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Best Practices: Franchise Eligibility Issues Not Specifically Addressed
in the SOP
By: Lynn G. Zeitlin, Esq.
 | | Lynn G. Zeitlin, Esquire |
SBA lenders know that a franchisor's consent to transfers cannot be unreasonably withheld or delayed and that franchisor rights of first refusal cannot be used for partial transfers of the borrower's business or any interest in the business. Most lenders do not, however, know there are many provisions in the agreements their borrowers are signing that can constitute "affiliation" (that is, excessive control) and render the franchise agreement ineligible for SBA lending. Let me give you a few examples of problematic provisions.
On transfers: Transfers are prohibited unless Franchisor has "...consented to the material terms of the transfer, including the price and terms of payment..."
In this paragraph, the franchisor has the right to "set the price and terms" for any sale by the franchisee to a third party. No one will argue with franchisors having the right to qualify a potential franchisee before giving consent (not unreasonably withheld or delayed, of course). Since the third party buyer will become a franchisee, it is not unreasonable for a franchisor to require a potential franchises to satisfy the franchisor that it can fulfill its obligations as a franchisee for the protection of the franchise system and reputation. But, allowing the franchisor to "control" the sale price and payment terms is not compliant with the policies of the SBA lending program, designed to allow a borrower to have the independent right to both profit from its efforts and risk loss.
Controlling how the franchisee gets paid on sale of the business: "If you are financing any part of the sale price of any transferred interest, you must agree that all obligations of the transferee to you under any promissory notes, agreements or security interests will be subordinate to the obligations of the transferee to pay any continuing fees, contributions and other amounts due to us and our affiliates, or otherwise to comply with this Agreement or the franchise agreement that is to be signed by the transferee ..."
Is this the same as the SBA's prohibition on small businesses guaranteeing post-transfer obligations of the transferee to franchisor ? Not quite - and yet the impact on the small business seller can be the same. Although this paragraph does not explicitly guarantee transferee's obligations to franchisor, the effect of making the selling franchisee take a back seat to the transferee/buyer's obligations to franchisor, the small business seller is not getting the full benefit of its bargain, that is, its right to profit from its efforts. The small business seller should have the right to get paid on at least a pari passu basis with other obligations of the buyer to satisfy the SBA test for franchisee's right to profit from its efforts.
Consent to Grant of Security Interest.. "No transfer in the nature of a grant of a security interest will be permitted without the written [sic] our prior consent, in our sole discretion. If we consent to a transfer in the nature of a grant of a security interest, and if the holder of the security interest later seeks to exercise your rights or assume your interest in the Franchise, this Agreement, any related agreement, or the Franchised Business due to your default under any documents related to the security interest, we will have the option to purchase the rights of the secured party by paying all sums then due to the secured party, and the secured party must sign an agreement to the effect before any transfer takes place."
This paragraph raises two different issues. First, you can see there are obvious issues if franchisor's consent is required in order to permit a "transfer in the nature of a security interest." SBA loan documentation will grant the lender a security interest in borrower's assets, including contract rights. Even assuming there is added the requisite "consent not unreasonably withheld or delayed" language, the most "control" franchisors generally have over security interests granted by franchisees relates, appropriately, to the franchisor's trade marks or trade names.
More importantly, this paragraph conditions franchisor's consent to receipt of a signed commitment from the lender to give the franchisor a one-way option to pay off the loan. In effect, this asks the lender to rely on the future financial ability of the franchisor - not its borrower - to pay the loan. At a minimum, the lender would need to perform a credit investigation of the franchisor and perhaps the right to receive periodic financial information.
For more information regarding franchises, please contact Lynn at (215) 542-7070 or at LZeitlin@StarfieldSmith.com.
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