The SBA has made it abundantly clear that a proposed loan to a franchise area developer is ineligible. The SBA specifically characterizes franchise area development deals as "inherently speculative" and "passive investments" in SOP 50 10 5 (F).
In many cases, however, an entity may be both an area developer and a franchisee at the same time. The SBA recognizes that simply having area development rights should not automatically make a borrower ineligible. The SOP states that a borrower can be eligible, even if its agreement contains area development rights, as long as the franchise portion of the agreement complies with the applicable SOP franchise regulations. In other words, a borrower can be eligible if its contract with the franchisor grants the borrower area development rights and also permits the borrower to operate one or more franchises.
The closer question is what happens when a borrower has both a franchise agreement and a separate area development agreement. The borrower could be eligible as a franchisee, but the existence of the area development agreement could potentially make the borrower ineligible. This scenario is not addressed in the SOP, yet it is the circumstance that arises most frequently.
Although this scenario is functionally the same as the scenario where the franchisor grants area development and franchisee rights under the same document, the language of the SOP is sufficiently specific that it can be relied upon where the rights are granted in the same agreement but should not be relied upon when there are separate agreements.
The risk of simply pushing forward in the two contracts scenario is substantial for the lender. If the loan defaults, the SBA could find that the borrower was ineligible. That finding would result in a fairly swift denial of the SBA guaranty. Eligibility is an "all or nothing" issue for the SBA and prudent lenders should avoid taking such chances whenever possible.
One way a lender can get more comfortable making a loan to a borrower in the two contract context is to make clear that it is lending to the borrower in its capacity as a franchisee and not as an area developer. The easiest way to do this is through the use of proceeds in the SBA authorization. If the loan is being used to finance the purchase of equipment, to make leasehold improvements to the franchise location, or to purchase inventory, the lender can make a clear case that the proposed loan is financing the franchise and not financing area development activities. The lender could make a strong case that the proposed loan is eligible because it would solely fund eligible activities.
But uses of proceeds are rarely that straightforward. For example, working capital could be used to fund both franchise operations and area development activity. In that context, the lender is still enmeshed in an eligibility gray area. Thorough documentation of the use of proceeds to ensure an eligible purpose is paramount in such situations. Until the SBA clarifies the language of the SOP to address the two contract scenario, lenders should thoroughly document their files and consider either submitting such loans through general processing and seeking specific guidance from SBA franchise counsel.
For more information about Use of Proceeds and Franchise Area Developers, please contact Greg at 215-390-1023 or at [email protected].