Many of our franchising clients are also tenants of premises. A big driver of the value of the franchise brand and its liability are the terms and conditions of leases of the premises occupied by your franchise businesses. Therefore, a big question you must ask yourself, is to what extent do your leases allow for a smooth transition from franchisor to franchisee, prevent duplication, and manage risk?
Here are some easy steps to ensure your lease is more franchise ready.
- Make it easy for the lease to pass on occupancy rights and obligations to a franchisee
As a franchisor, you will usually lease premises so you can secure the tenure and maintain control of your brand within a strategic location. As part of this process, you'll want to pass some of this risk onto your franchisee via licencing or subleasing the premises to them – granting them certain occupancy rights but requiring them to observe the lease terms and conditions.
Usually, a lease won't let you sublease or licence without landlord consent, and subject to a number of conditions, so you need to ensure that these can happen with minimal restrictions. Ideally, you'll just need to tell the landlord what you're proposing however, some landlords may require more. For instance, entering into a deed which says that you indemnify them against breaches of lease conditions by your franchisee and providing a copy of the licence to occupy a sublease.
The landlord may also need a copy of the Franchise Agreement as part of their consent – resist providing this if you can as your franchise agreement may contain conditions which you don't want to share with the rest of the marketplace.
If the franchisee leases the premises instead of you, you may need to negotiate with the landlord around stepping back into the shoes of the franchisee in the event they default or the business is sold. This can be documented by a specific clause in the lease or by separate deed.
- Get rid of duplication
If you're licencing or subletting to your franchisee, there will be times where it is easier for the franchisee to deal directly with the landlord. For example, if the franchisee is invoiced directly for rent, you won't need to receive an invoice for rent and then issue a separate invoice to your franchisee.
- Keep informed
A lease will usually state that notices can be served by the landlord on their tenant at the premises. If you've granted occupation to your franchisee, then there's a risk that notices will be served on the premises that you won't know about. This can be critical for notices regarding occupancy rights including relocation, redevelopment and breaches.
If you're unaware of what's going on, you can't respond which may have dire consequences - particularly when you're the tenant under the lease and ultimately responsible.
I would strongly recommend that the lease include that in the event that notices are served on the premises, copies should also be served to your head office, registered office, or other address as specified in the lease.
- Branding – your timetable versus your landlord's
A lease will usually include some form of redecoration of the premises during the life of the lease such as a complete refurbishment, repainting or refit. The lease may require this to take place every five years or upon exercise and an option to renew for a further term.
However, the timetable of refurbishment referred to in the lease may not coincide with that of your franchise model as a whole. What if the franchise is about to embark on a campaign of rebranding and this occurs shortly before or after the specified refurbishment date?
To overcome this I'd strongly recommend that your lease states that refurbishment doesn't occur during the term (and at all in the event that there is a make good that requires defit to bare shell). At the very least if there is to be a redecoration or refurbishment provision in the lease, it should be made subject to whatever your program for branding requires.
- Be clear on who is entitled to an incentive and restrict when that incentive can be taken away
Often a new lease will include an incentive of some form such as a rental reduction over the life of the lease or a cash contribution towards the cost of a fit out.
If you're entitled to an incentive and licence or sublease the premises, you need to consider whether to pass it onto your franchisee. If not, then when the licence or sublease piggybacks off the lease, you need to make it clear that any incentive provisions are excluded.
You also need to consider the circumstances in which the landlord can clawback the incentive. For example, documentation relating to the incentive might say that the landlord can take back either a portion or all of the incentive in circumstances such as default, assignment of lease, the tenant ceasing to occupy the premises or change in control of the tenant company.
You should try and restrict these circumstances – at the very least, it shouldn't apply in the event of change in occupation (particularly where there is a licence or sublease to a franchisee), assignment of lease or changing control of the tenant.
If the clawback provisions apply in the event of default you need to consider whether your franchisee indemnifies you for any clawback where the default has been caused by the franchisee's default.
You may also try and negotiate that this clawback can only take place within a certain period of time - such as the first three years or that the extent of the clawback reduces as the life of the term of the lease proceeds.
- Embargo of critical risks
A big risk when leasing premises is the ability of a landlord to either terminate the lease in the event of demolition or relocate the tenant in the event of some planned refurbishment. There are ways to manage this risk – ask questions and investigate before entering into the lease to see what is planned during the life of the lease. Another way is to negotiate that demolition or relocation can't take place until after a certain period of the term has lapsed.
- Make it easy to sell your brand, or take on new partners
At some point you may want to take on new partners, sell the business or undergo some other corporate restructure such as floating on a stock exchange.
Usually a lease will provide some restrictions on the ability of a tenant to change control, often stating that in the event of a change of control of a tenant company, the landlord's consent must be obtained and the same criteria that applies to an assignment of the lease would apply to a change in control of the tenant. Such restrictions may include an assessment of the incoming party who is taking equity or control of the tenant, and a requirement for the existing tenant to remain liable under lease - problematic when you want to sell your business altogether.
I would recommend that you water down such provisions as much as possible. Attempt to eliminate the requirement to obtain consent (difficult to negotiate with many landlords). In an ideal world you would simply be able to advise the landlord of the change of control but in reality this may be your starting point and you will need to give ground. Try and achieve a change of control provision which states that you would obtain landlord consent which cannot be unreasonably withheld in the event that the incoming party is not inferior to the current tenant and has sufficient financial resources. As discussed earlier you also need to ensure that such a control does not result in the clawback of any incentive, otherwise a potential purchaser of a franchisor business may view the cost of transitioning as too high.
- Risks at the front and at the end - traps to watch out for
In my experience, many franchisors proceeding down a growth path aim to secure key sites when they are first established.
When you secure a site you need to negotiate with the landlord around the fit out obligations. One big trap that franchisors leasing premises fall into is the amount they need to contribute to this fit out (beyond what their design and plans dictate) – for instance, altering connections to basic services such as air conditioning and plumbing may not be considered and can blow the budget.
You need to clearly establish when you need to contribute to these alterations where the basic shell provided doesn't cater for the proposed fit out. Crucially, if a franchisee is involved and contributing to set up costs, you need to let them know what these costs are.
Once the tenancy ends, there are also costs as the premises usually need to be returned to a complete bare shell. Again, it should be made clear to your franchisee if they're under a licence or a sublease whether they're responsible for such make good costs.
Ultimately, if your franchise operation involves leasing premises (and usually a large portfolio of premises) there are many hidden traps which can hinder the smooth operation of your franchise model and liabilities.
As a consequence we would thoroughly recommend a member of our franchising team sit down with you and carry out an audit on your leasing documentation to ensure that it is in fact franchise ready.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.