SBA Announces Changes for Franchise Financing

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.