the demands of sellers, manufacturers, floor-plan providers, mortgage bankers and other capital sources. One of the most difficult challenges in gaining the approval of an ownership change is navigating the capital policies of automotive manufacturers. There are basically two components to the capital policies of every automotive manufacturer. The first relates to the amount of debt that is allowed on the dealership balance sheet and the second concerns the amount of working capital that is required of the dealer. If factory thresholds are not met and the new dealership balance sheet is not acceptable to the manufacturer, the transaction will be turned down upon submission.

The manufacturer’s net working capital calculation is a key component of the new dealership owner’s franchise application. The calculation varies significantly among manufacturers. Basically, manufacturers fall into two categories when it comes to working capital requirements for a new dealership. The first group provides a standard at the onset of the application process that is based on planning volume or historical market share information. Typically, these manufacturers have a set dollar amount allocated per new vehicle projected. There is typically no negotiation when it comes to the requirement and the standard is provided upon delivery of the manufacturer’s document checklist. The second group provides a working capital standard based upon the new owner’s forward forecast. The requirement is typically provided in the middle of the application process and after the forecast has been reviewed by the manufacturer. With this group of manufacturers, working capital formulas and calculations vary among franchises. Additionally, the level of guidance and the amount of manufacturer input on the actual forecast varies among franchises. If you are purchasing a dealership that represents a manufacturer where the working capital guide is based upon the applicant’s forecast, its important to seek guidance from someone who understands manufacturer’s calculation before submitting your forecast. It could mean the difference of hundreds of thousands of dollars in start up capital. After the first year of operation, both groups of manufacturers typically use the past 12 months of historical performance to revise the working capital requirement.

The second group of key capital polices concerns the amount of debt allowed to be held on the dealership entity. General Motors has recently changed their accounting policy, which actually eases some cash equity burden on new dealerships and existing dealers. In summary, GM is allowing their dealers to borrow additional funds to meet their working capital requirements. While they are not changing their overall debt to equity policy of 42.5% maximum debt, they are allowing their dealers to count more debt towards their actual working capital calculation. This in turns allows for greater flexibility when it comes to capitalizing a new dealership. General Motors has always utilized a unique policy to the industry, which classifies debt as “qualified” or “unqualified” as it pertains to a dealer’s actual net working capital calculation. Historically, to qualify debt towards a dealer’s actual working capital, the debt had to be classified as an owners/officers note and could only be 50% of the dealer’s working capital standard. In other words, any money owed directly from the dealership to a traditional financial institution could not be counted in the dealer’s actual working capital calculation. As of February 1st, 2011, GM is allowing 100% of the working capital requirement to be borrowed and “qualified” towards the dealer’s actual working capital. The debt still has to be qualified as an owners/officers note but by allowing the dealer 50% more debt as it relates to the dealer’s working capital requirement, I would expect to see more debt on GM dealership balance sheets going forward.

Even with the recent capital policy revision, General Motors’ current policy of 42.5% maximum debt still is one of the strictest debt to equity policies in the industry. However, the most stringent debt to equity policy in the industry based on my experience is Ford Motor Company’s policy. While Ford allows its dealer’s to borrow 50% of working capital and fixed assets combined, the company requires its dealers to pay for any goodwill or blue-sky with a total cash equity contribution. Depending on the level of goodwill involved, this can require a significant portion of the dealership purchase price to be in the form of cash. This has not been a major issue over the past two years, as Ford goodwill values have been lower than in the past. However, as Ford continues to improve market share and shareholder value, I would expect goodwill valuations to increase in line with their industry success. If you are planning on purchasing a Ford dealership in the near future, it is important to understand that Ford Motor Company expects you to purchase all goodwill exclusively with cash.

Besides Ford and General Motors, most automotive manufacturers have a 1:1 debt to equity policy. In other words, borrowed capital may not exceed owned capital in the capitalization of a dealership. Of course there are exceptions to this policy among franchises. In addition, manufacturers do not want their debt to equity policy to reach the maximum threshold. This is especially true during a proposed ownership change or a buy-sell transaction. If an application is submitted with a balance sheet that pencils the maximum amount of debt allowed by the manufacturer, the approval process will be difficult for the new owner. A good rule of thumb is to maintain 80% or less of the maximum debt allowed.

Capital policies among the manufacturers follow a common thread. Manufacturers desire a strong cash position with their new dealers so as to meet the challenges of a volatile economy along with opportunity to borrow for future facility upgrades and expansion. As business picks up and manufacturers renew their push for facility renovations in the coming months, expect further scrutiny and possible capital policy modifications with respect to franchised dealership balance sheets.




January 2011

Increased Areas of Responsibility Can Spell Trouble for Dealers

General Motors Delivered New Market Definitions to Dealers on 12/17/10
BMW also revising Market Area Definitions based on Zip Code

Many manufacturers look at sales territory definitions as a way to grade dealers, motivate dealers and ultimately increase sales. Recently, some manufacturers have used territory definitions as a tool to terminate dealers. Carving a market definition is the foundation for sales efficiency calculations. Once a market is cut, defined and finalized, its difficult to revise and correct inaccuracies. Chrysler and General Motors used sales efficiency as the primary basis in their decision making process on whether to keep or terminate dealers going forward with the new companies. Many of the original market definitions used for the sales efficiency calculations were flawed, setting up the impossible task of making the final cut. For these dealers, it’s too late to correct the inaccuracies of a flawed formula.

Today, General Motors is in the process of sending out notices of re-drawn Areas of Responsibility (AORs) to their entire dealer body. While relatively small news to the industry, it’s monumental for GM dealers. These notifications were delivered to most GM dealers on December 17, 2010. The manufacturer’s strategy may be for the notices to be filed and forgotten, as GM only calculates sales efficiency on a yearly basis. Sending the notices in the first quarter of this year when sales efficiency ratings will not be calculated until 2012 allows plenty of time for the dealer to forget about the new market definitions before they get the results of their next sales efficiency rating.

The good news is that GM is providing for an appeals process for their new market area definitions. At this time, the process calls for an appeal within 30 days of delivery of the new market definition along with a provision for a 30-day extension. Within the two-month window, every GM dealer should review their new market and immediately prepare an appeal should the revised market prove inaccurate or unfair to the dealer. Once the 60 days are up and if a dealer is not on record with an appeal, the dealer may be in trouble when the new sales efficiency ratings are developed next year.

Reviewing markets on both the manufacturer and dealer level for nearly 20 years, I can attest that there is some degree of subjectivity in these market definitions. The subjectivity arises with traffic patterns, unique geography and general consumer shopping habits. There are a few tools the dealers can use to review and correct inaccuracies. 
Specifically, an independent market study should prove beneficial in establishing an accurate representation of the dealer’s market area. The study should take into account competitive dealership locations and sales performance, traffic counts, demographic trends and natural market boundaries. It should determine the best possible market boundary based on distance and customer convenience. It should be up to date with current demographics, vehicle registrations and maps.

However, rarely do dealers have the opportunity to appeal their market boundaries with the manufacturer. General Motors is giving their dealers this opportunity. By allowing dealers the opportunity to appeal new market definitions today, GM is making the case to close the door on future appeals permanently. This is why it is so important for GM dealers to take an active role in establishing an accurate area of responsibility for their dealerships. GM is asking their dealers who believe their markets are unfairly drawn to speak now or forever hold their peace.

Beyond GM’s recent re-draw, most manufacturers undergo periodic market studies approximately every ten years. The last time GM formally revised markets was 2002. Other manufacturers, such as Toyota, perpetually review metro markets and communicate their findings at collective dealer meetings within the specific metro market studied. These also occur in approximately ten-year intervals but do not happen all at once. Instead, markets are continually reviewed each year nationally or as necessary. A market study meeting would be the time to voice any objections to proposed detrimentally revised primary market definitions. Manufacturer planned market studies not only review market definitions, they address the optimum number of dealers recommended to cover a specific geography. When reviewing a market area for accurate boundaries, it is important to be aware of the possibility of opening a market to additional representation. Adding more dealers to an underperforming area is not always the answer. In spite of this, many markets that we have reviewed and revised in the past few years consisted of a minimal amount of census tracts dropped which accounted for sizeable gains in the reporting of sales performance. In other words, some studies result in a minimal amount of geography cut, resulting in large improvements in sales efficiency. It may just take the removal of one or two census tracts to achieve efficiency and realize all of the incentives that sales efficiency offers.

BMW is also sending out notifications of new primary market areas. In the coming months, I would expect that Chrysler and possibly Ford will follow GM with new market definitions. All dealers should be aware of the changing market dynamics and possible revisions to their areas of responsibility. Recently, luxury makes have entered into the sales efficiency game. There was a time when low days supply turned some luxury makes into allocation driven sales forces with evaluations and awards based exclusively on customer satisfaction. Today, virtually all manufacturers use sales efficiency to grade their dealers, determine incentive payments and/or provide guidance on whether or not to renew dealer agreements. Most manufacturers have an elite classification of dealers that are typically rewarded with increased incentives and advertising benefits. Standards of Excellence, Board of Governors, President’s Award and 5-Star are all examples. Sales performance relative to a specific market definition is a key component in each of these programs. As manufacturers continue to lean on sales efficiency as their primary evaluation tool, dealers have the right, responsibility and obligation to insure their markets are drawn accurately.