The Small Business Administration (SBA) has been a supportive, albeit imperfect, partner in helping franchisees obtain financing and thus helping franchise systems grow. Among other things, the SBA guarantees a significant portion of the loans made by lenders to franchisees, thus encouraging both loans that otherwise might not be made and loans with better terms than otherwise might be available. Beginning January 1, 2017, the SBA streamlined its procedures for obtaining such loans. For a copy of the new rules and a notice summarizing the new rules, click here.

As its name suggests, the SBA provides financial assistance to "small businesses." To be eligible for SBA- backed loans, a business combined with its affiliates must not exceed certain size limits (which vary by industry). Entities can be considered "affiliates" of each other when one controls or has the power to control the other.

Historically, there has been concern in the franchise context whether a franchisor can be deemed to be "affiliated" with its franchisees − making its franchisees ineligible for SBA-backed loans because they would not be small businesses − if the franchisor exerts too much control over its franchisees by virtue of various franchise agreement provisions. In the past, there has been a healthy list of provisions deemed problematical by the SBA because they allegedly have evidenced too much franchisor control. To avoid an affiliation determination based on the franchise agreement and thus to restore franchisee eligibility for SBA-assisted financing, the SBA required franchisors to amend the terms of their franchise agreements to eliminate the problematical "control" provisions that caused perceived "affiliation" to exist.

SBA regional offices originally handled this process in a rather inconsistent, unpredictable, and inefficient manner. To achieve some measure of consistency, therefore, the SBA contracted many years ago with a private program manager, FRANdata, to help create and run the SBA Franchise Registry, a listing of franchisors that were not considered by the SBA to be affiliates with their franchisees, either because their franchise agreements did not contain provisions deemed offensive by the SBA or because they were willing to change or expunge those provisions via an "SBA Addendum."

Beginning with loans to be made in 2017, the SBA purportedly has simplified the process for answering the franchisor-franchisee affiliation question, as reflected in an updated Standard Operating Procedure, SOP 50 10 5(I) ("SOP"). The new SOP is available here.

As reflected in the SOP, the SBA will no longer use or support a Franchise Registry or review (itself or through any program manager) franchise agreements to determine the nature of various provisions and, in turn, the apparent affiliation between the franchisor and franchisee. Instead, as the sole means of addressing the affiliation issue potentially triggered by a franchise agreement's controls, the SBA will require the lender to provide (and the franchisor and franchisee to sign for each loan) a mandatory, non-negotiable two-page "Addendum to Franchise Agreement." This SBA Form 2462 is available here.

The Addendum amends the franchise agreement in the following ways, some of which will be familiar to many of you because they are similar to required amendments made under the SBA's former process:

(1) Change of Ownership

(a) Limitation on franchisor acquisitions of partial interests. If the Franchisee is proposing to transfer a partial interest in the Franchisee, and the Franchisor has an option to purchase or a right of first refusal with respect to that partial interest, the Franchisor may exercise such option or right only if the proposed transferee is not a current owner or family member of a current owner of the Franchisee.

(b) Franchisor may not unreasonably withhold consent to transfer. If the Franchisor's consent is required for any transfer (full or partial), the Franchisor will not unreasonably withhold such consent.

(c) No transferor liabilities for post-transfer actions. In the event of an approved transfer of the franchise interest or any portion thereof, the transferor will not be liable for the actions of the transferee franchisee.

(2) Forced sale of assets

(a) Joint selection of appraiser. If the Franchisor has the option to purchase the business personal assets upon default or termination of the Franchise Agreement and the parties are unable to agree on the value of the assets, the value will be determined by an appraiser chosen by both parties.

(b) No mandatory sale of real estate. If the Franchisee owns the real estate where the franchise location is operating, the Franchisee will not be required to sell the real estate upon default or termination, but the Franchisee may be required to lease the real estate for the remainder of the franchise term (excluding additional renewals) for fair market value.

(3) Covenants

No recordation against real estate. If the Franchisee owns the real estate where the franchise location is operating, the Franchisor may not record against the real estate any restrictions on the use of the property, including any restrictive covenants, branding covenants or environmental use restrictions.

(4) Employment

No control over franchisee employees. The Franchisor will not directly control (hire, fire, or schedule) the Franchisee's employees.

The new Addendum is littered with imprecise wording and unfinished thoughts (e.g., what is "fair market value," and what is "control" over employees). However, the new Addendum likely will be acceptable to many if not most franchisors (certainly of systems not involving substantial real estate investments/purchases) because it is not materially different in substance from the SBA Addendum they have used in the past.

And franchisors also will be buoyed by the prospect of not having to wait unreasonably indeterminate timeframes for their franchise documents to be reviewed and vetted by the SBA.

Franchisors can, of course, elect to sign the Addendum for some franchisee borrowers and not for others (in which case the latter will not obtain SBA-assisted financing). Also, there is no prohibition on a franchisor signing the new Addendum while conditioning its willingness to do so on the creation and execution of separate, additional documentation with the franchisee and lender (including provisions that might have been crafted into the pre-2017 form of SBA Addendum that no longer may appear in the new SBA Addendum). The SBA's unwillingness thus far to grandfather previously-approved SBA Addenda for use in 2017 is forcing some franchisors to address system-specific issues in these other documents.

Conversely, franchise agreement provisions deemed problematical and thus subject to change in the past in order to avoid franchisor-franchisee affiliation issues will no longer be considered. For example, a franchisor's control of a franchisee's retail pricing, billing the franchisee's clients, controlling the franchisee's bank account, or imposing liquidated damages for a franchisee breach should no longer have any bearing on SBA loan eligibility from an affiliation standpoint.

There were in the past, and continue to be, a few scenarios that can still lead to SBA loan ineligibility. These include:

(i) Masters. Applicants who operate under Master Franchise Agreements are ineligible, as such agreements are considered to be (in what seems to reflect some lack of understanding) arrangements that are "passive investments and/or inherently speculative."

(ii) Restricted patronage. As a matter of policy, franchisees who restrict patronage (i.e., access for certain types of clientele to their businesses) may be ineligible. For example, a men's only or women's only health club is not eligible.

(iii) Adequacy of collateral. There continues to be an assessment of the adequacy of collateral for the loan. This requires the lender's evaluation of the restrictions recorded in various documents against the collateral that could affect its value and marketability, such as deed restrictions, covenants, easements, subordinations, leases, options, and more.

Interestingly, while the SBA will no longer require use of the "Franchise Registry" as a result of its desired objective to expedite the franchise lending process, we understand that due to supposed uncertainty within the lending community about how to deal with these changes, the SBA portion of the Franchise Registry will continue to exist with a revised purpose and format. FRANdata has announced plans to help franchisors and lenders through this change by revising the information that is displayed to lenders on behalf of franchisors on the Franchise Registry—allowing lenders to confirm franchisor decisions about the new process at the beginning of the loan origination cycle. To do so, the new Franchise Registry has been touted as:

  • Listing (for the benefit of lenders) those franchisors that are willing to sign the new mandatory SBA Addendum and/or those willing to sign with additional documentation requirements.
  • Helping evaluate the eligibility criteria described in (i) through (iii), above (i.e., passivity, patronage restrictions, and the adequacy of collateral).
  • Evaluating continuing SBA business affiliation requirements in the context of other franchisor documents and housing the historical decisions SBA made regarding these other requirements.
  • Facilitating the communication and documentation between lenders and franchisors.

Although the revised SOP and Addendum are intended to streamline the loan approval process for franchisees (and, as explained to us by senior SBA leadership, to make the process more understandable to a larger universe of lenders), whether they will do so in practice will depend upon how lenders respond to the new obligations placed upon them and how willing franchisors are to sign the new Addendum. Lenders will not be allowed to disburse loan proceeds without obtaining the executed Franchise Agreement and the new Addendum and reviewing all other documents the franchisor requires the franchisee to execute in order to ensure compliance with all the eligibility standards for the SBA Loan Program.

It will be interesting to see, in hindsight, if these new procedures lead to more or less loan volume for franchisees, and in years to come if the treatment of franchisee loan defaults will be different as between loans made under the old franchise affiliation approval system and the new mandatory Addendum approach.