Lease Issues 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.
When someone is looking to purchase a franchise, it is both an exciting and stressful time. 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 preferable to try and match these terms so that they align. The reason for this is best shown by way of an example. If John is signing 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, John can face serious issues if any of the following scenarios arise:
(a) Not everything in life works out as we plan it so someone in John’s shoes would face significant issues if they 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 business to cover those costs. John would only be able to get rid of these obligations if he could convince someone else to take over his lease.
(b) A similar problem could arise if John’s business is booming and he needs more room to expand. On the renewal of the franchise, John will either need to try and find someone else to take over the lease or he will need to resign himself to the fact that he’ll have to stay in unsuitable premises for another three years.
(c) A franchisor will often require their franchisee to have security of premises for the whole of each franchise term. John could face a problem if he wants to renew his 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 John and his franchisor would need to be confident that John could find satisfactory replacement premises when the expiry date of the lease approaches. Even if John could find such premises he 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 John would be able to make a decision on both the franchise and the premises at the same time and would be able to terminate both if that is what he wanted without having continuing obligations under one or the other. Similarly, if his business had been growing, John 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 terms match because they know that if John renews his lease, 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 you have sold your business and assigned the lease to the new business owner. Recent reviews of property law legislation in New Zealand considered changing this position, but this did not occur. 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.
Going back to our prior example, say John builds a successful franchise and then decides to sell it to Kate and assigns his lease to her. If Kate turns out to be a bad operator and the business folds then there is a chance that the landlord could seek lost rental from John unless he limited his liability at the start of the lease. If this is not possible, then John should take advice on restructuring his affairs so that in a worst case scenario, if the landlord calls up his guarantee, there may be some protection available for John’s 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.
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 and giving them the ability to rectify matters and 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 a landlord to obtain their consent to the required clauses.
Continuing with the prior example, say the franchise being run by Kate fails after she bought John’s business. If the lease contains terms that require the landlord to deal with the franchisor in the event of a default by Kate, then the franchisor will have the ability to take over the lease and establish a new franchise operation from the premises if it considers that there is value in doing so.
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 which will show the boundaries for various zones. In addition most lawyers and commercial real estate agents will be able to assist with zoning queries too.
If the Christchurch earthquakes have taught us nothing else, it is 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. In recent times 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 is because many standard form leases do not contain clauses to cover some of the eventualities that have arisen and that uncertainty has caused significant disputes between landlords and tenants.
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. 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.