The FranchiseVoice

Leasing of the Business Premises: Considerations for the Franchisor

The premises from which a franchise operates invariably impacts the success of the business and, by extension, the franchise system.  Accordingly, the franchisor must ensure that the lease for the premises addresses the intricacies of the franchise relationship.   In particular, the franchisor will want to ensure that the lease acknowledges the importance of standardization within the franchise system, the need for periodic refurbishment or remodeling of the premises, the contractually prescribed use of the franchisor’s trade marks, logos and other commercial symbols on the interior and exterior of the premises, the importance of the franchisor being able to assume the lease and occupy the premises in certain circumstances, and the interplay which necessarily exists between the franchise agreement and the lease documentation.

Where the franchisor or the franchisee owns the premises, the leasing arrangement will be relatively straightforward.   Where a third party owns the premises (as is most common), however, the franchisor must consider whether it will enter into a lease directly with the landlord and subsequently sublease the premises to the franchisee or whether the franchisee will be required to lease the premises directly.   This determination is largely a matter of preference for the franchisor, having regard to the desirability of the premises, the financial resources of the franchisor, and the franchisor’s leasing policies.

Lease of Premises by Franchisor

Where a franchisor elects to lease the premises directly, the franchisor will select a location and negotiate the terms of an offer to lease, or a lease agreement, or both, with the landlord.  Once the lease has been finalized, the franchisor will enter into a sublease with the franchisee.  In so doing, the franchisor will want to ensure that all obligations, financial and otherwise, for which it is liable under the head lease, including the payment of rent, operating costs, utilities, insurance and management fees, as well as responsibility for maintenance and repairs, operating requirements, and compliance with applicable rules and regulations, are passed on to the franchisee.  In addition, the sublease should address the following:

(a) Landlord Consent – if the lease contains restrictions on subleasing the premises, the sublease should be conditional upon the franchisor obtaining the landlord’s consent;

(b) Term – the term of the sublease should be equal to the term of the head lease, less one day, or otherwise risk being characterized as an assignment;

(c) Compliance with Franchise Agreement –  the sublease should expressly require that the franchisee comply with the franchise agreement and all ancillary agreements;

(d) Use of Premises – the sublease should restrict the franchisee’s ability to use the premises for any purpose other than the operation of the franchised business;

(e) Transfer of Sublease – the sublease should prohibit the franchisee from transferring its interest in the sublease to a third party; and

(f) Default – both the sublease and the franchise agreement should contain cross-default provisions whereby a default under one agreement constitutes a default under the other.

Where the franchisee will be required to enter into a sublease in connection with the franchise agreement, the franchisor must include a copy of the executed lease and the sublease within the disclosure document.

Advantages:

The primary advantage of leasing the premises directly from the landlord is that the franchisor, as sub-landlord, will be well-positioned to regain control of the premises in an organized and seamless fashion upon termination or expiration of the franchise agreement.

A second advantage is that the franchisor will, for the purposes of applicable commercial tenancy legislation, be considered a “landlord” and will have the benefit of certain rights in relation to the leased premises, namely, the right to re-enter upon the premises and the right to distrain against the franchisee’s goods and chattels in the event of non-payment of rent.

A third advantage is that the franchisor may be able to negotiate more favourable terms than would the franchisee.  Additionally, the franchisor will be in a position to ensure that the lease coincides with the franchise agreement, as follows:

(a) Term – the term and renewal options of the lease should correspond with those of the franchise agreement;

(b) Use of Leased Premises – the permitted use set out in the lease should reflect the then- current nature of the franchised business, including the types of goods and services sold, but should not be so specific as to hinder the franchisor’s ability to make changes to the system in response to changing consumer demands;

(c)  Exclusivity – the lease should restrict the landlord’s ability to enter into a lease with a tenant engaged in a similar business;

(d) Signage – the lease should permit the use of signage displaying the franchisor’s trade- marks, logos and other commercial symbols on the interior and exterior of the premises; and

(e) Sublease – the lease should expressly permit a sublease of the premises to an approved franchisee.

Disadvantages:

There are disadvantages associated with direct leasing arrangements, the most notable of which is liability under the lease. If the franchisor has the financial and operational resources to operate the business as a corporate location, liability under the lease may be of minimal concern.  Where the franchisor lacks these resources, however, it may wish to cause an affiliated corporation to sign the lease, thereby shielding its assets from seizure by the landlord in the event that another franchisee is not immediately available to begin operating the business from the premises.   Additionally, the review and negotiation of commercial leases can be both costly and time-consuming for the franchisor.

Lease of Premises by Franchisee

A franchisor seeking to avoid the disadvantages associated with leasing the premises directly from the landlord may require that the franchisee enter into the lease, subject to the requirement that the franchisor, franchisee and landlord enter into a tripartite agreement or conditional assignment which grants the franchisor certain rights in relation to the premises.  These agreements typically include the following provisions:

(a) Approval of Lease – the agreement should render the lease conditional upon the franchisor’s  approval  and  should  incorporate  the  following  terms  into  the  lease  by reference:

1. a copy of all notices of default must be sent to the franchisor;
2. the franchisor will have an opportunity to cure the franchisee’s defaults under the lease;
3. the  franchisee  must  acknowledge  that  the  landlord  has  the  right  to  disclose information regarding the franchisee and the leased premises to the franchisor;
4. any assignment or sublease of the lease must be approved in writing by the franchisor; and
5. any amendment to the lease must be approved in writing by the franchisor.

(b) Modification of Premises – the franchisor should have the right to enter upon and modify, refurbish or remodel the premises in accordance with system-wide standards and specifications;

(c)  Operation by Franchisor – in the event that the franchisee is unwilling or unable to operate the franchised business, the franchisor should have the right to enter upon the premises and operate the business;

(d) Assignment of Lease – the agreement should permit the franchisee to assign its rights, title and interest in the lease to the franchisor, in the absence of landlord consent; and

(e)  Assumption of Liability – the agreement should clearly state that the franchisor assumes no liability in relation to the leased premises until such time as it expresses its intention to be bound by the lease.

Advantages

The primary advantage of structuring the leasing arrangement in this manner is that the franchisor has no liability under the lease unless and until it expressly assumes such obligations. For many franchisors, a tripartite agreement represents a balance between the unwanted liability associated with  leasing  the  premises  directly  from  the  landlord  and  the  lack  of  control  associated  with requiring that the franchisee do so.

Disadvantages

The primary disadvantage with permitting the franchisee to enter into a lease directly with the landlord is that the franchisor has no direct involvement in the negotiation of the lease. Consequently, if the franchisor elects to exercise its rights under the tripartite agreement or conditional assignment, the franchisor may be forced to assume obligations which are more onerous that those which it would have negotiated. In addition, the franchisor may find that, even with a well-drafted tripartite agreement or conditional assignment, cautious landlords may create administrative hurdles where a franchisor seeks to enforce its rights under those agreements, which may cause substantial delay and operational challenges for a franchisor looking to take possession of the premises on an expedited basis.

The foregoing is intended to provide franchisors and franchise counsel with a brief overview of the interplay between franchising and commercial leasing and to emphasize the unique issues which should be considered when structuring the leasing component of the franchise relationship.

First published in The FranchiseVoice (Winter 2014)

About The Authors:

Daniel So

As a lawyer at McKenzie Lake, I focus my practice on franchise and intellectual property law and have been referred to as an expert by the Canadian Legal Lexpert^® Directory. In addition to my practice, I am a franchise consultant for CBC’s Dragon’s Den. For further information view my biography at or email me at so@mckenzielake.com.

Melissa Won

I have experience in all aspects of franchise and intellectual property law. I also advise clients with respect to intellectual property and information technology matters. For further information view my biography or email me at won@mckenzielake.com.