The U.S. Small Business Administration (SBA) is requesting comments from the public on all aspects of its franchise lending program.  The SBA issued its notice and request for comment December 8, 2014.  Comments must be submitted no later than February 6, 2015.

The SBA guarantees bank loans to franchisees that apply and qualify under certain SBA lending programs.  The SBA guarantee makes it possible for franchisees that otherwise would not qualify for a loan to finance their franchise businesses.  But not all franchise agreements fall within the scope of the SBA requirements.  Some franchise systems have provisions in their franchise agreements that make their franchisees ineligible for SBA loan guarantees.

The SBA’s loan programs are generally available only to independent small businesses as defined in the SBA’s regulations.  In franchising, the key question is typically whether “affiliation” exists between the franchisee and the franchisor.  If affiliation exists, the borrower franchisee will not be viewed as an independent small business.

Affiliation exists when the franchise agreement gives the franchisor excessive control.  In order to qualify for the SBA loan program, the applicant must have the right to profit from its efforts and must bear a risk of loss commensurate with the concept of ownership of an independent business.

An examination of the franchise agreement is a central part of the SBA review process.  The SBA understands that franchise agreements contain strict quality control requirements.  But many franchise agreements contain provisions that the SBA considers excessive, meaning that affiliation exists.

In the request for comment, the SBA gave the following examples of franchise agreement provisions that evidence affiliation:

  • Almost all franchise agreements require the franchisor’s consent to a transfer of an ownership interest in the franchise.  This type of restriction indicates affiliation unless the agreement states that the franchisor’s consent will not be unreasonably withheld or delayed.
  • After a transfer, the selling owner should not be liable for actions of the buyer.  If the owner remains liable for the actions of the transferee after the transfer, the SBA will view this as excessive control.
  • Provisions in a franchise agreement that give the franchisor the ability to manage the billing or collections function for a franchisee are sometimes considered evidence of excessive control.
  • Many agreements give the franchisor the option to purchase the franchisee’s business assets upon termination, expiration or nonrenewal of the franchise agreement.  A franchisor’s right to select the appraiser can be evidence of excessive control.  The franchisee must have the right to sell the assets of the business at the best price.
  • Many agreements allow the franchisor to step in and assume operations of the franchisee’s business in response to a critical incident for a limited time.  An agreement that allows step-in rights for an unlimited time or under routine circumstances would be considered excessive control.

The SBA noted that it has seen the following provisions in newer franchise agreements:

  • Some franchise agreements give the franchisor the unlimited right to set both minimum and maximum prices that the franchisee may charge.  The SBA’s position is that an independent business should have the ability to set its own pricing, enabling it to make a profit or risk a loss from its own actions.
  • Franchisors commonly have a right of first refusal on the sale of the franchised business.  But what about the sale of a partial interest in the franchisee’s business?  Should a franchisor have the right to become a partial owner simply because one owner wants to transfer all or a part of his interest to another owner or a family member?  What about the transfer of a partial ownership interest to a third party?
  • The SBA views a provision that requires the franchisee to sell the property to the franchisor upon expiration, termination or nonrenewal of a franchise agreement as evidence of excessive control, even if the provision provides for payment of the fair market value of the real estate.

The SBA’s “franchise registry” is well known in the franchise community.  This registry is a listing of franchise agreements the SBA has approved with respect to affiliation.