Best Practices: Key Provisions in Franchise Agreements

Franchise lending continues to be a hot topic amongst SBA lenders, as they set new policies and procedures for determining eligibility of franchise concepts and documenting their loan files.  There are a multitude of resources to assist lenders in assessing eligibility, and I offered some practical tips in my prior article published earlier this year.  See Best Practices: Franchise Lending Tips for SBA Lenders | Starfield & Smith Attorneys at Law (starfieldsmith.com).  As with any key contract, the franchise agreement contains many provisions of interest to a lender in extending SBA financing, and this article will briefly highlight several provisions that may impact a lender’s credit approval.

1. Collateral Assignment of Lease. Franchisors often require that the franchisee execute a conditional assignment of lease or a lease rider agreement, which provides the franchisor with notice of any default under the lease, the right to assume the lease and/or access the business premises, and the right to re-assign the lease to another franchisee.  Should an SBA lender require a collateral assignment of lease, it may need to negotiate lien priorities of the lease assignment with both the franchisor and the landlord.
2. Step-In Rights. If an individual franchisee dies or becomes incapacitated, or if the franchise agreement is terminated due to franchisee’s default, some franchisors reserve the right to step-in as the manager of the franchised business and charge the franchisee an interim management or step-in management fee during such period.  SBA lenders may request franchisors provide lender with copies of any notice of default by franchisee under the franchise agreement, similar to how lenders request a notice of default under a lease agreement to protect lender’s rights to the collateral.
3. Security Interest. Many franchisors require franchisees to grant a security interest to the franchisor in franchisee’s assets to secure all obligations due under the franchise agreement.  Lenders must take care to ensure they obtain the required collateral position on the franchisee’s assets by pre-filing their UCC-1 and/or obtaining a subordination agreement from franchisor, when necessary.
4. Repurchase Rights. Some franchisors include a right to repurchase the franchised business at any time from the franchisee.  This type of right could impact the borrower’s ability to continue to operate, and the terms of such purchase, may or may not result in a complete payoff of the SBA loan.  Lenders may request that such provisions be removed from the franchise agreement during the term of the SBA loan, or at a minimum that lender receive prior notice from franchisor should they exercise this option to repurchase the franchised business.
5. Liquidated Damages. Franchise Agreements may contain liquidated damages provisions that are due should the franchisee default resulting in a termination of the franchise agreement.  The amounts due to franchisor can vary between a set amount of liquidated damages as set forth in the franchise agreement, or a multiple of the average royalty fees for the prior year times the number of months left in the franchise agreement or a set number of months (i.e. 24 months).  Lenders will need to assess whether they believe these provisions are reasonable and do not represent an unreasonable or punitive amount.

Lenders must carefully review all franchise documents, as the above list is not exhaustive concerning the provisions that may impact a lender’s credit decision.  Failure to identify provisions of concern in a franchise agreement may result in a difficult situation for a lender as the franchisor exercises its multitude of rights and remedies under the franchise agreement, leaving a lender scrambling to access collateral or assist a struggling borrower with transferring its business, as potentially impacting the guarantee.  For assistance with franchise eligibility determinations, please contact us at info@starfieldsmith.com.