Franchise eligibility for an SBA loan, and what happened to the franchise directory

Franchise lending is routine. Lenders like it: there is a documented model, comparable unit economics from other locations, and a franchisor with an interest in the unit surviving. For a first-time owner, a franchise is often easier to finance than an independent start-up with the same numbers.

The eligibility question is narrower than most applicants think.

The actual issue is control, not the franchise label

SBA size standards count affiliates. Affiliation turns on control, and a franchise agreement is a contract in which one party accepts a lot of direction from another. If the agreement gives the franchisor control beyond what is needed to protect the brand, the two businesses can be treated as affiliated — and the franchisor's revenue or headcount would be counted against your size standard, which almost always puts you over.

Provisions that draw attention include the franchisor's right to control day-to-day operations beyond brand standards, restrictions on transferring the business, rights to force a sale, and control over employment decisions or the choice of premises. The distinction is between protecting the brand, which is fine, and running your business, which is not.

The directory, and where things stand

For several years the SBA maintained a Franchise Directory listing brands whose agreements it had reviewed, with an addendum used to fix problem provisions. A listing made the eligibility check simple. The SBA later retired that directory and moved the review back to lenders, who apply the affiliation and control rules in the current SOP to the agreement itself.

Because the process has flipped once, do not assume either that a directory exists or that a listing you remember still means anything. Ask the lender how it currently reviews franchise agreements and how long that review takes. Confirm at sba.gov.

What the lender will want

• The full franchise agreement, including any area development or multi-unit agreement.
• The franchise disclosure document.
• Any addendum or amendment the franchisor is willing to sign.
• The initial fee, ongoing royalty, marketing contributions, and required build-out or equipment spend — all of which have to appear in the project costs.
• Item 19 financial performance representations, if the disclosure document contains them, plus whatever unit-level data the franchisor will provide.

The project cost, and the number people get wrong

Illustrative only — a single unit.

• Franchise fee: $45,000
• Build-out: $310,000
• Equipment: $165,000
• Opening inventory: $28,000
• Working capital: $60,000
• Soft costs and closing fees: $22,000

Total project cost: $630,000.

Suppose the lender requires a 10% injection against the project. That is $63,000 of your own money, with a loan of $567,000.

The mistake to avoid is budgeting the injection against the franchise fee alone, which would be $4,500. The requirement attaches to the project, not to the franchisor's invoice, and the distance between $4,500 and $63,000 is why a meaningful share of franchise files stall three weeks before closing.

Two things to settle early. Whether an injection requirement applies to your deal, and at what level, depends on the loan programme, the current SOP and whether this is a start-up or a change of ownership — get the lender's figure in writing rather than inferring it from anything you read. And ask what the lender will accept as the injection, because cash, a documented gift, a seller note on full standby and equity in contributed assets are treated differently from one another.

Multi-unit and area development agreements

If you have signed an area development agreement committing you to open further units, the lender is underwriting more than the unit in front of it. An obligation to open on a schedule is a contingent liability: it commits capital you have not raised, and a default under the development agreement can terminate the unit franchise that the loan is secured against.

Expect questions about how the remaining units will be funded, what the development agreement says happens if you miss a schedule date, and whether the franchisor will amend the schedule in writing. Bring those answers rather than waiting to be asked for them.

Practical advice

1. Send the franchise agreement to the lender before you sign it, or at least before your deposit becomes non-refundable. A provision that creates an affiliation problem can sometimes be fixed by amendment, and franchisors that finance a lot of units through SBA lenders know exactly which clauses cause trouble.
2. Ask the franchisor which SBA lenders have funded their units recently and how those files went. A franchisor that cannot answer is a signal in itself.
3. Budget the franchise fee and build-out into the project cost, and expect the required equity injection to be calculated on the whole project rather than on the loan.
4. Do not let the franchisor's in-house financing desk be your only quote. Their job is to sell units.

What tends to hold a franchise file up

• The franchise agreement arriving late in the process, after project costs and equity have already been discussed.
• An addendum the franchisor will sign, but only through a legal department with its own queue and no interest in your closing date.
• Project costs moving once the build-out is properly quoted, which changes the injection and reopens the credit decision.
• A landlord who will not sign the lease assignment or the waiver the lender requires.
• Equipment ordered and deposited on before the loan closed, which creates an obligation the lender did not approve and sometimes cannot finance.

Every one of those is knowable in week one. Ask the lender in week one which of them it expects to be the problem on your file, and ask the franchisor the same question about its last three SBA closings.

The franchise is not the obstacle. The agreement's control provisions are, and they are readable in advance.