SBA proposes to eliminate Franchise Directory requirement for SBA lending
The U.S. Small Business Administration (SBA) publishes a Franchise Directory (Directory) which contains all franchise and other brands eligible for SBA financial assistance. The Directory only includes business models that are reviewed and found eligible under SBA's affiliation rules and other eligibility criteria. If an applicant's brand meets the Federal Trade Commission (FTC) definition of a franchise, it must be in the Directory in order to obtain SBA financing. A link to the SBA Franchise Directory is listed here.
The Small Business Act, 15 U.S.C. § 632(a)(1), mandates that the SBA makes its business loan programs available only to independently owned and operated small businesses. To determine whether an SBA loan applicant is an independent small business, the SBA must analyze whether there are any other parties with which the loan applicant may be affiliated who may exert control over the loan applicant. Under the current SBA rule, if a franchisor’s control is excessive, the prospective franchisee ceases to be independent, and the affiliation policy must be applied to verify the loan applicant is an independent small business. In franchise loan applications, the SBA must review the franchise agreement and other related agreements to identify provisions where control by the franchisor could render the applicant dependent on the franchisor.
On October 26, 2022, the SBA published proposed amendments to various federal regulations governing the SBA's 7(a) Loan Program and 504 Loan Program, including use of proceeds for partial changes of ownership, lending criteria, loan conditions, reconsiderations, and affiliation standards, to expand access to capital to small businesses and drive economic recovery.
As part of the SBA’s proposed amendments, it is proposing to implement a major change in affiliation criteria for franchises and distributorships/licensees by eliminating current principles for determining affiliation arising from management and control, franchise or license agreements, and identity of interest. Instead, the SBA proposes to streamline affiliation determinations based only on ownership criteria. This development will lead to the Franchise Directory being eliminated.
The Franchise and Business Opportunities Project Group of the North American Securities Administrators Association (NASAA), which was established more than 30 years ago to study and make recommendations to NASAA about model acts, statements of policy, and interpretive commentaries that benefit investors of franchises and business opportunities and those industries, has the following concerns regarding the proposed amendments:
- While the simplification regarding affiliation is a welcome step for lenders, the elimination of the entire franchise review process is not as it puts the burden on individual lenders to wade through franchise documents to determine if a franchise brand meets program requirements for eligibility. Many lenders may be hesitant to take on sometimes complicated eligibility reviews because the SBA is no longer vetting franchise agreements for all eligibility program requirements with the change in affiliation standards.
- If the proposed amendments are adopted and SBA lenders remove the control component from the affiliation analysis, franchisors will be able to include provisions in franchise agreements that will decrease investor protection. The limitations on franchisor control imposed by the control component of the affiliation analysis also protect the franchisee by prohibiting covenants that encumber the franchisee’s real estate and by prohibiting excessive control related to the hiring, firing, and scheduling of employees.
- The Directory is an effective tool for prospective franchisees as they perform their due diligence. The Directory allows the franchisee to identify whether a franchisor is eligible to participate in the SBA’s business loan programs. If a franchisor is listed in the franchise Directory, then both the lender and prospective franchisee know the investment meets the SBA’s loan program eligibility requirements. Eliminating this tool would likely create more delays and confusion in processing SBA loan applications, not less.
The deadline for public comment on the proposed amendments is December 27, 2022.