Franchise Sales: What Franchisors Should Know About SBA 7(A) Loans and How They Structure Their Franchise Agreements?
SBA 7(A) Loans
The Small Business Administration’s “7(a)” loan program serves as a reliable and effective source of financing for new franchisees. The SBA 7(a) Loan program is the primary loan program offered by the SBA for franchisees who are purchasing a franchise and establishing their franchised operations. Under this program, the SBA does not issue any loan but, rather, encourages SBA qualified banks to loan funds to qualified start-up business owners and, in turn, the SBA will guarantee to the bank repayment of a significant portion (up to 85%) of the loan.
The value of SBA 7(a) Loans are readily apparent to franchisors as these loans may serve as a solid source of financing for new franchisees. Naturally, SBA 7(a) loans involve a more stringent review and qualification process. This review and qualification process not only applies to “borrower franchisees” but also to the franchisor and, in particular, the nature of the franchise relationship and the terms of the relevant franchise agreement. So, when preparing, developing and updating your FDD and franchise agreement, as a franchisor, you must be aware of SBA franchise agreement qualification requirements. Some of the many SBA underwriting loan requirements and/or regulations that may impact your franchise agreement include:
- No Affiliation – The franchisee borrowing funds must be independent of the franchisor. The franchisee cannot possess an “affiliation” to the franchisor. Franchise agreement factors that the SBA will evaluate in determining whether or not an “affiliation” exists will relate to whether or not the franchisees possesses full right to earn and maintain the profits generated by the franchised business and, conversely, whether or not the franchisee will be required to bear the full risk of loss associated with the operations of the franchised business. So, the SBA will evaluate the franchise agreement to ensure that, legally, the franchisee possesses control over the franchised business and that the franchisee is free to transfer and sell the business. Essentially, franchisors cannot utilize 7(a) loans to finance the establishment of franchisor owned/controlled stores.
Franchise Agreement Red Flags
- Provisions (outside traditional royalty and franchise fees) that serve to remove the profits or losses from the franchise, i.e., additional “royalty fees” or “deposit obligations” and franchisor funding and “rebate provisions.”
- Provisions that allow the franchisor significant “step-in” rights to manage the day-to-day operations, other than temporary step-in provisions that are designed to remedy a franchisee default.
- Provisions that authorize the franchisor to hire the personnel for the franchised business.
- Provisions that authorize and transfer to the franchisor collection activities.
- Provisions that grant a franchisor the right to purchase the real property – owned by the franchisee and wherein the franchised business is located – is not permitted. Even where such option is triggered after franchise agreement expiration or default.
- Provisions that permit the franchisor to control the price that the franchised business may be sold for.
The SBA recognizes that franchisors possess a legitimate concern as to franchise transfers and that franchisors must maintain a right to review and approve the transfer of a franchised business. However, for the SBA – the entity that will be determining whether or not to approve a loan to your franchisee – a franchisor's right to approve transfers cannot be absolute or unrestricted. That is, the franchise agreement must include some language and right whereby the franchisor acknowledges that the franchisor’s review and approval of a franchise transfer shall “not be unreasonably withheld or delayed”.
Liquidated damage provisions in franchise agreements, typically, relate to an agreed upon formula or monetary amount that franchisor and franchisee agree to (at the time of signing the franchise agreement) for the purpose of determining the amount of damages the franchisor may be entitled to in the event that the franchisee breaches the franchise agreement. Naturally, if a franchise agreement default occurs, the SBA wants to ensure that potential repayment of the SBA guaranteed loan is not jeopardized by an excessive award of damages to be paid by franchisee to franchisor. Accordingly, the SBA scrutinizes franchise agreement liquidated damages provisions and requires that these provisions be “reasonable.” These provisions should only be triggered after a breach of the franchise agreement and, at the time of signing the franchise agreement, the nature and potential amount of the liquidated damages must be reasonably ascertainable.
For franchisors, the SBA conducts a pre-approval process wherein the SBA will review and evaluate your franchise agreement and your franchise offering. If approved, your franchise will be added to a registry of SBA approved franchisors. This approval does not guarantee that the SBA will approve loans to your franchisees but, rather, will serve to expedite the review process should a franchisee apply for an SBA loan. Start-up franchisors should consider this review process as a good test of their franchise agreement and a great opportunity to identify potential problems and recommended franchise agreement modifications.
For additional information on starting a franchise we recommend reading the following publications by Charles N. Internicola, Esq.:
Start a Franchise
How to "Franchise Your Business": Part I - The Basics and the Information Gathering Mindset