It’s a refrain that my colleagues and I have often heard: if you’re a franchisee, it can be really, really hard–perhaps almost impossible–to be verified as a service-disabled veteran-owned small business.
A recent case demonstrates the difficulties in obtaining SDVOSB status as a franchisee. In the case, the SBA’s Office of Hearings and Appeals held that the Center for Verification and Eligibility had correctly denied a company’s SDVOSB application because, in the eyes of the CVE and SBA, the terms of the franchise agreement impeded the veteran’s control of the company.
OHA’s decision in The Hope Cos, LLC, SBA No. CVE-204-A (2021) involved the SDVOSB application submitted by The Hope Cos, LLC, a professional and leadership coaching business. The company was run as a franchise under a ten-year franchise agreement between the Hope Cos, LLC and a franchisor, whose name was not released in OHA’s published decision.
The CVE determined that the franchise agreement placed “numerous restrictions” on the franchisee’s veteran owner, John Hope. These restrictions included, but were not limited to:
- Management functions could be delegated only with the franchisor’s permission.
- The Hope Cos could not offer services and products that are not approved by the franchisor, and could not operate outside of a certain designated territory.
- The Hope Cos was required to comply with the franchisor’s operating manual, which the franchisor could unilaterally revise at any time.
- The franchisee was restricted in its ability to advertise.
- The franchisor had control over the franchisee’s website.
- The franchisor had to approve the hiring of key employees.
- The Hope Cos was required to use computer systems, equipment, furniture, fixtures and signs specified by the franchisor.
- The franchisor could inspect and audit the franchisee at any time.
The CVE denied The Hope Cos’ SDVOSB application. The CVE noted that 13 C.F.R. 125.13 requires that a service-disabled veteran control the management and daily business operations of an SDVOSB. The CVE found that “Mr. Hope does not fully control the daily business operations of [The Hope Cos], due to provisions in the Franchise Agreement.” The CVE noted, for example, that because the franchisor’s permission was required for advertising, “Mr. Hope cannot fully control this aspect of daily business operations.” The CVE also wrote that the franchise agreement “allows [the franchisor], a non-SDVOSB, to exert actual control over” the Hope Cos, contrary to the “control” requirements for SDVOSBs.
The Hope Cos appealed the CVE’s decision to OHA, arguing that the denial of the application was improper.
OHA reiterated that an SDVOSB must be controlled by one or more serice-disabled veterans. It concluded:
CVE identified numerous terms within the Franchise Agreement which restrict Mr. Hope’s ability to fully control the “daily business operations” of Appellant, including provisions related specifically to Appellant’s marketing, production, sales and administrative functions; to the supervision of Appellant’s executives; and to the implementation of business policies. These provisions within the Franchise Agreement improperly limit Mr. Hope’s ability to control various aspects of Appellant’s daily business operations. CVE thus did not err in denying Appellant’s application for verification as an SDVOSB.
OHA denied the appeal and upheld the CVE’s determination.
The Hope Cos case does not say, of course, that a franchisee can never be verified as an SDVOSB, nor do SBA’s SDVOSB regulations expressly prohibit it. The fact remains, however, that there is an inherent tension between ordinary franchise agreements, on the one hand, and the SDVOSB control requirements, on the other.
Even assuming that the franchise agreement at issue in this case contained more restrictions than most, almost all franchise agreements that I’ve seen contain some restrictions on the franchisee. For example, this franchise agreement for Baskin-Robbins includes restrictions on the franchisee’s advertising, business hours, equipment, signage, supplies, hiring, and many other aspects of the business. These sorts of restrictions are–again in my experience–par for the course when it comes to franchises, and most of the restrictions look awfully similar to those at issue in The Hope Cos.
The CVE seems to agree with my take. A few years ago, the CVE released a fact sheet on franchises. The fact sheet said that franchises are not per se banned from participating in the SDVOSB program, but then said this:
To the extent the franchise agreement does not impose restrictions on the Veteran owner’s ability to manage and control the franchise, the franchisee may be found eligible. However, that is not usually the case. Most franchise agreements seek to maintain control of the company in a manner which prevents the Veteran from making decisions concerning day-to-day operations and the overall direction of the company.
In other words, if you’re a typical franchisee–even one with a less restrictive agreement than the one at issue in The Hope Cos–good luck getting verified as an SDVOSB.
But should the SBA and VA treat franchises this way, effectively excluding most (if not nearly all) franchises from the SDVOSB program? According to a government report, more than 10 percent of American businesses are franchises. And in some industries, franchises are dominant, comprising, for example, 100% of new car dealerships and 75% of fast food restaurants. That’s a lot of companies to effectively exclude from SDVOSB status. (Also, it seems a little unfair for the VA CVE to reject franchises for SDVOSB status while the same entity that operates CVE–the VA OSDBU–essentially promotes franchise opportunities to veterans).
One potential way forward would be to adopt the more nuanced approach used by SBA in its small business affiliation regulations at 13 C.F.R. 121.103(i). That regulation says:
(i) Affiliation based on franchise and license agreements. The restraints imposed on a franchisee or licensee by its franchise or license agreement relating to standardized quality, advertising, accounting format and other similar provisions, generally will not be considered in determining whether the franchisor or licensor is affiliated with the franchisee or licensee provided the franchisee or licensee has the right to profit from its efforts and bears the risk of loss commensurate with ownership. Affiliation may arise, however, through other means, such as common ownership, common management or excessive restrictions upon the sale of the franchise interest.
Using this approach in the SDVOSB context would allow more veterans to access the SDVOSB program, while ensuring that only franchises with “ordinary” franchise restrictions would qualify. Adopting this approach would require a regulatory amendment, but I certainly think it is something the SBA should consider.
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