One of the key criteria for being a Service-Disabled Veteran-Owned Small Business (SDVOSB) is, as you might expect, that a service-disabled veteran control the company. Under Small Business Administration rules, an agreement similar to a franchise agreement can render an SDVOSB applicant ineligible, because the franchisor restrictions on the actions of the company are too strong. A recent case reminds us of the control imposed by these types of arrangements.
The case, Holistic Serendipity LLC, SBA No. CVE-242 (2022), looked at a business that had sought SDVOSB verification from VA. (Note that, as of October 24, 2022, the VA is no longer accepting applications for SDVOSBs–those must go through SBA starting January 1, 2023.) The company (Holistic) sought to “address mental and physical health symptoms with organic hemp products.”
Holistic had an Affiliate Agreement, somewhat similar to a franchise agreement, with another company called Native Ceuticals. Based on this agreement, VA’s Center for Verification and Evaluation (CVE) found that Holistic had “restrictions on operational decision making and requires a specific business model.”
Some of the items CVE had problems with included the following sections:
- Control over Holistic’s website and “ability to operate outside a designated location or to set prices higher than the ‘established maximum'”
- Requiring Holistic “to exclusively sell products created or approved by Native Ceuticals.”
- Native Ceuticals’ approval for things like “marketing materials”; “product inventory”; “interior design for a store” and “an employee handbook that contains policies and procedures set by Native Ceuticals.”
Under SDVOSB rules, veteran “control” means control over both daily business operations, and its long-term decision-making, are conducted by service-disabled veterans. 13 C.F.R. § 125.14. The regulations define “daily business operations” as including, but not limited to, “the marketing, production, sales, and administrative functions of the firm, as well as the supervision of the executive team, and the implementation of policies.” 13 C.F.R. § 125.12.
On appeal, SBA Office of Hearings and Appeals (OHA) agreed with CVE, noting that a number of provisions in the Affiliate Agreement restricted actions by Holistic. For instance, Holistic “must ‘not promote, market, offer, or sell any other brand of CBD products in the Store Location or any other location, including without limitation any website or e-commerce, unless approved by [Native Ceuticals] in writing, in its sole discretion.’” This is in addition to the various other restrictions noted above. OHA concluded that these provisions gave Native Ceuticals power to control aspects of Holistic’s “daily business operations”, including “provisions related specifically to Appellant’s marketing, production, sales, and administrative functions and to the implementation of business policies.”
The SDVOSB rules, as interpreted by VA and OHA, have long had a problem with franchise and similar agreements like distributor agreements. We’ve discussed those types of agreements before, but it continues to be an issue, as this case demonstrates.
SBA’s proposed SDVOSB certification rule is poised to potentially change how SBA interprets the franchise agreements. SBA’s commentary states: “[a]s proposed, SBA control regulations do not address franchise, license, or distributor agreements. SBA is seeking comment as to whether these types of agreements should be addressed” in the SDVOSB rules. “For example, should SBA take a similar approach to the agency’s loan assistance regulations in § 121.301(f)(5)?” That provision states:
(5) Affiliation based on franchise and license agreements. The restraints imposed on a franchisee or licensee by its franchise or license agreement generally will not be considered in determining whether the franchisor or licensor is affiliated with an applicant franchisee or licensee provided the applicant franchisee or licensee has the right to profit from its efforts and bears the risk of loss commensurate with ownership. SBA will only consider the franchise or license agreements of the applicant concern.
It will be interesting to see if SBA addresses franchise type agreements in the final rule for SDVOSB certification. If not, then SDVOSB applicants must continue to be wary of franchise agreements, distributor agreements, and the like.
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