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July 8, 2015

Best Practices: Making Sense of Management Agreement Eligibility

by Greg T. Kupniewski

Many small business borrowers, especially franchisees, utilize a third party management company to handle its “back office” functions. Use of management companies are increasingly common in the assisted living, storage, and hospitality industries. Although this structure benefits the small business by freeing up its owners/employees to focus on customer service and sales, a small business concern’s use of a management company may create eligibility issues for the SBA. As the Agency’s program requirements offer only general guidance, lenders should exercise care when reviewing these agreements.

Eligibility concerns may arise through findings of affiliation or the SBA’s prohibition on passive investments. The SBA may find affiliation exists if the management company exercises “excessive control” over the borrower. In certain circumstances, the SBA may also conclude the management company is the real operator and the borrower/owner is simply a passive investor. The borrower likely is ineligible under either scenario.

Of course, not all management agreements create “excessive control” in the SBA sense or relegate the borrower to passive investor status. Nonetheless, because there are no bright line rules on these issues, each agreement should be analyzed on a case-by-case basis.

It is more likely that the borrower will be considered independent and active if the borrower controls its money. We prefer to see structures in which the borrower’s monies are retained in accounts under its name. The small business concern alone should possess the right to borrow money on its behalf. Moreover, any operating budget should be approved by the owner/borrower. Similarly, any significant expenditures should require prior borrower consent.

The borrower also will be more independent and active if it exercises control over its employees. Eligibility is easier to justify if the borrower has hiring and firing authority. While the management company may have on-premises personnel who provide day-to-day supervision, we suggest that the borrower retain the right to hire, discipline and terminate its employees. The borrower should also have the ability to terminate the management company itself upon reasonable notice without penalty.

Because the SBA’s determination of eligibility is an inherently subjective process, lenders should carefully document its findings that the borrower is an independently owned and operated business. The ability to hire and fire, terminate the arrangement and control the small business concern’s finances will help to ensure program compliance. When in doubt, we strongly encourage lenders to seek guidance from the SBA or qualified counsel before approving a borrower that uses a management company. If unsure, consider submitting the loan through standard processing. If the issue is not properly addressed up front, the lender risks an outright denial of its SBA loan guaranty. For more information, please contact Greg at 215-390-1023 or at gkupniewski@starfieldsmith.com.