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January 21, 2015

Best Practices: Affiliation Determinations and Franchise Agreements

by Jennifer Borra

SBA determines affiliation based upon a number of factors, including ownership, management, previous relationships with or ties to another concern, and contractual relationships.  The Code of Federal Regulations is clear that any affiliation analysis is based upon the “totality of the circumstances”.  One criteria in evaluating whether the applicant is small is undertaking a review of all franchise/license/ jobber agreements related to the subject business.  Many SBA lenders conduct such analysis and it is a routine part of underwriting the potential loan.  An interesting requirement, however, is that SBA also requires a review of all affiliate agreements or contractual relationships, which could exert excessive control over the applicant’s business.  If excessive control exists over the affiliate, it will increase the size of the affiliate and potentially make the applicant exceed the size standard for its industry.  Therefore, when evaluating affiliate agreements, lenders should keep several considerations in mind:

First, Lenders should carefully identify which individuals, entities or other concerns exercise control or have the power to control the applicant or each other.  In making the determination, lenders must evaluate not only majority ownership and affirmative power to control, but also the potential for minority ownership to exert authority through contractual rights (i.e. shareholder agreements, bylaws, etc.).  Once a lender determines the identity of all potential affiliates, it must require background information on such affiliates and its business dealings to identify any contractual relationships, such as a franchise agreement, that may require review.

Second, if an affiliate’s franchise agreement is not approved on the SBA Franchise Registry, then the lender must conduct an affiliation analysis of the agreement.  If the lender has PLP status or other delegated authority, it may submit affiliate franchise agreements for SBA’s affiliation review to theDelegatedFranchiseReviews@sba.gov mailbox.  Alternatively, PLP lenders may also conduct such affiliation analyses on their own.

Third, as with franchise affiliation reviews for the applicant, if SBA or Lender determines that affiliation exists between a franchisor and affiliate, Lenders must “fix” the agreement in question to modify the offending provisions and make the agreement eligible under SBA affiliation rules.  In practical terms, this requirement is a daunting task for Lenders and small business applicants.  The affiliates are not beneficiaries of the SBA loan; however, they are required to modify their contracts to comply with SBA’s requirements.  Oftentimes, applicants are able to work with their affiliates’ franchisor/licensor to modify the terms of the agreements solely for the duration of the SBA loan term.  However, if the parties are unable to modify affiliate agreements, lenders must take the size of the franchisor/licensor into account when determining whether the applicant, together with affiliates, meet SBA’s size requirements.

Affiliation determinations are complex, subjective and represent a growing area of uncertainty for SBA lenders.  When analyzing affiliates, lenders must take care to ensure they also evaluate all franchise/license/dealer agreements of the affiliate in determining whether control exists and whether size standards are in jeopardy.

For more information regarding affiliation analysis of franchise agreements, please contact Jennifer at 267-470-1206 or at jborra@starfieldsmith.com.