Thursday, January 23, 2014

For Franchisor, Franchisee and Landlord: Ways a Franchise Agreement and Commercial Lease May Conflict (Part 3 of 3)

By Barbara I. Berschler

Part 3 of 3

From the Landlord’s Point of View

In this final installment of my blogs that have examined some overlapping, and therefore potentially conflicting, questions faced by a franchisor, franchisee and landlord, I consider some issues in the business deal from the point of view of the landlord and how the other parties may respond.


A major objective of a landlord with a significant retail tenant mix (i.e., a shopping or strip center as opposed to a mixed-use project with first-floor and/or lower level retail) is to maintain a balance of the kinds of goods and services offered in its project.  It wants a varied mix so that consumers have more reasons to visit the complex with the expectation that sales among the tenants will increase making them more economically stable.  Additionally, the landlord may have committed itself not to rent to certain competing businesses. 


Under such circumstances, the landlord on the one side and the franchisor and franchisee on the other side likely have conflicting interests.  In this context, the lease’s “Use” clause is critically important, because the landlord does not want to commit to one kind of tenant, say a donut and coffee shop, only to find out later that the tenant has expanded into also selling yoghurt.  Yet from the point of view of the franchised business, it may need to expand into other product lines because the public has tired of donuts.  Arriving at a solution to allow for adjustments in the franchisee/tenant’s use of the space without asking the landlord to undermine its own position vis-à-vis its other tenants requires careful accommodations among the parties.


Another instance where the interests of the landlord and the franchisor may conflict can arise where the landlord charges percentage rent (i.e., rents based on the sales numbers of the tenant).  For example, in order to maximize the opportunity to collect such rents, the lease may restrict the tenant from having a competing business within a certain radius of the shopping center.  However, a major goal of the franchisor is to maximize its presence in a particular geographic area.  It does that by opening more franchised outlets.  When it opens more franchised outlets, those compete with the existing franchisee causing fewer customers to come to its location.  In turn, the existing franchised store does not generate the same number of sales, which lessens the amount of percentage rent the landlord can collect.

Under this scenario where the lease sets a radius restriction for identical businesses and where the franchise agreement gives the franchisor unfettered rights to open stores, the tenant may be placed in an untenable position.  On the one hand, the tenant’s interests and those of the landlord may actually be in alignment against that of the franchisor, but, at the same time, the tenant cannot control what the franchisor does in opening new establishments within the restricted radius which had been imposed by the lease.  Knowing that such a problem can exist allows the landlord to require concessions from the franchisor during negotiation of the rider.  Unless a mutually satisfactory arrangement can be achieved, such diametrically opposed objectives could cause problems and perhaps result in the deal floundering. 

These blogs have examined only a few of the overlapping issues which can greatly affect the outcome of any negotiation among these three parties.  When each negotiator understands the interests of the other parties, not simply its own, there is a greater likelihood of arriving at creative accommodations.

Tuesday, January 14, 2014

For Franchisor, Franchisee and Landlord: Ways a Franchise Agreement and Commercial Lease May Conflict (Part 2 of 3)

By Barbara I. Berschler

Part 2 of 3

From the Franchisor’s Point of View

In my previous blog looking at the troika-like relationship created among a franchisor, franchisee and landlord, I focused on some issues which the franchisee should look out for to avoid being placed in the proverbial “rock and a hard place” between its franchisor and its landlord[BB1]  I now turn my attention to some issues that the franchisor may want to press with the landlord and how the landlord may respond.


A major objective of the franchisor is the growth of its franchise system.  Because any new location reflects much effort and expense on the part of the franchisor to expand its presence, it wants to maintain flexibility with respect to the leased premises to keep it in the system once the business has opened without necessarily becoming overly obligated to the landlord.  To that end, the franchisor will want the landlord to enter into a rider to the lease which addresses a number of issues which give the franchisor leverage to maintain indirect control of the premises.  


Matters likely covered in the rider are: 1) requiring the landlord to keep the franchisor informed of important events that occur during the life of the lease, such as tenant default, amendments to the lease, and  assignment of the lease by the landlord;  2) limiting the name under which the business can operate; 3) restricting approved uses of the premises; 4) restricting the landlord from leasing other space in its property to competitors; and 5) allowing the franchisor or its chosen replacement franchisee to assume the lease if, regardless of the reason, the franchisee ceases operations.


While some landlords sign riders without requiring changes believing it good to have a well-known business included in its tenant mix, more sophisticated landlords will push back and require concessions from the franchisor in the process. 

One especially important example of a competing interest arises when a landlord wants to take action against a defaulting tenant.  At such a time, a landlord wants freedom of action against a tenant in default.  The lease will be written to allow a landlord to act quickly once any cure period for a tenant default has expired.  However, the franchisor, not wishing to lose the location to its system, will want the opportunity to replace the current franchisee.  Accomplishing such an outcome will take time and the landlord may not wish to wait an extended period of time, especially if it has obligations to third parties, such as its lender, which restrict its own choices.

This clash of interests may be ameliorated by amending the proposed rider to impose certain conditions on the franchisor, such as:  1) setting a limit on the additional time the franchisor will be allowed to assume the lease or identify a substitute franchisee after the notice of default had been issued; 2) requiring that all monetary and non-monetary defaults be cured before the lease is assigned; 3) requiring that any substitute franchisee meet the landlord’s criteria as to financial capability and operating experience; and 4) requiring that the rent be adjusted to the then-fair market rental value for the premises.

All negotiators know that no deal is ever perfect for one side or the other.  However, if each understands what is really important to the other side, accommodations can be arrived at that allow all parties to walk away as winners.

Thursday, January 9, 2014

For Franchisor, Franchisee and Landlord: Ways a Franchise Agreement and Commercial Lease May Conflict (Part 1 of 3)

By Barbara I. Berschler

Part 1 of 3

From the Franchisee’s Point of View

Many franchise business models require use of commercial real estate.  The franchised business may be operated out of a store in a strip shopping center, regional mall, office complex or a stand-alone structure.   In most instances the space is leased by the franchisee from a third party—the landlord, thereby involving at least three major players:  the franchisee who is also the tenant, the franchisor and the landlord.

Each player has high expectations of protecting its own interests.  By understanding these interests, those negotiating the transaction will be more successful at arriving at a mutually satisfactory arrangement.  This three-part blog will examine some overlapping issues from the perspective of each of the parties and will start from the point of view of the franchisee.

Among the three players, the franchisee comes to the project with the least bargaining power, yet it is the party most affected by the obligations imposed by the others.  To counter this effect, an important tool for the franchisee to have is a clear understanding of the relationship between the franchise agreement and the lease.   

Even before any thought of securing leased premises arises, the franchisee, while it is doing its due diligence, should become thoroughly familiar with the franchise agreement, which sets forth the relationship between the franchisor and franchisee. Among the various obligations required of the franchisee under that agreement, there will be terms that can affect the franchisee’s relationship with its future landlord.  If the franchisee also understands typical provisions that will appear in a lease, it will be better able to raise the potential conflicting issues with the franchisor while it evaluates the franchise agreement.  The following discussion covers some issues which can overlap in a franchise agreement and a lease.

A major issue where the franchise agreement and lease intersect concerns the length of time that each relationship exists; in other words the “term” of each agreement.  If, for example, a ten-year term imposed by the franchise agreement begins upon execution of that document, much of the time could be eaten up before the franchisee has identified a commercial location, entered into a lease, built out the premises and opened for business.  Yet the lease will have its own independent term of existence.  What happens to the franchisee/tenant when the franchise term has expired but the lease still has a year or more to run?  Knowing that such a situation likely will occur, the franchisee can raise the matter and negotiate a suitable method for calculating the term of the franchise agreement.


Another area where overlap may occur concerns the advertising expenses that the franchisor and landlord expect the franchisee/tenant to shoulder.  In most franchise agreements, a franchisee is asked to contribute not only a certain percent of its gross revenues to a general marketing/advertising fund administered by the franchisor but also to spend a minimum amount for local advertising. 

While advertising is an important business expense, if the franchisee’s premises are in a shopping center, the lease may also require tenants to make comparable contributions to the landlord’s shopping center marketing fund and local advertising.  Without some relief, the franchisee may be faced with further erosion of both the monies it needs to run its operation and its bottom-line profit.  In this situation, a franchisee is well advised to build into the franchise agreement a suitable formula to calculate its overall advertising expense.  Whether or not the franchisor makes concessions in this matter, the franchisee should also raise the matter with its prospective landlord.


A third area of conflict can arise with respect to the identification signage which will appear at the entrance of the premise or at other locations in the shopping center.  Obviously, the franchisor has expectations of the use of its logo and may have a standard sign package it wants to see installed.  However, the package may contravene the landlord’s sign criteria for its project.  When the franchisee is evaluating a particular location for its premises, it will be able to see how the landlord handles signage in general.    If it appears that there could be a conflict in expectations, the franchisee should raise the matter early in lease negotiations with its prospective landlord.
These are just a few areas of overlap between a franchise agreement and lease.  The savvy franchisee should know what they are so it is in a better position to raise them while negotiating with its franchisor and its future landlord.