Negotiating the Franchise Lease

When a restaurant or retail tenant is also a franchisee, there are specific challenges in negotiating the lease. The tenant/franchisee needs to carefully review and negotiate the lease agreement to ensure that its lease meets all of the franchisor’s requirements, and that its lease obligations do not conflict with its franchise obligations. The landlord may need to make certain concessions for a franchisee tenant, while protecting itself from the credit risk inherent in a small-business tenant. The franchisor needs to protect its interests in the physical location of the franchise business, even though it is not a party to the lease.

The Letter of Intent. The Letter of Intent is where the landlord and prospective tenant hash out the basic business terms before investing the time and effort of preparing and negotiating a full lease.

Even if the franchisor has no involvement in the LOI stage, the landlord and the franchisee/prospective tenant should proactively seek to understand the franchisor’s minimum requirements for its lease approval as well as any potential conflicts between the lease and the franchise agreement.

If a franchise agreement contains specific requirements for the franchisee’s lease (whether those are provisions to be included in the lease, a lease rider, or both), it is best to bring these up when the LOI is being finalized.

The Franchisor’s Lease Rider. A Franchise Disclosure Document often includes a form that a franchisee is supposed to have executed by a landlord as a condition to the franchisor’s approval of a lease. The document goes by various titles, such as “Lease Rider”, “Collateral Assignment of Lease and Agreement of Lessor,” or “Lease Addendum.”

The Lease Rider will cover various issues important to the franchisor. One of the most common provisions is to require the landlord to send the franchisor copies of any lease default notices, and to give the franchisor a window to cure any default by the tenant.

A second common provision is a right of the franchisor to assume the lease as a “pre-approved” assignee. The franchisor will also want the right to further assign the lease to a new franchisee, or to have the lease assigned directly by one franchisee to another. The landlord may be willing to agree to this, but will often insist that the assignee cure any defaults and that the assignee meet financial and other qualifications.

Important Issues in the Franchisor/Landlord/Franchisee-Tenant Triangle.

(1)  Length of Term. When does the lease expire, and when does the franchise agreement expire? If they expire on different dates, there is obviously a potential problem. A franchise agreement typically runs for a specific number of years from the date of execution. Sometimes a franchise agreement will run for a term of years from the date the franchisee opens for business.

Unless the tenant insists on getting the same expiration dates, the term of the lease will almost always end on a different date than the franchise agreement. In a retail lease, the expiration date might not even be known when the lease is executed. For example, a 10-year lease term may expire on the “120th full calendar month following the earliest to occur of (i) 120 days after the Tenant obtains all construction permits, (ii) 180 days after the date of this Lease, or (iii) when Tenant opens for business”.

The unwary franchisee/tenant may run into a gap where its franchise term has expired but it’s still obligated on the lease. “Going dark” before the end of the lease term is often a default under the lease, and not a good outcome for the tenant or the landlord.

Conversely, the franchise/tenant may face a gap where its lease has expired but the franchise term is still in effect. In that case, the franchise/tenant may face significant liability under the franchise agreement, and the franchisor will unexpectedly lose a unit.

The franchisee/tenant may avoid this by specifically negotiating for a lease term (or option) that expires on the same date as the franchise agreement. If the landlord refuses to agree, the franchisee/tenant may be able to go back to the franchisor and negotiate a change to the franchise term.

(2) Permitted Use. The “Permitted Use” clause limits the business that the tenant may operate in the retail space. Generally, the tenant wants maximum flexibility, while the landlord wants to specify the trade name as well limit what sort of business is conducted under that trade name. At a minimum, the landlord will require that the Permitted Use not conflict with any existing “exclusive rights” granted to other tenants in the shopping center; the landlord may also want the ability to bind the tenant to exclusive rights that landlord may in the future grant to other tenants.

The franchisor and landlord will be in agreement on the trade name – they want the tenant to operate only the franchisor’s brand. However, a conflict may arise over any limits on the business conducted. A franchise agreement will typically require the franchisee to offer the franchisor’s entire menu or product offering. If the lease prohibits the franchisee from complying with changes to the menu or product offerings, the franchisee will have to breach one of its agreements.

(3) Construction; Signage and Decor. A franchise agreement will require the franchisee to construct its premises according to the brand’s requirements, including layout, equipment, signage and décor. The franchisor will typically have approval rights over all aspects of franchisee’s construction.

The landlord will usually have approval rights over the tenant’s construction and signage as well. To the extent possible, the franchisee/tenant should seek to have its construction and signage plans pre-approved by the landlord prior to lease execution.

If the shopping center (or the local jurisdiction) has limits on color schemes, construction materials, signage, or other aspects of the business, the franchisee will need approval from the franchisor to deviate from its standard brand requirements.

(4) Future Remodeling Obligations. Under a typical franchise agreement, the franchisor can require the franchisee to remodel their business to the franchisor’s then-current “brand image” for new franchisees. There may be some limits on this right (such as remodels not being required more than once every five years). In the lease, the franchisee/tenant should seek to have the right to remodel the premises consistent with the franchise agreement.

(5) Assignment Clauses. As discussed above, one of the franchisor’s primary goals is to ensure the franchised location stays open under the franchisor’s brand, regardless of who is the franchisee. The franchisee/tenant will want the ability to sell their business to a new franchisee. The landlord, however, will, at a minimum, want any future owner to meet the landlord’s financial and other requirements for tenants. The franchisee/tenant will want to be released from all liability upon an assignment of the lease. The landlord, of course, prefers to keep the original tenant liable, while the franchisor is generally indifferent on this point.

Conclusion. Negotiating a lease is often a difficult, contentious process between the landlord and prospective tenant. When the prospective tenant is also a franchisee, the process can be even more complicated. The franchisor, the franchisee/tenant, and the landlord all benefit from understanding the perspectives of the other parties and the issues that arise among the three different parties. By addressing franchise-specific issues early in the process, the tenant and landlord can more easily move the deal to closure.

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