The more experienced (translate "older") lenders reading this column may recall a time during which 7(a) loans to franchise operations had few, if any, additional requirements from SBA.
During the last 20 years, that, of course, has gradually evolved as the Agency placed greater scrutiny on franchise loans.
What policy considerations led the Agency to view a franchise operation any differently than a Mom-and-Pop operation? Stripped down, the basic SBA concern is one of affiliation, or size. It will surprise no one that the Small Business Administration is not in the business of lending to franchisors. Rather, SBA is in the business of lending to individual franchisees.
That sounds simple enough. However, the water gradually becomes muddy when introducing the concept of affiliation. For size purposes, SBA looks at the size of the small business applicant and any affiliates of that applicant. While affiliation is most commonly determined by looking at ownership (e.g., if the owner of the applicant owns an unrelated business, the latter is deemed an affiliate) affiliation has historically also stemmed from franchise and license agreements in certain situations. Again simplifying, in the eyes of SBA, if the terms of a Franchise Agreement indicated such franchisor control over the operations of the small business applicant, the Agency would find that franchisee and franchisor were affiliated – and thus not eligible for SBA financing due to size.
The SBA role in the franchise affiliation determination gradually grew over the past 2 decades. Despite the creation of a centralized Registry which allowed franchise systems the opportunity of obtaining SBA legal review and approval of the Franchise Agreement, a combination of factors—the increase in the number and type of Agreements reviewed by SBA, the increase in 7(a) and 504 loan volume, and shrinking staffing numbers within SBA Legal—led inevitably to frustration and delay for lenders and loan applicants.
In recognition of these difficulties, effective Jan. 1, 2017, SBA made certain adjustments, the stated purpose of which were to "streamline the procedures for determining size eligibility based on affiliation for franchised businesses." To the extent that these changes have increased efficiencies in the 7(a) loan application process, Lenders should recognize that this is partly due to some shifting of responsibility from SBA to Lender.
A summary of changes or clarifications in the area of franchise lending follows:
- Franchise and similar Agreements are no longer reviewed for eligibility by SBA. Instead, this responsibility shifts to the participating lender. The nature of the review itself has also changed. SBA has now adopted the FTC definition of "franchise," meaning that an Agreement can meet the definition of franchise even if called something else (such as License Agreement, Membership Agreement, Dealership Agreement, Supply Agreement, etc.) It is the responsibility of the lender to review Agreements to determine whether the commercial relationship in question is in fact a "franchise." SBA will continue to conduct a brief review of Agreements deemed (by lender) to fall within the definition of franchise for data collection purposes.
Very briefly, under FTC guidelines, an Agreement must meet 3 elements to be deemed a franchise: (a) Franchise will obtain the right to operate a business that is identified with the franchisor's trademark, or offer goods/services associated with that trademark, (b) Franchisor will have the authority to exert control over the methods of franchisee operation or provide significant assistance, and (c) as a condition of obtaining the franchise, the franchisee makes or commits to a required payment to the franchisor.
- SBA will no longer maintain or support centralized Franchise listings such as the Franchise Registry. The practical impact is that Agreements must be reviewed on a case-by-case basis to conclude whether the Agreement falls within FTC guidelines for franchise.
- SBA Regulations now state a presumption that the restraints imposed on a franchisee by its franchise or other Agreement will not result in a finding of affiliation ("...provided the applicant franchisee or licensee has the right to profit from its efforts and bears the risk of loss commensurate with ownership.") However, for each Agreement deemed to meet the definition of franchise SBA now requires that a standardized Addendum be signed by the Franchisor/Licensor/etc. That addendum addresses areas previously deemed to indicate excessive franchisor control. The loan may not fund without such Addendum.
As more of the responsibility for the determination of franchise shifts from SBA to lender, it is critical that lenders develop processes to capture and document the decision process. Of course WBD is prepared to tackle these issues on your behalf if you are utilizing the 504 program or taking advantage of our 7(a) loan packaging services. Give us a call!
Schneider is lender services manager at WBD, Your Business Finance Resource.