Dirt Law

Dirt Dictionary: F Is for Franchise Leasing

The franchise has become ubiquitous throughout the country and the world and, yes, even in cosmopolitan New York. Some recent statistics may be worth citing: There are an estimated 1,500 different franchisors (franchise business companies) operating in the U.S., employing more than 8 million people and generating some $782 billion in revenue. The franchise industry accounts for approximately 40 percent of all retail sales in the U.S. A new franchise business opens every eight minutes of every business day. Approximately one out of every 12 businesses in the U.S. is a franchise business. Interested in more mind-numbing statistics? I’ll put a plug in here for the resource-laden International Franchise Association (IFA, website at http://www.franchise.org).

So the bottom line for us real estate types is that knowing one’s way around a franchise agreement and understanding how it affects leasing practice is a worthwhile exercise.

We start with three major players: landlord, tenant (franchisee) and franchisor. (Yes, there are scenarios where the franchisor is the tenant and then subleases to the franchisee, but not only is that arrangement less common, it’s also less complicated and so less interesting for law column purposes. Understanding and balancing the three interests is required to successfully navigate this leasing course.

To summarize, the landlord is looking for stability—an uninterrupted rental stream and as few post-execution changes to the lease as possible. The franchisor and tenant/franchisee are looking for flexibility to accommodate the “changes” that may take place over a 10- to 20-year franchise relationship.

The key to the franchise relationship is finding the right location and then, once found, making sure that it will be retained in the hands of the franchisee or, should they stumble, that it can be readily taken over by the franchisor.

The landlord will welcome a national trade name as it brings recognition to a shopping center. Also, the franchisor has been vetted by the franchise as a person of some significant wealth and business experience and is therefor  pre-qualified as a credit-worthy tenant. (One common misconception among smaller landlords is that renting to a franchise tenant means having the credit of that big corporate franchisor backing up the individual commitment. Well, that simply is not the case. For the most part, the franchisor is simply licensing its trademarked name and products to the franchisee and has no direct relationship–privity, if you’ll pardon some old fashioned contract legalese–with the landlord.)

The savvy landlord will carefully review the franchise agreement. Provisions that touch on real estate matters—in particular, the security of the long-term lease—are of paramount importance. For example, termination rights—going either to or from the franchisor—introduce an element of uncertainty that the landlord must weigh in moving ahead.

The franchise-related lease itself often looks different in that a new element—the franchisor’s rider—must be reviewed and negotiated. Typical rider language includes the franchisor’s right to receive notices of default and a proviso that the franchisor’s consent be obtained in connection with a proposed material modification of the lease.

We see that the rider’s version of the use clause shows it has been tailored to standard and time-tested verbiage but also leaves room for changes in concept and execution over the years. Often, there will be detailed provisions as to exclusives—that this Burger King be the only fast-food burger venue in the mall. (In that event, the landlord will do well to include a complementary radius clause.)

As branding identity is a key element of the franchise business, this rider will also have a proviso for both initial branding and, if the store should close or the franchisee lose their franchise, the right to de-brand the premises—the removal of marks, logos and the like.

As long as we’re cataloging pro-franchisor provisions, let’s add a free hand with store remodeling and even the right to temporarily close a location without landlord consent. As franchise restaurant concepts become stale, franchisee’s plan to change the menu, the look and many facets of business operations, and the lease must give this needed flexibility. Having a brand name that dominates radio, TV and print on the other side of the table certainly gives the landlord a level of comfort that smooths the way for these negotiations.

To keep stores up to date also often requires remodeling, and the goal would be to obviate the need for landlord consent to changes required or authorized by the franchise agreement. A reasonable compromise would be not to require landlord’s consent, if the changes in the facility and signage are part of a franchise-wide regional or national upgrade. Use clauses (discussed above), trade name provisions (for example, Kentucky Fried Chicken is now KFC) and other restrictive language come into play as well.

Lastly, and this applies mainly in the shopping center leasing context, the franchisee may under certain market conditions ask for the drastic remedy of the right to terminate. This will require the franchisee agreeing to pay some sort of early termination penalty fee. Examples include failure to meet the minimum percentage of retail occupancy by a certain date. In that event, the franchisee would be allowed to pay a modified base rent until the requested percentage of occupancy has been reached. Alternatively, if it is not reached within a certain time period, the franchisee would have the right to terminate the lease and receive some sort of reimbursement for unamortized tenant improvements or other costs that the franchisee has expended. Also keep in mind co-tenancy requirements that a major anchor or movie theater open and remain open—what’s the pizza shop worth if the movie theater isn’t open?

At this point, we’re just scratching the surface of this subject, but understanding this interplay is essential to effective franchise lease negotiations.

Practice pointer: As to the shopping center’s promotional program, if you are a franchisee with an advertising requirement built into your franchise agreement, try to get credit so you won’t have to double your ad budget.

Jeff Margolis is the founding principal of The Margolis Law Firm in New York City, where he specializes in “dirt” law—buying, selling and leasing. Follow Jeff via RSS jamargolis@newyorkleaselaw.com

Follow Jeffrey Margolis via RSS. Jamargolis@newyorkleaselaw.com