Commercial Leases and Franchise Agreements

January 3, 2022by Brian Walsh

According to Forbes magazine, the franchising industry is booming as the effects of the Covid pandemic seem to be lessening. The opportunity to own a proven business model with a national brand is especially attractive to first-time business owners restarting careers. The location of a prospective franchisee is critical, necessitating the negotiation of commercial lease arrangements with property owners.

Interested Parties in a
Franchise Commercial Lease

After a site is identified, the first critical question is “who owns the property?” In a franchise arrangement, the property’s location whereby the franchised business operates is crucial to the company’s success (or failure). The franchisee must then determine “who will be the tenant?” under the lease. In some cases, the franchisor is the lessee and subleases to the franchisee.

The most common arrangement is the franchisee (as a corporation, Limited Liability Company, or sole proprietor) being the tenant with lease provisions acceptable to the franchisor. A franchise real estate lease typically involves three to four separate principal parties:

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  • Franchisee Business Entity. Business owners often elect to do business as a C-Corporation (Inc.) or a Limited Liability Company (LLC) to limit the principal’s liability, inherent when operating as a sole proprietorship. A C-Corporation or an LLC is a legal entity distinct from its owner(s).
  • Franchisor. A franchisor is a legal entity that owns the rights to a brand, supplier arrangements, and documented business practices used to deliver the franchisor’s products or services. In return for an initial fee and continuing royalties, the franchisor provides the use of a brand, access to specialized providers, and business training.
  • Property Owner.  The property owner provides business space to a franchisee to operate the franchisor’s business plan in return for a lease payment. Under the lease terms, the property owner gives rights to the franchisor to replace and assume the Franchisee Business Entity under certain conditions.
  • Individual Franchisee Owner. The individual(s) who own the Franchise Business Entity may be required to personally guarantee specific financial or performance obligations to the commercial property owner or the franchisor.

Understanding the impact of a commercial lease agreement on each affected entity is critical before accepting a lease contract. Inexperienced franchisees can unintentionally agree to lease terms that unnecessarily increase their personal and business risk or operating costs.

Franchisee, Franchisor,
and Property Owner Relationship

Franchise agreements typically require that commercial leases comply with specific franchise standards and requirements as a condition of the licensing of a franchise. Their requirements can conflict with the interests of the property owners and complicate negotiations.

Franchisees may not realize the nuances of a franchisor’s requirement for specific provisions in the lease. For example, the overriding priority of a franchisor is to protect its brand and usually includes the right to approve a franchisee’s location before opening the business. A franchise agreement typically gives the franchisor the right to intervene in property owner and franchisee disputes.

Conversely, a commercial property owner might expect the franchisor to indemnify the owner for any liability arising from franchise operations. The franchisor and property owner frequently require the franchisee (or the owner of the franchise in the case of a corporation or LLC) to guarantee the franchisee’s performance personally. Negotiation, agreement, and documentation of the resolved issues become necessary when the parties’ intent conflict.

Long, confusing boilerplate paragraphs appear in commercial real estate leases. A misunderstood or overlooked clause in the lease can become critical in a subsequent dispute. For that reason, no one should sign a contract without prior review by a licensed attorney in the State that governs the agreement.

Common Issues With
Commercial Franchise Leases

Common issues that arise in commercial real estate leases include:

  • Exclusivity. No business owner, including a franchisee, wants to have a competitor in proximity. They seek to be the exclusive provider of their service within the commercial property, whether mall, shopping center, or building. Since property owners seek to have total freedom to lease with any party, an exclusive clause should include a definition of the service, the geographical area of exclusivity, and remedies to cure defaults. Large retailers or service centers may be competitors if the percentage of their revenues attributable to a service similar to that provided by a franchisee exceeds a negotiated rate.
  • Co-Tenancy provisions. The presence of complementary businesses that draw customers to the area affects the desirability of franchise locations. For example, large malls and strip retail centers typically have anchor stores that consistently attract visitors. In the event of an anchor’s closure, provisions that lower the franchisee’s lease payment or permit the franchisee’s termination of the lease are desirable.
  • Business interruption contingencies.A protracted loss of business due to natural disasters (fires, floods, hurricanes), traffic interruptions (extended street repair or closure), or property management decisions (remodeling, parking lot repairs) can dramatically reduce franchise revenues for a period.
  • Transferability/Termination.Clauses in the event of a change in franchise ownership – voluntarily or involuntarily – are desirable, including a reduction or release of a franchisee’s guarantee. A contingency often overlooked is the change in ownership of the franchisor, including bankruptcy.
  • Additional products and services. A provision that permits the franchisee to sell all future products and services required or recommended by the franchisor is mandatory.
  • Franchisor rights. Franchisors often require clauses = “conditional assignment” – in a commercial lease that allows them to take over the lease if the franchisee defaults or the lease agreement terminates. A franchisor’s rights can include notices of franchisee defaults, proposed amendments to lease terms, or efforts by the franchisee’s attempt to assign the lease to third parties. Clauses to limit a franchisor’s rights in the event of certain events – disputes between franchisor and franchisee, a change in majority ownership of the franchisor, or the franchisor’s bankruptcy – may be warranted.
  • Personal liability limits. Provisions that affect the personal liability of the franchisee (or the individual that owns the franchisee) must specify the maximum dollar amounts of liability, particular circumstances and procedures for calling upon the guarantee, and alternative payment arrangements. Franchisees benefit from a schedule of negotiated, time-based periodic reductions in their liability exposure.
  • Signage and branding. Limits on the type, appearance, or location of franchise signage may be limited in the lease agreement.
  • Improvements, alterations, and fixtures. Lease provisions affecting the appearance or operation of the franchise business may be unreasonably restrictive. Negotiable issues include ownership of assets, financial liabilities, and operating responsibilities, including installing and maintaining the leased space and physical assets contained therein.
  • Lease terms and renewal rights.  Franchisees contract to use the leased commercial property for specific terms. Experienced franchisees recommend lease terms that match the duration of the franchise agreement. An alternative is a short term initially with provisions for the franchisee to renew the lease for multiple successive terms unilaterally.

Final Thoughts

Franchise agreements and commercial real estate leases are complicated and contain specialized language with unique meanings. An inexperienced reader may not know the legally assumed obligations under either contract.

The terms of a commercial property lease must allow the franchisor to protect its business interests and simultaneously permit the franchisee to operate profitability. Whether you are a franchisee or a franchisor, pursue the advice of an attorney experienced in franchise and real estate law before signing any agreement.

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