Home > Implications and Complications When Leasing to a Franchised Enterprise
Implications and Complications When Leasing to a Franchised Enterprise
Jo-Ann M. Marzullo and Debra E. Scribner
With the proliferation of businesses operating under a franchise concept, retail landlords face an increasing pool of tenants looking for space in which to operate a franchised enterprise. A major incentive for leasing to a franchised enterprise, rather than a mom-and-pop business of the same use, is that a franchise provides an established business model that benefits from a recognizable name and a predictable clientele. The anticipated predictable and stable cash flow provides some comfort to a landlord that the tenant will fully perform its obligations under the lease. For the more well-established franchises, the landlord’s other tenants may derive additional business from that franchise’s customers. A customer may go to a franchise restaurant for a meal and shop at another tenant’s store; however, absent the franchise restaurant, that same customer might not have made the effort to go to the other store.
For landlords, leasing to a franchised enterprise presents unique issues and potential pitfalls of which any landlord should be aware. This article presents an overview of the most common issues that should be addressed in a franchise-related lease. Because most leases involving franchised enterprises are with a franchisee as tenant, that scenario will be discussed first, and thereafter the alternative scenario of the franchisor or an affiliate of the franchisor as tenant will be examined.
Using Lease Riders
Under the terms of many franchise agreements, the franchise-related lease is subject to the franchise agreement. Accordingly, the rights of the franchisor under the franchise agreement will govern regardless of the lease terms. This is often accomplished by means of a lease rider, the terms and conditions of which must be affirmatively agreed to by the landlord in writing.
Terms of the Rider
Typically, such riders contain provisions that: (1) grant the franchisor the right to assume the obligations of the tenant in the event that the franchise agreement is terminated prior to the expiration of the lease term; (2) grant the tenant the right to assign its rights in the lease to the franchisor (or an affiliate of the franchisor) at any time; (3) require the landlord to provide copies of default notices to the franchisor when it sends them to the tenant; (4) give the franchisor the right to cure a tenant default; (5) upon termination of the franchise agreement or lease, grant the franchisor the right to remove franchise-related property (including signs, fixtures and other identifying property) from the premises if the tenant fails to do so; (6) require the tenant to make alterations to the property to remove identifying marks and designs (even paint colors) upon termination of the franchise agreement or lease; and (7) grant to the franchisor the rights of a third-party beneficiary of the tenant’s lease rights.
In addition, franchisors will often require that a lease contain specific limitations on the right of the landlord to lease surrounding space to a competitor. While use restrictions are a common concept in retail leases, the term “competitor” can be much broader in franchise concepts than in general retail concepts. For example, in the case of a franchise restaurant, is the landlord willing to agree that no other restaurant will operate in the shopping center? Will the franchisor accept that the noncompete cannot apply to existing leases, which may be extended, and for which the permitted use is any lawful retail use?
Further, typically a franchisee will have obligations under the franchise agreement to remodel the space every few years. Leasing to a franchisee means that the landlord must accept the right to remodel and accept the risks that are associated with substantial tenant work. The benefit to the landlord is that the premises will remain contemporary with then-current market standards and will be attractive to customers and potential other tenants.
Impact of the Rider
Franchisors do not usually negotiate their lease rider. Therefore, before agreeing to the lease rider as the controlling document, landlords should consider how it affects the other current leases for that shopping center, as well as the future leasing of that shopping center. For instance, there may be prohibitions on any outside construction during designated periods, in order to comply with restrictions on disruptive construction during prime retail periods of an anchor tenant. Another issue to the landlord might be how long after lease expiration or early termination will such franchisor have to remove franchise-related property, since the landlord will not be able to deliver the premises or perform improvements on the leased premises until the items are removed or the time for the franchisor to remove such property has expired.
Further, as part of the mandated remodeling, franchisee tenants will often require that the landlord permit nonstructural alterations to the property or to mechanical, plumbing and/or electrical systems. Such changes may disrupt other tenants and may create liens on the property if the tenant does not pay for such alterations as agreed. A landlord may want to require certain limitations on the dollar amount of such alterations and notice requirements for any such changes. It may also want to clarify what types of alterations would be permitted as a matter of right and what types would require prior written consent of the landlord.
Issues Arising from Termination of the Franchise
A landlord may want to require the tenant to maintain the franchise agreement throughout the full term of the lease and any extension periods. Without a valid and enforceable franchise agreement, a tenant’s business may no longer be viable or may not consist of the same quality or character that was dictated by the terms of the franchise agreement. Specifying that the termination or expiration without renewal of the franchise agreement is an event for which the landlord may declare an event of default under the lease gives a landlord the flexibility to declare or not declare an event of default if the franchise is lost. Such flexibility may further benefit the landlord by avoiding an unwanted lease event of default if the mere existence of such event would be grounds for the landlord’s lender to declare an event of default. By structuring the lease with flexibility regarding the permitted use and other lease requirements, the landlord may have more options under its credit facilities if the franchise agreement is terminated or not renewed.
Landlords with strong negotiating positions may want to specify in the lease that a downgrade or a default under the corresponding franchise agreement would also be an event for which the landlord may declare an event of default under the lease. Requiring the tenant to submit copies of all notices of default, downgrade or termination of the franchise agreement would also be beneficial to a landlord.
Other issues surrounding permitted use and operation include:
- Is the landlord relying on the franchise requirements to describe the permitted use?
- May the restaurant be any nationally or regionally recognized restaurant concept?
- Once the restrictions of the franchise agreement no longer apply, will the gift shop selling a variety of high-quality gift items become a store not selling a wide variety of items—i.e., just party goods or a store selling lesser-quality goods—once the restrictions of the franchise agreement no longer apply and if the lease does not set its own standards for operation?
- Once the restrictions of the franchise agreement do not apply to the leased premises, how will the location be operated?
- How should the permitted use in the lease be drafted to deal with such a situation?
Some older franchise agreements covered operating the franchised enterprises in a territory. Now, it is typical that a development agreement covers a territory, and the franchise agreement is unique for each location. But if the leased premises are to be an additional location within an existing franchise agreement, then the landlord should consider the likelihood that the franchise agreement may expire during the lease term or an extension period.
What flexibility is to be permitted for the trade name to be used in the leased premises after the franchise expires? Once a franchisee has firmly established the location and the customer base is accustomed to going to that location, a tenant may be able to convince its landlord that it can more profitably operate independently after the franchise agreement expires. This arrangement, however, would only work if the franchisee itself, rather than the franchisor, is the tenant. As the tenant, the franchisee is the one that can exercise extension rights, and the landlord may only enter a new lease with the franchisee once the tenant has no rights to remain in possession of the leased premises for the intended term of the proposed new lease.
Established Business Concept
A landlord looking to lease space to a prospective franchisee tenant may want to weigh the benefits of having an established business concept as a tenant with the corresponding restrictions placed on the landlord. Factors, such as the financial health and reputation of the franchisor, the length of time during which the franchisor has been operating and the number of other similar franchise concepts in the area, should be carefully considered as part of the decision whether to rent to a franchised enterprise.
The landlord may require a prospective tenant to provide the franchisor’s lease rider at the initial stages of negotiations with the tenant, even before the initial draft of the lease is drafted, so that those provisions may be considered before undertaking the lease negotiation. Landlords may want to avoid extended negotiations, first with the franchisee and then with the franchisor, thus delaying lease execution and store opening—and, therefore,the commencement of rent payments.
Franchisor as Tenant
The franchisee is not always the tenant. There are some franchisors that prefer to control the leased premises on which their franchise is operated and sublet the space to the franchisee. This structure presents a more straightforward lease for the landlord. The franchisor receives royalty payments from the franchisee, and that, together with the subrent, provides the funds with which the tenant-franchisor pays the lease obligations. Leasing to a well-capitalized franchisor provides an additional margin of safety for the landlord.
A variation of the situation involving the franchisor-as-tenant occurs when the franchisor wants to isolate the lease obligations from its base business. In this scenario, the franchisor may establish an affiliate entity to act as tenant. The affiliate tenant’s ability to pay rent is based solely on receiving the subrent, or the subtenant may pay the rent and additional rent to the landlord directly. Accordingly, where a separate affiliate entity is used to lease a franchised location, such affiliate tenant may require the lease to contain a disclosure and landlord acknowledgment, disclaiming and waiving any lease liability for the franchisor as follows:
Landlord recognizes and acknowledges that Tenant’s assets consist almost exclusively of leases, subleases and options to purchase leased premises. Landlord also recognizes and acknowledges that Tenant was organized principally for the purpose of negotiating and drafting leases with a view towards subletting the Premises to franchisees of [franchisor]. Landlord recognizes and acknowledges that it has been advised that [franchisor] owns all rights to award franchises for [trade name] and that Landlord has also been advised that Tenant has no rights whatsoever to award franchises for [trade name] or collect any franchise related royalties from any prospective subtenant of the Premises….Landlord also recognizes and acknowledges that Tenant intends to sublease the premises to a person(s) who has or will be awarded a franchise for [trade name] from [franchisor] under which sublease subtenant will pay rent directly to Landlord so that the rent payments from such subtenant will normally not be received or held by tenant. Although subtenant may open a business operation doing business as a [trade name] and may have franchise and other business relationships with corporations related to or associated by the general public with “[trade name],” as it is commonly known, Landlord recognizes and acknowledges that the sole and exclusive persons or entities against which it may seek damages or any remedies under this or any other document in which Landlord and Tenant or Landlord and subtenant are parties, whether for unpaid rent and associated damages, claims of unjust enrichment, claims of unfair trade practices, or any other theory of recovery of any kind or nature, is Tenant or subtenant. Further, it is expressly understood and agreed that there will not be any liability whatsoever against (a) [franchisor], its shareholders, directors, officers, employees and/or agents, and/or (b) any persons and entities who are the shareholders, directors, officers, employees, and/or agents of tenant. Such exculpation of liability shall be absolute and without any exception whatsoever.
Leasing that involves a franchise location presents landlords and their counsel with unique situations that must be examined from both a business and a legal perspective. The franchisor may require lease provisions or structures that are restrictive and unusual to the landlord. As noted in this article, all parties must understand the potential benefits and pitfalls inherent in these situations.
Jo-Ann M. Marzullo is a partner with Posternak Blankstein & Lund LLP, Boston, MA. She represents landlords and retailers with lease negotiation and administration, among other commercial real estate matters.
Debra E. Scribner is a partner with Posternak Blankstein & Lund LLP, Boston, MA. She represents commercial financial institutions and small businesses in real estate and other types of secured credit facilities, as well as small businesses in franchise and general business matters.