What are the SBA’s Franchise Bug-a-Boos?

SBA loans may be a viable option for the franchisees trying to finance or buy a franchise. However, there are some catches. SBA [Small Business Administration] loans are only available for independent small businesses. The key word here is independent. If the business is not independent, there is no loan for your prospective franchisee.
How does the SBA decide if the franchise opportunity is independent? What makes a franchise opportunity un-independent? Simply being in a franchisee/franchisor relationship does not make the franchise opportunity un-independent.
In the recent request for commentary, examples of the common affiliation issues found in franchise agreement were enumerated. These affiliation issues are some of deciding factors for determining if the franchise opportunity is independent. Affiliation issues can affect if prospective franchisees may be eligible for SBA loans. Let’s take a look at the list.

1. Restrictions on the Ability of the Franchisee To Transfer the Business or an Interest in the Business. Every franchise agreement has a provision that requires the franchisor’s consent for transfer of the franchise business. This will not kill SBA eligibility if there is saving language allowing for “reasonableness and timeliness.”

2. Deposit of Receipts Into an Account Controlled by the Franchisor. Okay this is per se excessive control. A.K.A it is an SBA eligibility killer. For the franchise to be independent, the franchisee must have the ability to control its own funds, including the payment of royalty fees to the franchisor. If the franchise agreement gives the franchisor the right to collect and control franchisee funds, deduct the royalty fees, and remitting the remaining funds and receipts to the franchise, this is excessive control. It is also excess control if the franchisor requires the franchisee to desposit all funds into an account controlled by the franchisor.

3. Franchisor Billing and Collecting From Franchisee’s Customers. This is a red flag, but not an SBA eligibility killer. In order for this to be okay, it must be necessary per the franchise business concept and common place in the core business industry. The example given is the fitness industry where gym members are provided access to the entire fitness center network. In that case it is deemed necessary and okay for the franchisor to bill and collect monies from the franchisees’ customers in order to enable the sharing of other facilities in the network.

4. Establishing a Price for the Sale of Assets Upon Termination, Expiration, or Non-Renewal of the Agreement. It is okay for the franchisor to have the right to purchase the franchise asset from the franchisee upon termination or non-renewal, or transfer of the franchise agreement. The catch here is the purchase price. The purchase price must be at FMV [fair market value].

5. Franchisor’s Assumption of Control of Franchised Operations or Employees [“Step-In Rights”]. This is a yellow flag. It is okay for the franchisor to assume operations of the franchise business, but only for set reasons and only for a limited period of time. It is never okay for the franchisor to have hiring and firing control of the franchisee’s employees.

That is the historic list of 5 common provisions the SBA takes issues with. Incident to the commentary, the SBA has added 3 more watch-out provisions. Here they are. The SBA wants your comments on these. Should they be considered deal breakers for SBA eligibility?.

6. Pricing. We have seen the cases of $1 menu fights between franchisors and franchisee. The SBA take the position that “an independent business should maintain the ability to set its own pricing, which enables it to make a profit or risk a loss from its own actions.” The SBA’s current stance is that establishing pricing for national accounts or national advertising is okay so long as the  pricing maximum and minimum are not targeted at a specific franchisee or location. What are your thoughts? How does this effect your franchise brand?

7. Right of First Refusal [ROFR] on a Partial Assignment or Change of Ownership. What if a franchisee transfers part of the business ownership to a spouse, child, or relative, should the franchisor have a first right of refusal [ROFR]? What if the transfer is to an unrelated third-party- say an employee or new business partner? The SBA says EXCESSIVE control if the ROFR involves a family member. The SBA is on the fence if the partial transfer involves an unrelated third-party. Now, remember this not about consent or approval. This is about if the franchisor has the right to buy the assets in event of a partial transfer.

8. Option To Purchase/Lease Real Estate Owned by the Franchisee. The franchisee has a brick and mortar location. The franchise agreement expires. Should the franchisor have the right to assume the brick and mortar location? What if the franchisee owns the land? What if the franchise agreement does expire, but is terminated. Still the same outcome?

The SBA starts off with saying that if the franchisor wants the location, the franchisor should buy or lease the property and sublease or lease the property to the franchisee. In many franchise relationships traditionally, that is how it worked. But, with changes in real property condition, the cost of owning and leasing property, franchisors have gotten away for owning property and subleasing property to franchisee. What is the solution?

Here is the SBA’s position. If the franchisee owns the property and the franchise agreement expires, not default, hands down, the franchisee gets to keep the property. They may be required to de-brand the property, but the franchisee gets to keep the property. The franchisor may have a ROFR, but the franchisor can not force the franchisee to sell or lease the property.
The issue becomes more fuzzy if the franchisee does not own the property and/or if there is a default. The SBA wants your comment on this issue.

The issues presented in the commentary have wider value. If you are a prospective franchisee, considering buying a franchise, consider these issues. They are recognized issues of control that may affect the value of the franchisee’s opportunities and operational issues.
If you are franchisor, take a look at the provision in your franchise agreement. Do any of the provisions go against the SBA’s excessive control positions? Even if you are not interested or concerned about SBA eligibility, these issue are worth visiting. These issues will likely be raised by attorneys representing prospective franchisees.

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