Franchise Agreement Provisions That Affect Eligibility for SBA Loans

Vol. 15, No. 2

By

DLA Piper LLP (US)

I. Introduction

Franchise systems continue to face significant hurdles in securing lending sources to finance the development and opening of new locations. While access to conventional credit sources remains somewhat limited, loans guaranteed by the Small Business Administration have become a key resource for franchisors and franchisees. But SBA loans are available only under certain conditions and those conditions may be difficult to reconcile with the terms of certain franchise programs.

Basically, an SBA loan is available to a credit-worthy small business. A business is “small” for SBA purposes typically based on revenues or number of employees (e.g., a restaurant concept would qualify if revenues were less than $7-10 million, depending on the type of concept). The critical issue is whether the business is independent enough such that its owner has the right to profit from his/her efforts and bears the risk of loss commensurate with ownership. In evaluating independence in a franchise context (i.e., proving that the franchisee is not “affiliated” with the franchisor), there are difficulties in weighing the degree of control a franchisor exercises over a franchisee. SBA staff are tasked with determining eligibility but, because they are scattered around the country and standards of interpretation vary, historically there has been some lack of uniformity among the SBA offices. In some cases, a franchisor’s franchise agreement may pass muster in one SBA regional office while another office will deny eligibility or impose conditions affecting key elements of the franchise program.

II. The SBA Franchise Registry

In 1998, the SBA established an alternative path specifically for the franchise industry to avoid inconsistent eligibility determinations in its regional offices. That alternative is a public/private program called the Franchise Registry. If a franchisor files an application for inclusion on the Registry, its franchise agreement is reviewed by a private program manager, FRANdata, in consultation with the SBA national office in Washington, D.C. As described above, the review focuses on elements of the franchise program indicative of independence from and non-affiliation with the franchisor, i.e., the right to profit and bear losses. There is a cost to file with the Registry (currently $2,500), and the review process can take as long as several months. But once a franchisor is listed on the Registry, the franchise agreement is presumed to be eligible for SBA financing and the borrower’s creditworthiness becomes the only material issue on the table for the lender.

Some franchise systems are structured in a way that their programs will never qualify for the Registry without first undergoing significant program restructuring. But most systems, albeit with some modifications to their franchise agreements, should be eligible for inclusion.

The following are the principal issues that are considered by Franchise Registry administrators in connection with their review of franchise agreements:

  1. Hiring/Firing of Franchisee’s Employees. If a franchisor reserves the right to hire or fire a franchisee’s employees, that will be a basis for disqualification. However, a franchisor can have a right to approve the manager of the franchised business. A franchisor may also retain an option to take over the franchisee’s business, and hence serve as the employer of the franchisee’s employees, for a limited period of time (in 90- to 120- day increments, but not exceeding 12 months).
  2. Bank Account Control. A franchisor will be disqualified if it requires that the franchisee deposit receipts into a bank account controlled by the franchisor. Similarly, a requirement that the franchisee get franchisor approval for a withdrawal from a franchisee-controlled account will be problematic. But these restrictions do not apply to electronic withdrawals (via EFT or ACH) by the franchisor from an account controlled by the franchisee.
  3. Billing Control. If the franchisor controls the billing of the franchisee's clients/customers, the franchise program will not qualify for SBA approval.
  4. Step-In Rights. A franchisor may retain the right to take over the operation of the franchisee’s business (a/k/a step-in rights) for only a limited period (see #1 above). This right typically would come into play in the context of a franchisee default.
  5. Transfer Approval. The franchise agreement will be disqualified if the franchisor is allowed to withhold approval of a transfer “in its sole discretion.” Instead, the franchisor cannot unreasonably withhold or delay approval of a transfer.
  6. Transfer Pricing. The franchisor cannot unilaterally dictate the price at which the franchisee can sell its business to a third party or to the franchisor in a repurchase. A price based on an appraisal or some other reasonable method will be permissible, as long as both parties participate in the appraiser selection process.
  7. Franchisor Purchase Option. Assuming the pricing formula is approved (see #6 above), a franchisor can acquire the franchisee’s personal property (upon a termination or expiration). However, the franchisor cannot have the right to acquire the real estate on which the franchise is located, nor can the franchisor demand a lease of such real estate.
  8. Real Estate Control. The franchisor cannot impose deed restrictions, covenants or reversionary interests with respect to the real estate owned or controlled by the franchisee.
  9. Right of First Refusal. A franchisor may provide for a right of first refusal with respect to the sale of the entire franchised business. But such right of first refusal cannot apply to a partial transfer of ownership in the franchisee entity. By a “partial” transfer, the SBA is focused on situations where, by exercise of its right of first refusal, the franchisor would become a substantial co-owner of the franchise. In such a situation, the business is no longer “small” and therefore would be disqualified from SBA loan eligibility. Partial ownership transfers become more problematic when a franchisee retains a small ownership interest and sells the bulk of the stock or interests to a third party. If this occurs, the franchisor may not be able to exercise its right of first refusal, but the SBA anticipates that the franchisor could reasonably refuse to approve the transfer. That may not solve the problem so additional clarification from the SBA may be necessary.
  10. Liquidated Damages. If the franchise agreement provides for liquidated damages in the case of a franchisee breach, the damage formula must be reasonable and damages should be ascertainable at the time of signing.
  11. Retail Pricing. A franchisor may not mandate the franchisee’s retail pricing structure but is allowed to establish national price advertising programs and limited-time promotional offers. The SBA is currently working on a clarification of its position on this issue.
  12. Multi-Unit Arrangements. In general, master franchise, development agent, area representative and similar programs are not eligible for SBA loans. However, area development arrangements (i.e., an agreement by the franchisee to develop and operate multiple units typically in a specified geographic area) may qualify.
  13. Fee Issues. If the continuing fees payable by the franchisee are confusingly described or are excessive, there will be a qualification issue. Obviously, the word “excessive” is subject to interpretation so presumably this is not an oft-cited basis for disqualification.

III. Other Matters

A listing on the Registry must be renewed on an annual basis. Any future changes to the franchise agreement with respect to the issues described above must be vetted through FRANdata before implementation.

In summary, listing on the Franchise Registry has a number of benefits, including:

  • Once listed on the Registry, the franchise agreement will not be reviewed on an ad hoc basis by SBA regional offices.
  • Some lenders view the Registry as an additional badge of legitimacy.
  • A franchisor may gain a measure of credibility via a listing on the Registry.

Not all franchise programs will qualify but, for most franchisors, the SBA Franchise Registry is a worthwhile investment.

IV. Recent Developments

Even if a franchisor elects to forego filing on the Franchise Registry and, instead, decides to deal with SBA regional offices on a case-by-case basis, some recent developments may prove beneficial. The SBA has instituted a national franchise appeals program, where a franchisor can appeal an adverse decision by a local SBA counsel. The SBA hopes that the appeals process will result in a greater degree of harmonization throughout its regional offices. While the Franchise Registry may continue to be a better option, the appeals program may help to eliminate major variations in reviews by SBA offices.

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