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August 19, 2015

Best Practices: Franchise Area Development Agreements

by Starfield & Smith

Last month, we identified problems with a franchisee’s utilization of a management company to handle a small business’ “back office” functions. Today, I will focus on the tricky nature of area development agreements when financing SBA loans.

Franchise development agreements, also known as master franchise agreements, are often found to be ineligible by SBA, primarily because they are often inherently speculative and may constitute “passive” enterprises. Development agreements typically provide the developer with a geographic area within which it may grow additional franchise units, and provide the developer royalty payment income from each franchise unit in the developer’s geographic territory.

When a lender can establish that its franchisee’s agreement merely contains “development rights” within a specified geographic area, however, it may be found eligible by SBA. In these circumstances, savvy lenders should identify the revenues a borrower receives from its franchise units (which may be derived from royalty payments) and compare these with revenues derived from the franchisee’s business operations. The more the business relies on royalties or fees from outside franchise units, the more likely it is that the structure will be deemed ineligible. Because the eligibility determination requires the Agency’s Office of General Counsel to conduct a subjective analysis of revenues and any other affiliation concerns, we recommend that, when these agreements are not on the Registry, lenders submit such agreements through standard processing.

For more information on Franchise Agreements, please contact Greg at gkupniewski@starfieldsmith.com or at 215-390-1023.