Avoid Conflict Between Your Franchise Agreement and Commercial Lease
February 7, 2019 by Barbara Berschler
If you plan to buy a franchise which requires retail space, your business activities will be governed by at least two major contracts-the franchise agreement and the lease. In your dual roles as franchisee and tenant, you will want to know how the provisions in the franchise agreement and the lease interrelate to lessen the chance of conflict between them and to maximize your successful performance under each.
Because the franchise agreement and lease usually bind you from between five to twenty years, and because the future business climate cannot be accurately predicted, a major goal when negotiating either document is to preserve as much flexibility as possible so that you can better respond to unexpected changes to your circumstances. However, a major goal of the franchisor and the landlord will be to restrict your options because they want to see royalty fees and rents come in without interruption, even when a changing business environment exists.
Because you are selecting the type of business you want to operate, you will first need to address the franchise agreement. Keep in mind that it is not always a bad thing when the franchisor seeks to assert some influence over your leasing arrangement. If handled properly, the franchisor can actually be your ally in obtaining better terms with your
landlord. Something to consider, however, is who will be your ally when trying to obtain better terms with the franchisor?
During your general review of the franchise agreement, pay attention to any provisions that could affect your performance as a tenant. As you examine the agreement, some provisions that influence your leasing options may be more obvious than others, so poring over the document, especially regarding obscure terms and jargon, which can be important
in the end. Here are some examples of ambiguous phrasing that often appear in franchise agreements and that can affect your future lease.
Most franchise agreements call for the franchisor to approve the location of your store. If the franchisor is running a sophisticated operation, they should be able to help you identify the most strategic site(s) for your operation. By contrast, your real estate broker may not have that special insight to pick the best location for the particular type of franchised business you are buying. However, you should also realize that, in many cases, the franchisor’s approval is merely perfunctory. Therefore, just because the franchisor approves a location, you cannot count on its approval ensuring that this is the best site or one that is merely adequate.
Franchise agreements frequently require the franchisor to approve construction and layout of the premises. This can be a good thing if the franchisor provides practical information about the optimum size and configuration of your space. Good franchisors readily share their expertise. That is, after all, one of the reasons why you pay a franchise fee. In the end, you can potentially save a great deal of time and money if you rent or buy only the appropriate amount of space given what should be an already proven business model. If you take on too much space, you will pay more than necessary because most rental
calculations are based on square footage. If you initially contract for too little space, you can be well into the build-out phase when you realize the need for more space, resulting in tricky negotiations, delays, and needless expense.
Franchise agreements sometimes call for the franchisor to approve the lease itself. Does such a provision mean that the franchisor will work closely with you during the lease negotiation stage or will you merely be handed a list of provisions that the franchisor wants to see within the lease? If your franchisor is well established, their assistance in the negotiation of the business and other terms of the lease can be invaluable in that their reputation and staying power can lend more credibility to your proposal. For example, some franchisors will not approve a lease that calls for the collection of percentage rent (i.e., rent above the minimum rent that is based on gross sales above a certain sales figure). This is understandable given that franchise royalties are calculated from gross sales as well. If the property owner knows that his prospective tenant is likely to draw and keep customers in his shopping center, it increases the likelihood that they would forego percentage rent. This outcome could save you a considerable amount of money through the years, but you have to be involved with a franchisor that backs you up while also having developed a recognized brand. Otherwise, you may find the combination of franchise royalties, base rent, and percentage rent are prohibitive.
Consider the relationship between the expectations of your franchisor and the expectations of your landlord relative to how much time it will take to find the right site, negotiate for the space, obtain building permits, and then build your store according to franchisor expectations. You don’t want to find yourself short of time, especially when it might involve losing the upfront franchise fee or rent security deposit due to the fact that you can’t open for business by a specific date, as stated in your franchise agreement or lease.
Sometimes, franchisors want the option to enter into the lease with the landlord, and then sublease the space to you. In fact, the franchisor may have already found a location and negotiated the lease, claiming the deal is a “turn-key operation.” This example highlights how some franchisors try to restrict a franchisee’s maneuverability. If for some reason, you want to disengage from the franchise system or any disputes arise between you and the franchisor, they will have another level of control over you as they have become your de facto landlord.
After you have entered into a franchise agreement, the next big tasks will be to identify space and negotiate a lease. From the start, you will probably have more bargaining success with the landlord than with the franchisor, who is aiming to develop a highly uniform system of operations across a large geographic area. With that in mind, consider the following list of lease terms and how they might affect your franchise agreement.
Are the duration of the lease and franchise, with any options to renew, consistent with one another? If they are not, you could find yourself paying unnecessary franchise renewal fees and opening yourself to substantial site renovation costs.
Does the lease call for periodic site renovation? If so, is the specified period for repairs consistent with any similar requirements in your franchise agreement?
Under the lease, must you contribute to an advertising fund? Your franchise agreement may also require such participation. Can you obtain credit for one by participating in the other program?
Are the allowed uses for the space so narrowly defined that all you can operate is the specific franchised business? Can you use any other trade name beside that of the franchisor without obtaining the approval of the landlord? If your options are restricted, what would happen to your business if the franchisor goes into bankruptcy or you want to disengage from the franchise system altogether?
How do the assignability provisions in the two contracts interrelate? You do want to insist that both the franchisor and landlord act reasonably with respect to granting approval as to whom you may assign your rights and obligations under the franchise agreement and lease. This is to preserve your options to sell your business should the right opportunity present itself. Additionally, in the case of the landlord, it is good to obtain pre-approval of any new franchisee qualified by the franchisor.
The items listed above do not exhaust the myriad ways in which your franchise agreement and lease may influence one another. Clearly, there is a high likelihood that they will affect one another, so your review of the terms and conditions of both, when trying to avoid possible conflict, is a critical part of your analysis of the business opportunity you are considering.