End of Year Leasing Health Check for Franchise Tenancies
It's that time of year again, where many of us start to wind down (or in some cases, wind up prior to the Christmas deadlines) and start thinking about whether our house is in order. As such, Coleman Greig would like to remind you of some of the common pitfalls that we often see in our leasing practice, particularly within the world of franchising.
Don't leave things to the last minute
If you are approaching the final 12-18 months of your lease, you will need to start thinking about when your option to renew needs to be exercised. This is a very important question, as I often see my clients miss deadlines for exercise of option.
This may be a critical factor if you are a franchisee and a condition of your franchise agreement is to have a lease signed within your particular territory. If you do miss your opportunity to exercise the option, you are likely to find yourself in a very difficult negotiating position with the landlord - who may still agree to similar lease terms, but may impose some new conditions that are less favourable to you and your business. If you are desperate enough to want to retain your premises (potentially due to your business' goodwill being tied up in the site), you may be forced to agree to unfair or unreasonable terms simply due to you not having anywhere else to go.
Whilst you may indeed exercise your option to renew your lease in time, if your rent is subject to a market review, you might not be left with enough time to consider what the market rent could be, and could in turn be left in a very difficult position where you are forced into a market rent that you don't agree with, due to time constraints.
If on the other hand you manage to get in early, you may be able to place yourself in a position to control negotiations for the market rent. In fact, under the Retail Leases Act, you may be permitted to request a market review ahead of the date for exercise of option, which would put you in a position to make an informed decision with regard to exercising your option.
In any event, I suggest that you consider reviewing your lease terms before the end of the year, and that you similarly take a look at when your option to renew is up, as well as the basis upon which your rent will be reviewed.
Generally speaking, your lease will state that you must provide either a bank guarantee or cash deposit. There are many variations on the terms relating to this form of security, however it is often the case that the lease allows the landlord to increase your bank guarantee or cash deposit in line with any rental increases that you have been requested to pay over the course of the year.
Again, if you are likely to find yourself in this position (particularly if your franchise business falls within the retail sector, which is both struggling and facing a tight credit environment), you may wish to think ahead and consider whether your bank will be prepared to allow an increase in your security. If they are unprepared to do so, you may need to consider alternative ways to finance your increase in security. It is important to remember that if you cannot provide the updated security as requested by the landlord, they may terminate the lease and have subsequent grounds to hold you in breach of the lease (and will thus have the ability to terminate the lease). Coleman Greig has seen this happen before.
Is it time for a makeover?
Generally speaking, your lease will at some point require you to carry out some form of refurbishment (e.g. either at the end of the third or fifth year of your lease, or at the end of the initial term). This will be even more likely if yours is a retail lease. Depending on the landlord, these requirements may be quite expensive, therefore as the year draws to an end it may be time to review your lease and determine whether you are facing the prospect of a refurbishment in the new year.
It is important to align this with what your franchise agreement states with regard to national branding and standards, and to consider whether or not you have the finance to be able to afford this. It may be time to have a discussion with your landlord to see whether they might be prepared to waive this requirement, particularly if you are struggling in a tight retail market.
Is it time to put the 'For Sale' sign up?
It may be the case that as the year draws to an end, you start to contemplate selling the business located within the premises that you currently occupy. This could be due to your franchise not doing so well, you deciding that it's time to cash in, or you may have found yourself in circumstances where you cannot continue to operate the business due to either health reasons or other personal commitments.
Whatever the case may be, you need to consider the requirements of your franchise agreement, lease and any other ancillary documentation in order to enable the sale of the business. For example, you will need to clarify the requirements for obtaining the landlord's consent to assign the lease, if you are going to sell the goodwill of the business and therefore will assign your lease or rights to a new buyer, or alternatively transfer the shares in the tenant entity.
Either way, you will need to consider well in advance what any such sale or assignment will trigger - for example, you might see a clawback by the landlord of any incentives that were previously provided. Within the context of incentives, your lease may state that in the event of an assignment or sale of shares in your business (and your lessee company), the landlord is able to recover either the whole, or part of any incentive provided, which may in turn diminish the value of the sale of your business.
You also need to consider what other obligations you have when assigning the lease. For example, it may be that if the lease is in your name as the franchisee, your franchisor has step in rights to have the lease assigned to them prior to you offering it to somebody else. The landlord themselves may similarly have step in rights, or rights of first refusal, meaning that prior to you offering the lease to a new party, you are required to offer it to the landlord first.
As you are winding down towards the end of the year and reflecting on the many individual factors which might influence a decision to sell your business, I would urge you to start reviewing your documentation well in advance in order to ascertain exactly what you need to do to ensure a smooth and effective sale.
I am deciding to close the door - what are my 'make good' obligations?
As the new year approaches, it may be that the terms of your lease and your franchise agreement are coming to an end, and that you are not going to renew either arrangement. If that is the case, you will need to consider what your 'make good' obligations are.
Over the years I have encountered too many instances of clients not considering the 'make good' requirements of their leases early enough prior to the end of their terms, and where they have subsequently found themselves in very difficult positions. This is due to the fact that if they don't make good in accordance with the lease (as perceived by the landlord), the landlord has the ability to continue charging rent until the tenant does make good. The worst-case scenarios that I have seen have involved landlords commencing actions against my franchise clients for failure to make good in accordance with the lease provisions.
Difficulties can arise with regard to franchisees meeting their 'make good' obligations, often due to either:
- the franchisee not being the first occupant of the premises; or
- the landlord changing, meaning that the ownership of the property may have changed hands during the course of the lease.
Either way, there may be a lack of corporate history relating to what the condition of the premises was like prior to it being handed over to the franchisee. In such situations there is ambiguity, particularly where the 'make good' provision states that the tenant must return the premises in the same state that it was in prior to the assignment of the lease.
With this in mind, I strongly recommend reviewing your lease well ahead of your termination date in order to see what your make good obligations are, and to ensure that you are able to have a smooth exit from the premises.
Some questions to ask when looking at the 'make good' requirements of your lease are:
- Does your lease say that you must return to a bare shell?
- Does your lease say you are only to remove those items that you installed in the premises, or as the landlord directs?
- When can the landlord return your bank guarantee or cash deposit? It is important to remember that the lease usually states that the security will not be returned until such time that you have satisfied your obligations under the lease - this will include your responsibility to 'make good'.
I want to add another string to my bow
The leadup to the end of year may see you contemplating the purchase of another franchise, and in turn potentially entering into another new lease. If this is the case, there are some key due diligence questions that you might need to consider prior to entering into the lease.
These questions include, but are not limited to:
- Do the numbers stack up - are you exposing yourself financially by taking on the obligation of another lease? Don't forget that once you sign the lease you will be bound by the terms of that lease, including the full rental and other monetary obligations. It won't be possible to back out of the agreement once it is signed.
- If you are taking on another franchise, what are the fit-out costs going to be, and what are the components of the fit out? For example, will you need to spend significant funds on the alteration of key services such as water, electricity, drainage and ventilation? These are commonly referred to as Category 1 works, and you might consider negotiating a cap on those costs.
- Will your bank allow you an additional bank guarantee?
- Have you seen an accountant to work out what the best structure is going to be for your tenant entity?
- Have you considered what other funding you will need for the fit-out? Will you need to encumber any of your fit-out or equipment, and will this require the landlord's consent? I have seen many a sad situation where the parties can't agree on the financier's requirements, including encumbering items covered under the lease.
There is much to ponder as the year draws to a close
If you run a franchise business that involves a lease, there will be much to think about as the year draws to a close. As the head of the Commercial Property team here at Coleman Greig (and as someone with a passion for leasing), I urge you to reach out if you feel that any of the information in this piece may apply to you and your business - or if you have a separate leasing matter for which you would like to speak with an experienced property lawyer: