SBA Announces Changes for Franchise Financing

by Lee Plave3 Min Read

The Small Business Administration (SBA) recently announced a significant change in their process for reviewing applications by franchisees for SBA-backed financing. The changes are the result of a years-long dialogue among the agency, the International Franchise Association, franchise lawyers and critical third-party vendors such as FranDATA.

The SBA's staff had previously wrestled with the question of whether there was too much "affiliation" between a franchisor and a franchisee. In their view, if the franchisee was too closely "affiliated" with its franchisor, then the franchisee would not be sufficiently independent to be eligible to receive SBA backing for a bank loan.

The just-announced revisions streamline the process. The SBA issued a new "Standard Operating Procedure" (SOP) on November 22, 2016, which follows on regulatory amendments adopted in July 2016. 13 C.F.R. § 121.301. Among other things, the new SOP states that if a franchisor and a franchisee sign a standard two-page addendum to their franchise agreement, then, in most cases, the SBA will not conduct any further review of the franchise agreement.

The key points are:

  • The new rules take effect January 1, 2017. As of then:
  • The SBA will no longer require or maintain a registry of franchisors that have been pre-approved for SBA-backed financing; and
  • Franchisors no longer need to apply to be eligible for their franchisees to obtain SBA-backed lending.
  • The change is only to the "franchise agreement" portion of franchisees' application. Franchisees will still have to qualify as borrowers - both with the bank and the SBA - on the merits of their application.
  • The two-page addendum (which you can find at the link here) cannot be changed. The addendum is not perfect but marks a considerable improvement over past years' positions taken by SBA.
  • Among other things, the SBA backed off of its earlier positions that put its staff at odds with the U.S. Supreme Court on matters such as maximum and minimum pricing.
  • The SBA made clear in its policy statement that with the signed addendum, its inquiry is done, and without the signed addendum, it will not back a loan: "If the Franchisor and Franchisee have signed the SBA Addendum to Franchise Agreement, SBA will not deem the Franchisor and Franchisee to be affiliated. SBA will not make a loan to an applicant franchisee without the signed SBA Addendum to Franchise Agreement."

The mandatory addendum will make several changes to franchise agreements, such as:

  • Narrowing the limits imposed on a franchisor's right of first refusal in the case of a partial transfer. Those limits now apply only where there is a partial transfer to another current owner or to the family members of the principal or the other current owner.
  • Franchisors cannot "unreasonably withhold" their consent to a proposed transfer.
  • Following an approved transfer, the franchisor cannot require the selling franchisee to remain liable for the obligations of the buyer / new franchisee.
  • Upon termination or expiration, the franchisee's assets may be purchased for an agreed-upon price, or the price can be established by appraisal. This is more cumbersome, costly, and time-consuming than various other methods for pre-determining depreciated value.

If the franchisee owns the real estate upon which it operates the franchised business, then:

  • the franchisor cannot record restrictive covenants against the use of that real estate (such as restrictive covenants, branding covenants, or environmental use restrictions); and
  • the franchisor cannot require the franchisee to sell the real estate to the franchisor upon termination  or expiration, but the franchisor may require a market-based lease of the premises for the remaining term of the franchise agreement.
  • The addendum also includes a statement that the "[f]ranchisor will not directly control (hire, fire or schedule) [the] Franchisee's employees." This statement is hardly objectionable.

A few other interesting notes:

  • SBA-backed financing won't be available for master franchise arrangements, but will be available for conventional area development agreements (if the addendum is signed).
  • Businesses that restrict patronage for any reason (other than capacity) won't be eligible for SBA-backed financing (e.g., a women's only health club) - although "targeting" one gender is different and may require that additional documentation be submitted to the SBA.
  • The applicant cannot be "dominant in their field of operation." (The SBA's general standard suggests that the business won't be considered "dominant" if it does not exercise a controlling or major influence on an industry - on a national basis. 13 C.F.R. § 121.102.
  • All other documents that need to be signed in connection with the financing may also need to be submitted (e.g., a consent to financing).

Overall, while not perfect, for most franchisors this development is by and large positive and will likely save cost, time, and uncertainty.

Lee Plave

@PlaveKoch | LinkedIn | Website | Email

Lee Plave is a co-founding partner of Plave Koch PLC, an entrepreneurial law firm in Reston, VA. He counsels franchisors and distributors, drafts and negotiates agreements for international and domestic transactions, and advises clients on all aspects of franchise and distribution law.

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