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SBA 504 – Franchises

by John Reichard on Tuesday, August 11, 2015 2:00 PM

One popular type of business, especially for retired vets looking to start their own business, is a franchise.  A franchise offers pre-opening and ongoing support to the franchisee and typically involves an established product or service that may already enjoy brand-name recognition.  But in dealing with a franchised business, the SBA needs to review the franchise agreement in order to determine eligibility for an SBA 504 loan.  Today’s blog focuses on franchise reviews.

The primary review of a proposed franchise project is of the Franchise Agreement.  The main concern the SBA has is to make sure that the borrower is an eligible small business.  In most cases, a franchise, especially a national franchise, would not be considered a small business due to their size.  So a determination needs to be made as to whether or not the Franchise Agreement creates an affiliation between the franchisor and the borrower, thus making the borrower ineligible for a 504 loan due to size.

Possible affiliation can exist through four areas: common ownership, common management, excessive restrictions upon the sale/transfer of the franchise interest, or control by a franchisor either directly or through an affiliated entity or agent such that the franchisee does not have right to profit from its efforts and bear the risk of loss commensurate with ownership.  This typically does not include restraints relating to standardized quality, advertising, accounting format, and other similar provisions.

To facilitate the review of these agreements, SBA makes available a list of franchise agreements (the “Registry”) that have been approved by the SBA Franchise Committee for size/affiliation and control issues. This information is currently available to the public at www.franchiseregistry.com. We must ensure that we have the correct date of the agreement that the applicant/franchisee is operating under in order to access the correct Registry documents. If we are unable to determine the date from the documents, we can contact the franchisor directly. SBA will accept the executed Certification of Franchise Documents, Addendums, etc. matching the correct year of the agreement as conclusive evidence that the franchisee is not affiliated with the franchisor based upon the agreement.

If an agreement is not on the Registry, the SBA has a Franchise Findings List at www.sba.gov/content/franchise-findings that lists any findings for a particular Franchise Agreement, which if still in the Agreement or not allowed to be waived/amended for the particular borrower, would result in a determination of affiliation.  If an agreement is not on the Registry or a new agreement is in place that has not been reviewed by the SBA, a copy of the Franchise Agreement and franchisor’s disclosure statement that is required by the Federal Trade Commission will need to be submitted to, reviewed by, and approved by the SBA prior to application submission. 

The following are some examples of common situations that are considered conclusive evidence of control, and therefore, would constitute affiliation with the franchisor:

  • ·       Including a transfer provision that requires a franchisor’s consent unless it expressly states “Consent must not be unreasonably withheld or delayed” or its equivalent. SBA will not infer this into a franchise agreement. Reasonable Business Judgment is not an acceptable substitute.
  • ·       Setting the Applicant’s net profit.
  • ·       Requiring the payment of excessive franchise continuing fees.
  • ·       Directly controlling the applicant’s employees including hiring or terminating, except short term step-in agreements for 90-120 days are acceptable, provided the period of control by the franchisor does not exceed 365 days in the aggregate over the term of the agreement.
  • ·       In the temporary personnel industry, temporary employees paid by the franchisor are acceptable as long as the franchisee makes all employment determinations.
  • ·       Requiring that the billing activities, deposit receipts or revenues for the applicant be handled by the franchisor or a Third Party chosen by the franchisor (Exception: automatic debits from a franchisee account are acceptable).
  • ·       Including an option to purchase the applicant’s personal property upon expiration or breach of the agreement, where the franchisor has the ability to control the price at the time of purchase (Exception: right of first refusal is allowed provided it is on commercially reasonable terms).
  • ·       Requiring the franchisee (or EPC owner, if applicable) to sell the real property to the franchisor upon expiration, breach or termination of the agreement. (This type of provision may be found in the agreement itself or recorded against the real estate as a purchase option.) Exception: The franchisor may require a lease of the property upon termination for a period up to the remaining term of the original franchise agreement.
  • ·       Including a Right of First Refusal on a partial transfer of ownership between existing owners of a franchise entity or their close relatives.

Certain industries such as insurance, fitness, and most importantly gasoline have other provisions that determine whether control and affiliation exists.  If dealing with a gas station for example, a review of the Dealer Agreement between the gasoline supplier and the borrower will need to be completed and approved prior to application submission.

While franchises do have benefits to small business owners, not all franchises are equal.  So when looking at an SBA 504 loan for a business involving a franchise, be aware that some up-front due-diligence will need to be done to determine whether the borrower will be eligible or not.

John Reichard

Information related to the SBA 504 loan program for small businesses.