One of the important determinations that must be made on all SBA guaranteed loans is whether any affiliation concerns exist, and one of the more complicated affiliation issues that arises is whether the borrower operates under any agreements that the SBA would deem to create a “franchise” relationship.

To understand and resolve this potential issue, it is important to be familiar with the Federal Trade Commission’s (FTC) definition of a franchise, which is the definition that the SBA follows. Broadly, the FTC defines a franchise as any continuing commercial relationship wherein: 1) The franchisee will obtain the right to operate a business that is identified or associated with the franchisor’s trademark; 2) The franchisor will exert or have the authority to exert significant control over the franchisee’s operations, or provide significant assistance in the franchisee’s operations; and 3) As a condition of commencing operation of the franchise, the franchisee makes a required payment to the franchisor, or commits to do so.

When conducting due diligence for potential SBA guaranteed loans, all franchise, license, jobber, dealer, agency, and other similar agreements under which the borrower operates should be reviewed to determine whether the agreement meets the FTC’s definition of a franchise. If the agreement does meet the FTC’s definition of a franchise, then it needs to be added to the SBA’s Franchise Directory before submitting the loan application (for non-delegated processing) or requesting an SBA Loan Number (for delegated processing). This strict timing condition requires lenders to know and understand the SBA’s rules about franchise agreements so that these issues can be identified and resolved early in the loan application process.

A common misconception about the franchise rules outlined in the SBA’s SOP 50 10 5(K) is that they only apply in situations where the borrower is operating under a franchise agreement with a well-known brand, such as a nationally recognized restaurant brand. However, the SBA’s franchise rules also extend to other agreements that may not be clearly labeled as franchise agreements. For example, independent insurance carriers often operate under several agreements with various insurance companies, each of which gives the agent the right to market and sell that insurance company’s products. While such agreements are not commonly thought of as franchise agreements, they do need to be reviewed and analyzed to determine whether any of them technically meet the FTC’s definition of a franchise. If any of them do meet that definition, they need to be added to the SBA’s Franchise Directory. Once an agreement is added to the Franchise Directory, the SBA will indicate whether an addendum to the agreement needs to be signed, and if so, what type of addendum is necessary. Any required addendum needs to be executed by the borrower and franchisor/brand before closing.

The process for adding a brand to the Franchise Directory can be complicated because it requires the franchisor/brand to submit the agreement to the SBA for review, which can present potential problems. Many brands that do not consider themselves to be franchises do not want to be identified as such on the SBA’s Franchise Directory, so it can be difficult to obtain their consent to having the agreement reviewed by the SBA. Additionally, because the SBA needs to thoroughly review each agreement to determine whether they need to be added to the SBA Franchise Directory, the process takes time and can often cause delays to the closing process. Understanding the SBA’s franchise rules and related processes can help lenders effectively communicate the requirements to any brands that need to be added to the Franchise Directory, and it can also help lenders manage timeline expectations with their borrowers.

If you have any questions about the SBA’s franchise rules, or if you would like assistance reviewing any agreements that might meet the FTC’s definition of a franchise, please contact Your SBA Legal Department® at Jellum Law