By: Jessica Zolotorofe, Attorney, Ansell Grimm & Aaron
As of the last Census Bureau Report, the franchise industry accounted for approximately 40 percent of all retail sales in the United States, and has increased since. Thus, landlords of retail centers are increasingly likely to encounter franchisees as potential tenants.
There are many benefits to having a franchisee-tenant, however there are a few important issues for landlords and their lawyers to keep an eye out for.
BENEFITS TO LANDLORD:
National Recognition: Franchisee-tenants bring a familiar trade name, additional franchise locations, and as a result, an existing customer base. Other tenants are drawn to retail centers, and will even sometimes pay increased rent where nationally recognized tenants occupy a unit within the center.
Qualification of Tenant: Franchisors generally review potential franchisees’ experience, finances, and other pertinent factors to determine whether they will be able to maintain successful businesses. The franchisor has often undertaken extensive due diligence, and pre-qualified its franchisees before they get to the landlord.
Franchisee Investment: A franchisee will likely have invested significant money that an independent startup tenant would not, such as a franchise fee, legal fees for the franchise agreement and accountants’ fees for the preparation of budgets and projection reports for review by the franchisor. The franchisee will then invest additional funds in building-out the premises, and purchasing inventory, equipment, and signage in accordance with the franchisor’s requirements. As such, a franchisee-tenant has even more invested in the success of the location.
Franchisor Cure: Most franchisors have the right to cure lease defaults, to step into its franchisee’s shoes, as tenant, or to assign to a replacement franchisee. This is advantageous in that, (i) the landlord does not have to expend money on evictions or to enforce the lease or guaranty; (ii) the landlord is not without rental income; and (iii) the continuous operation of the business maintains foot traffic at the landlord’s center.
BEFORE NEGOTIATING A FRANCHISEE LEASE:
Timing: Landlords do not want to undertake due diligence to approve a tenant or guarantor, or pay lawyers to negotiate and draft a lease agreement before a franchisor fully approves the franchisee and the site. So, ideally, landlords should delay incurring the bulk of the costs associated with the lease until the only outstanding contingency to the tenant obtaining a franchise agreement is the franchisor’s approval of the lease.
Compliance with Loan Documents: Landlords should look back at any loan documents executed in connection with financing of their property to ensure that the lease and the franchisor rider do not conflict with their obligations as borrower thereunder. Particular areas of concern are (i) which party is entitled to insurance proceeds, and whether there is an obligation to rebuild after casualty; (ii) any conflict with a franchisor requirement that landlord waive its interest in, or subordinate its rights to lien or execute upon the franchisee-tenant’s bank accounts, or FF&E after a lease default; (iii) and whether the lender has the right to approve leases, or assignments or amendments thereof.
The Franchisor Lease Rider: Often, extensive negotiations of a lease are completed, the lease is ready to be executed, and only then does the franchisor lease rider or addendum (some form of which most franchisors require to be annexed to their franchisees’ lease agreements) first surface. And the provisions of that rider may conflict with the fully negotiated terms of the lease. Some franchisors are more flexible in the negotiation of their riders, while others are not negotiable. Landlords should review and attempt to resolve any concerns in the rider before expending money and time on lease drafting.
IMPORTANT PROVISIONS IN A FRANCHISOR RIDER:
Franchisor’s Consent: If a franchisor requires that landlord and the franchisee-tenant obtain franchisor’s prior consent to any lease amendment, landlord should add that only material modifications or amendments require consent, and that consent may not be unreasonably withheld or conditioned by the franchisor. To avoid delays, landlords may also propose a time period within which the franchisor must provide consent or notice of denial, a lack of response within said period being deemed franchisor consent.
Default Notices and Cure Periods: Commonly, franchisors require additional time beyond a tenant’s cure period before a default becomes actionable. Landlords may wish to agree, provided the franchisor serves notice, prior to the expiration of the franchisee-tenant’s cure period, that franchisor will, in fact, cure the default. Landlords should not be prohibited from taking action against a tenant for an extended period of time if at the end of that period the default will nonetheless remain uncured. Additionally, if a rider provides a franchisor the right to take over or assign the lease after a default, the landlord should include a provision that requires the franchisor to cure all defaults as a condition to the landlord’s approval of the lease assumption.
De-Identification: Franchisors often seek the right to ‘de-brand’ the leased premises. A landlord should attempt to negotiate (i) a certain time period during which the franchisor has the right to enter the premises after the tenant’s occupancy ceases, and thereafter, franchisor shall either be liable for the payment of rent, or landlord shall have the right to remove and dispose of all branded items without any liability; (ii) that the franchisor must indemnify landlord for any and all activities performed on the premises by franchisor; and (iii) that the franchisor shall restore the premises to the condition the franchisee was required to surrender it pursuant to the lease.
Alternative Franchisee: Many franchisor riders include the franchisor’s right to assign the lease to an alternative franchisee. Landlords should require financial statements, and the right to approve or disapprove of the replacement franchisee, within their reasonable discretion. Landlords should also require written assignment and assumption agreements so that all parties understand their respective obligations post-lease assignment.
LEASE PROVISIONS TO LOOK OUT FOR:
Signage and Exterior Prototype: Landlords should have the right to review the franchisors’ signage requirements and exterior prototype to ensure that, especially in a multi-tenant shopping center, they are consistent with the general aesthetic of the center. Landlords should also require a pre-approval condition to any renovations or material interior alterations of the premises.
Length of Term: It is crucial that a franchise agreement expires either contemporaneous with or after the term of the lease, and Landlords should additionally seek franchisee representations as to any termination rights of either the franchisor or the franchisee under the franchise agreement.
Use Provision: Because franchise concepts tend to evolve over time, flexibility is often sought regarding signage, design, trade name, and use provisions. For example, if a restaurant franchise alters or adds menu items, the franchisors want to ensure that all franchisees can comply with the new protocol. Landlords should not be overly restrictive in this regard, but should include that any changes must be subject to exclusive use provisions in other tenants’ leases within the center.
Guaranty: There is a common misconception that a landlord will be receiving a franchisor guaranty when it accepts a franchisee-tenant. That confusion can be bolstered when a letter of intent is accompanied by statistics regarding the franchise, as opposed to the actual franchisee-tenant entity. Assuming the franchisee is a newly formed entity having no value or assets other than its franchise rights, landlords should review the financial statements of the principals of the entity and try to secure a personal guaranty.
As one in twelve businesses in the United States are now franchises, it is important for landlords to familiarize themselves with ways to minimize the risks and effectively navigate the franchisee-lease negotiation process.
Jessica Zolotorofe is an attorney at the Northern New Jersey office of the law firm of Ansell Grimm & Aaron. Her practice is focused on commercial real estate transactions all over the Country, including financing, acquisitions, development, sales, leasing, and structuring tax-deferred exchanges.