Lease Considerations for Franchisees
This article was written by Mark Sherry and was first published in the Business Franchise Australia and New Zealand magazine, and has been reviewed and updated in April 2020.
At the time a buyer acquires a franchise they have a lot of different things to focus on. In many instances, the main focus is on the franchise itself and other issues are only given peripheral attention. However, when a franchise is being purchased that requires premises to operate from, it is important to give due consideration to the following issues:
The Term of the Lease
Many people purchasing a franchise do not give consideration to the length of their franchise term and how that compares with the term of the lease they are signing up to. Where possible, it is highly preferable to try and match these terms so that they align. If someone signs up a franchise for an initial period of five years, but the landlord of the premises will only agree to an initial lease term of eight years, then upon the expiry of the initial franchise term, the franchisee will potentially face serious issues if any of the following scenarios arise:
(a) If the business has been struggling and the franchisee did not wish to continue in business, or if they have their franchise terminated for some other reason at the end of the first term, they would still have three years of obligations to meet under the lease and no operating business to cover those costs. The only way to be able to get rid of these obligations would be to convince someone else to take over the lease by taking an assignment of it.
(b) A similar problem could arise if the franchise business is booming and it needs more room to expand. On the renewal of the franchise, the franchisee will either need to try and find someone else to take over the lease or they will need to resign themself to the fact that they’ll have to stay in unsuitable premises for another three years.
(c) A franchisor will often require their franchisee to have security of tenure in premises for the whole of each franchise term. Therefore, a franchisee would face a problem in renewing the franchise for a further five years in circumstances where the landlord wants the premises back at the end of the eight year lease term. In this case both the franchisee and franchisor would need to be confident that replacement premises could be found when the expiry date of the lease approaches. Even if such premises were available, the franchisee would need to relocate and fit them out for the final two year period before his franchise is due for renewal again. That can be a significant cost.
If the terms of the franchise and the lease match, then a franchisee is able to make a decision on both the franchise and the premises at the same time. Both are able to be terminated if that is what is wanted without having continuing obligations under one or the other. Similarly, if the business had been growing, the franchisee would be able to exit the premises and take on a new lease while continuing with the franchise. The franchisor also gets a level of comfort when lease and franchise terms match. They know that if the lease is renewed on a term that matches the franchise, then the franchise will have premises to operate from for the whole of the next franchise term.
Many people are unaware that liability often continues under business leases in New Zealand even when a business is sold and the lease is assigned to the new business owner. If a tenant wishes to remove the potential for ongoing liability after they have assigned the lease, they must negotiate this at the outset of the lease. It is during this negotiation period that a prospective tenant can often convince a landlord to be more accommodating on such issues, as they are looking for a tenant to start paying them rental.
Many people don’t think of their exit strategies when entering into a franchise. They are too focused on the new operation. However, sound exit strategies are a very important part of business. If a franchisee builds a successful franchise and then decides to sell it then the lease needs to be assigned to the buyer. If the buyer turns out to be a bad operator and the business folds then there is a chance that the landlord could seek lost rental from the previous tenant unless liability was limited at the start of the lease. If this is not possible, then wise business owners should take advice on restructuring their affairs so that in a worst case scenario, if the landlord calls up a guarantee, there may be some protection available for valuable assets.
When a franchisee is leasing premises in a block of shops or a shopping mall, it is easy to overlook the fact that during the initial negotiation it may be possible to get the landlord to agree to terms that may enhance their franchise’s chances of success. An example of this could be getting the landlord to agree not to lease any of their other premises to competitors of the franchise, so that they can have some exclusivity for their business type from that site. Obviously this does not work for all types of businesses unless carefully drafted. Fast food businesses often are more successful when there is a critical mass of competitors around them, as the mere existence of different food options creates a destination where prospective customers have options. Therefore, it might be best, to negotiate exclusivity on being the only burger outlet in the premises, rather than just the only fast food outlet.
Clauses Required by a Franchisor
Many franchise agreements have specific clauses in them that relate to premises. Some franchise agreements allow for the franchisor to take a head lease of premises and then sublease them to the franchisee. The purpose of this is to allow the franchisor to have direct control over what they consider to be a strategic site. However, more often that not, a franchise agreement will simply provide that a lease should contain certain clauses that give the franchisor an element of control over the leased premises. Essentially the franchisor wants the option to be able to take over a lease if the franchisee’s business fails by having the landlord agree to not take any action for defaults under the lease without first giving notice to the franchisor, giving them the ability to rectify matters and then become the tenant.
Getting a landlord to agree to such clauses can sometimes be a delicate negotiation and it is not uncommon for an Agreement to Lease to be signed up for premises without consideration even being given to the specific terms in a franchise agreement that relate to premises. If a franchisee fails to obtain a landlord’s consent to the clauses that the franchisor requires it to, then technically this can put a franchisee into default right at the outset of its franchise. However, it is not uncommon for a franchisee to have their franchisor involved in the premises selection and the franchisor can often assist in the negotiations with the landlord to obtain their consent to the required clauses.
Most urban centres have city plans and those plans will create different zones for different potential uses. When signing up a lease of premises for a franchise it is important to make sure that the zoning allows for the type of business being operated. In some cases it will be blindingly obvious that a zone is appropriate, say if a franchisee wants to operate a retail outlet and the site is surrounded by other retail operations. However in other instances the zone that premises are in may not clear. In such cases it is important to check that the rules do not prohibit proposed operations. Many councils have their city plans online and these will show the boundaries for various zones. In addition most lawyers, valuers and commercial real estate agents will be able to assist with zoning queries too.
It is very important to note that where premises have had a prior use that differs from that of the new franchise operation, that the change of use will not trigger unexpected upgrades to things such as fire systems, provisioning of toilets or building strength. Examples that the writer is aware of include when former retail premises are suddenly to be used as a food outlet and the council required upgrades to fire systems as well as engineering modifications to the building. Most modern leases will preclude a landlord from taking responsibility for such costs when a tenant seeks to assign an existing lease, so the change of use itself can lead to significant costs.
Leading on from the prior topic, it is critical to make sure that a proper due diligence is carried out on the buildings that businesses are to operate from. They must not only be safe, but they must meet a certain level of the building code. Some business owners think they don’t have to do this as a tenant and that it is more of a building owner’s issue. However, after the Christchurch earthquakes, councils around New Zealand have issued notices to building owners to stop certain premises from being occupied where they are deemed to be an earthquake risk. This has meant that the businesses that occupy those premises have been shut out of them. In some cases, businesses have been closed where their premises happen to be located next door to buildings that are deemed to be dangerous, even though their own premises are sound.
Historically tenants did not necessarily look at such issues as they were merely leasing the premises and not buying the building. However, recent events have brought about a re-think in this regard. From a tenant’s perspective it is advisable to try and negotiate a clause allowing for a right to terminate a lease if the premises are closed and unable to be occupied by them for a period of time. This would help an affected business relocate and reestablish itself whilst avoiding significant disputes between the landlord and tenant.
Although many leases are signed up on relatively standard form documents, the specific terms of them are able to be negotiated. The level of negotiation that is able to be achieved will depend not only on the attitude of the specific landlord and tenant but also on the market environment and whether it currently favours landlords or tenants. Further, the more money a landlord is contributing to assist the tenant in fitting out premises, the less likely they will be willing to negotiate on things like the term of the lease and other potential issues that might make a lease more tenant friendly. However, offsetting that can be the influence that strong and reputable franchise systems can bring as they are perceived as good quality tenants. It is therefore important to take expert legal advice prior to entering into both lease and franchise obligations so that the best possible outcome can be achieved and mismatches can be avoided.