SBA-Backed Franchise Lending Today

The U.S. Small Business Association’s loan guaranty program has gone through a number of changes in recent years. The current rule became effective January 1, 2018, and supersedes changes described in my blog postings in December 2014 and 2016.

A franchisor that wants its franchisees to be able to obtain SBA-backed loans to finance their franchised businesses must be listed on the SBA Franchise Directory. The directory, which is maintained on the SBA’s website, shows to franchisees and lending banks the franchise systems that qualify for SBA-backed lending.

To be listed on the SBA Franchise Directory, a franchisor must submit to the SBA its franchise agreement, its franchise disclosure document (FDD), and any other documents the franchisor requires the franchisee to sign. The SBA then undertakes an affiliation review (explained below) and an eligibility determination.


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Structuring a Multi-unit Franchise

A multi-unit franchise owner can structure its operations in a number of ways, but one approach in particular often makes a lot of sense: a developer entity that acts as the parent company for the individual franchise locations.

First some background.  Many franchisors seek out franchisees who want to open three or more units. One approach is to sign a development agreement in which the developer commits to open an agreed-upon number of franchise units in a defined territory over a specified period.  In exchange, the franchisor agrees not to open a company-owned unit or to grant a franchise to anyone else in that territory while the development agreement remains in effect.

In most franchise systems, the developer opens each franchise under a separate franchise agreement. The multi-unit developer typically signs the development agreement and the first franchise agreement at the same time.  Each subsequent franchise is then opened pursuant to a separate franchise agreement. The development agreement typically ends when the developer signs the franchise agreement for the last franchised unit promised in the development schedule.  Territorial exclusivity in the development agreement ends, but the more limited territorial protection in the individual franchise agreements remains in effect.


When are Parent Company Financial Disclosures Required?

A franchisor selling franchises in the U.S. must disclose its audited financial statements in Item 21 of the franchise disclosure document (FDD).  Sometimes, parent company financials are used instead of the franchisor’s financials.  This is easily done when the parent company is a public company that already has audited financials.  But most franchisors are not public companies.  They are not likely to have parent company audited financials and would prefer not to incur the added expense of auditing a group of companies rather than just the franchisor entity.  Audits are expensive.  The franchisor may also want to shield its parent company from liability to franchisees.

The FTC Rule requires parent company financial disclosures in certain cases.  Specifically, the FTC Rule requires disclosure of the financial statements of “any parent that commits to perform post-sale obligations for the franchisor or guarantees the franchisor’s obligations.”

So if the franchisor wants to avoid disclosing parent company financials and to protect the parent company from the liabilities of the franchise company subsidiary, the simplest approach is to be sure that the parent company does not perform any post-sale obligations of the franchisor to the franchisee.  In other words, a franchisor should ensure that either the franchisor itself or an affiliated company, and not the parent company, performs any post-sale obligations of the franchisor.  These obligations might be, for example, a requirement to supply specified equipment, goods, inventory or services to franchisees.  An affiliate other than a parent company is permitted to provide goods or services to franchisees without triggering an added obligation to disclose financials.


Testing a New Franchise Concept

One of the toughest challenges an aspiring franchisor may face is selling its first franchise.  Who would take the risk of buying a franchise from a franchise company that has no franchisees?

For a few successful business owners, the idea of franchising may come from one or more customers who love the business concept and initiate the idea of buying a franchise even before the owner has taken the first step to prepare a franchise offering.  But this rarely happens.

Here’s another suggestion:  If the aspiring franchisor has a successful business unit (a store or a restaurant, for example) that is operated well by a trusted manager, that manager might be a good candidate to buy the business at that location and become the company’s first franchisee.  The manager will already know the business inside out, having successfully managed the business as an employee.  The transaction would entail the sale of the existing business at a single location in which the buyer undertakes to continue operating as a franchisee of the seller.  The buyer’s newly-formed company would sign a franchise agreement as part of the purchase of the business. 


The New SBA Addendum

man's hand holding a pen writing his signatureEffective January 1, 2017, any franchisor that wants to offer SBA guaranteed financing for its franchisees will use a single, two-page form addendum.   In a notice issued just before Thanksgiving, the SBA announced that it will no longer review franchise agreements to determine whether affiliation exists between the franchisor and franchisee in any specific franchise system.  Previously negotiated SBA addenda will no longer be accepted.

SBA loans are only available to independent small businesses as defined in the SBA regulations.  Some franchisors impose a level of control in the franchise agreements that the SBA considers to create “affiliation” between the franchisor and franchisee.  When “affiliation” exists, the franchisee is not viewed as an independent business and is therefore ineligible for an SBA loan.  In the past, franchisors worked with the SBA and FRANdata, a private company that operated the Franchise Registry, to craft specific addenda modifying certain control terms in their franchise agreements.

Now, in a step toward simplicity, one form addendum will fit all franchisors.  Presumably, lenders will be able to finance franchisees faster and the SBA will have a lighter workload.  Franchisors would not need to be listed on the Franchise Registry in order for their franchisees to qualify for SBA backed loans.


Correcting an Accidental Franchisor Violation

Young woman making a mistakeWhat’s a franchise?  Franchise registration and disclosure laws define a “franchise” more broadly than people generally realize.  A company may be franchising without knowing it.  The “license” agreement may have been drafted, for example, by an attorney who has limited knowledge about franchise law.  Hence the popular topic (at least among franchise lawyers) of the “inadvertent” or “accidental” franchisor.

A business owner who has run a successful “test” of licensing its business may decide that the next step is to set up a franchise system, not realizing that the test was already a franchise sold in violation of one or more franchise laws.  The violation would consist of the licensor’s failure to prepare a franchise disclosure document (“FDD”) as required by the Federal Trade Commission’s trade regulation rule on franchising (the “FTC Rule”) and to deliver the FDD to the prospective franchise buyer at least two weeks before the franchise buyer signs an agreement or makes a payment to the franchisor.  If a state franchise law applies, the violation may also consist of the licensor’s failure to register the offering with the state.


Suspending Franchise Sales

In several states that require franchise registration, franchisors should suspend franchise sales while an amendment or renewal application is pending with the state.  Franchisors commonly suspend franchise sales pending registration in most states that require franchise registration.  But California and New York each offers a unique and very different approach than a blackout or suspension of sales.

California takes an approach that is eminently practical.  In California, a franchisor may deliver to a prospect the franchise disclosure document (“FDD”) as filed with state for renewal or amendment together with a written statement that the filing has been made but it has not been reviewed by the examiner and is not effective, and that the franchisor will deliver to the prospect an effective FDD showing any further revisions at least 14 days before any agreement is signed or any consideration is paid. (Cal. Corp. Code §31107.) This approach seems to be one that would not be objectionable in any registration state even if it is not part of the laws of the other state.  How could anyone object to a disclosure of filed materials while the actual sale is being suspended until the registration is effective and the franchisor makes a new disclosure after the amendment or renewal is effective and waits the required 14 days?

New York also does not require franchisors to completely stop all sales while an amendment to the franchise registration is pending.  But New York’s approach is impractical, leading franchisors generally to suspend sales during the time that an amendment is pending.


What Does Brexit Mean for Franchisors?

The coming negotiation over the specifics of the UK’s departure from the EU is an unfortunate necessity that follows from the UK’s unfortunate “leave” vote on June 23, 2016.  It is too early to know what the relationship between the UK and the EU will be once the UK actually leaves the EU, or indeed, whether there might be a way to reverse the vote.  For now, the laws remain unchanged.  The actual changes may take two years or more to work out, depending on when the UK notifies the EU of its departure pursuant to Article 50 of the Lisbon Treaty.

If those in the UK who are expressing regret today work to maintain a close relationship with the EU without actually reversing the Brexit vote, the approach might be similar to that of Iceland, Liechtenstein and Norway.  Those countries are not EU members.  They are members of the European Free Trade Association (EFTA) and European Economic Area Agreement (EEA). The UK could join these countries and continue its participation in the EU single market.  But it would require the UK to make large payments into the EU budget and to allow for the free movement of labor.  At this point, the UK may not be ready to accept those conditions.  Switzerland is also an EFTA member, but has its own agreement with the EU on trade instead of the EEA Agreement.


Notice of Rights Enhances Trade Secret Protection

trade secretsIn order to access the full range of remedies the Defending Trade Secrets Act of 2016 (DTSA) offers, a trade secret owner must notify employees and contractors of certain rights they have under the DTSA.

The DTSA allows a trade secret owner to seek damages and injunctive relief in federal court against someone who misappropriates the company’s trade secrets. The trade secret must be related to a product or service used or intended for use in interstate or foreign commerce. The action must be brought within three years after the misappropriation was discovered or reasonably should have been discovered. And the misappropriation must have occurred after the date of the DTSA enactment, May 11, 2016.

If trade secrets are misappropriated willfully and maliciously, the court may award (i) exemplary damages equal to twice the amount of the actual loss and (ii) attorneys’ fees.

But a trade secret owner can forfeit the right to recover exemplary damages and attorneys’ fees by neglecting to follow one simple requirement. The trade secret owner must notify employees and contractors that they are protected against liability for disclosing trade secrets in certain circumstances. This notice applies to agreements entered into or updated after the date the DTSA went into effect. In other words, franchisors and other trade secret owners should update their documents now.


New Tool to Protect Franchisors’ Trade Secrets

Obama Signing CeremonyOn May 11, 2016, President Obama signed into law the Defending Trade Secrets Act of 2016 (the Act). The Act amends the Economic Espionage Act of 1996 to create a federal private right of action for the misappropriation of trade secrets.

The Act offers to all companies with trade secrets new tools to protect against their misappropriation in interstate commerce as well as foreign commerce. Trade secret owners can use the Act in defending against both domestic and foreign threats.