The Franchise Memorandum

On May 11, 2023, the United States Small Business Administration will eliminate the SBA Franchise Directory, a move that may impact evaluation of franchise loans by some lenders. The change comes from the SBA’s revision of “affiliation” and “control” standards in its lending rules for small business loans, including those administered under the 7(a) and 504 Loan Programs often utilized by franchisees. With these changes in the SBA rules, there is no longer any need for the SBA Franchise Directory.

What is the Franchise Directory? Under SBA rules prior to May 11, a borrower, such as a franchisee, must demonstrate to the lender that it is not affiliated with or controlled by a larger entity that would not be eligible for a small business loan guaranteed by the SBA. Franchisors were therefore required to demonstrate to the SBA that they were not, or would not be, affiliated with their franchisees, nor control their franchisees through certain elements in the franchise agreement. If the franchisor could demonstrate an absence of affiliation, the SBA would include the franchise brand on the SBA Franchise Directory. In many situations, the SBA would require franchisors to modify their franchise agreement to remove certain indicia of control or affiliation through the use of an SBA mandated or approved SBA Addendum. A franchisor that agreed to use the SBA Addendum would be included on the SBA Franchise Directory. If a brand was listed on the SBA Franchise Directory, it was a shorthand confirmation that the franchisee satisfied the SBA’s affiliation standards for the loan. SBA lenders would rely on the SBA Franchise Directory as part of their due diligence and underwriting process in making loans to franchisees.

What does this mean for franchisors and franchisees? With no SBA Franchise Directory, franchisors no longer need to apply to be included on the SBA Franchise Directory, nor need to submit their FDDs and franchise agreements to the SBA. Further, franchisors are no longer required by the SBA to use the SBA Addendum.

For franchisees, there are no legal or contractual changes. However, some commenters on the proposed SBA rule change have expressed concern that the elimination of the SBA Franchise Directory will increase the burden on lenders to confirm that the franchise relationship does not pose lending risks or eligibility concerns. Consequently, lenders may spend more time evaluating franchise loans. Also, a possible side effect of this rule change may be that different lenders will reach inconsistent conclusions regarding control or eligibility for loans to franchisees, even for franchisees in the same franchise system or within the same industry sector.

Addressing this concern, the SBA has stated that because it is removing the concept of affiliation based on control, including control by a franchisor over a franchisee’s business, this should not increase a lender’s burden. Lenders must still evaluate the franchisee for creditworthiness and other eligibility and underwriting standards, and must still consider ownership and control of the small business. The SBA provided the following guidance: “(W)hen lending to a Franchised business, the SBA Lender must determine who owns the applicant business and any businesses the applicant owns in accordance with these regulations. However, neither the SBA Lender nor SBA will review the applicant Franchised business for affiliation with other entities beyond ownership; the applicant business will not be considered affiliated with the Franchisor or other Franchised businesses except by ownership.”

A copy of the SBA’s Rule as published in the Federal Register can be found at: https://www.govinfo.gov/content/pkg/FR-2023-04-10/pdf/2023-07173.pdf.