Key Issues in Franchise Lease Agreements

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A properly negotiated lease protects the franchised business, as well as the franchise network and the brand.

By Matthew Brandt
 
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Experienced and start-up franchisors alike would agree that a key element in operating a successful franchise system is obtaining great retail locations in which to operate franchised units. The old adage “location, location, location” is not merely a cliché, but is a hard truth that franchisors must realize when doing business. Whether you are a seasoned franchisor in the midst of expansion or a corporation planning to enter the franchised marketplace, it is important to secure leases that properly protect your ownership interest in the franchised business. This article will explore a few key lease provisions and negotiation approaches that are unique to leases for franchised locations.

What Use Is Permitted?

Most landlords will want to restrict the use of the premises, therefore, the permitted use and exclusive use clauses are often the most negotiated clauses in a retail lease. First and foremost, the franchisor must guarantee that the use clause permits it (or its franchisee) to operate the franchised business at the premises. Franchisees typically want a broad use clause to have more flexibility in the event the business fails. Franchisors want the use clause narrowly tailored to limit the franchised unit’s operations of the premises to the use set forth in the franchised agreement. Franchisors, however, must be careful as to negotiate certain carve-outs to the use clause in order to anticipate changes in the franchised business. A use clause must always include language that allows the use to be modified as changes to the franchised business occur. For instance, a coffee franchise’s use clause should include language stating that “the premises will be used primarily for the sale of coffee and other menu items typically found at other locations operating under the trade name.” Thus, the location will be able to sell breakfast sandwiches if the franchised business expands to include breakfast food service.

Too Many Cooks in the Shopping Center

Just as landlords will want to restrict the use of the premises, the franchisor will want to restrict the use of the surrounding shopping center to protect against competition. A “hamburger chain” franchisor will want assurances from the landlord that it will be the only restaurant serving hamburgers in the shopping center. Traditionally, retail leases tie an exclusive use clause to a percentage of sales; however, such provisions are difficult to monitor and enforce. In drafting an exclusive use clause, the best practice is to restrict a competitor by being specific in drilling down on the items for which the exclusivity applies, naming specific types of competitors, and limiting the amount of exclusive items on another tenant’s menu or by limiting the percentage of floor area in which another tenant may use to sell the exclusive items. 
The franchisor must make sure there are explicit remedies and rights in the event that the landlord violates the exclusivity clause. A franchisor should demand an abatement of rent and a right to terminate after a period of time if the violation of the exclusivity provision persists. A powerful landlord will likely ask for a radius restriction if it gives the tenant exclusivity. The franchisor should reject the radius restriction if the franchisor itself is entering into the lease for a “corporate store.”  If the premises is a franchised unit, the franchisor must confirm that the radius restriction only binds the franchisee, allowing the franchisor to open other units — either as corporate stores or through separate franchise agreements — in the market.

Exercise Control

Expansion and brand protection are two of the biggest concerns for franchisors. Drafting favorable assignment provisions amongst its leases is an important component to a franchisor’s ability to freely expand its franchised business. A franchisor entering a lease as a tenant (i.e., for a corporate location) must require a more lenient landlord standard for approval of the assignment of its leasehold interest to potential franchisees. If a franchisor wants the flexibility to operate fewer corporate locations in the future, the franchisor will need to be able to freely assign the corporate leases to franchisees. In terms of brand protection, if a franchisee is directly entering into a lease, the franchisor should require the franchisee to negotiate an assignment provision in which the lease may be assigned to either the franchisor or another franchisee without the prior consent of the landlord. This would allow the franchisor to take over the lease, and if desired, to subsequently assign it to another franchisee in the event the franchisee is not complying with the franchise agreement or if the franchised unit is underperforming.

Many franchisors prefer to address assignment rights through a lease rider which is often attached to the lease. Assuming that the landlord accepts the attachment of the lease rider, the franchisor should ensure that the rider contains the following: (i) a conflict provision which states the terms of the rider controls in the event of conflict with conflicting lease terms; (ii) a collateral assignment provision; and (iii) a notice provision which obligates the landlord to deliver notices to the franchisor simultaneously with any notice delivered to the franchisee. In the collateral assignment provision, the franchisee assigns its rights under the lease to the franchisor, giving the franchisor the ability to “step into the shoes” of the franchisee in the event of a default under the lease.  The landlord’s consent to the collateral assignment must be obtained prior to lease execution; otherwise, the landlord may not be obligated to honor the franchisor’s rights. Further, a franchisor needs to be notified of any default under the lease or the landlord’s disapproval or approval of any request sought by the franchisee so the franchisor may react appropriately. Lastly, prudent franchisors will include language in the rider preserving recovery rights against the franchisee in the event of default.  

Brand Protection

To help protect the franchisor’s brand, the franchisor must be able to monitor its franchisee’s performance under the lease. Either through a lease rider or the lease itself, the franchisor must be notified in the event the franchisee defaults, and be given the opportunity to step into the shoes of the franchisee and cure any default. Franchisors should push for additional time beyond the cure period provided to the franchisee to cure the default. Importantly, franchisors must confirm that the franchisor has the option, not the obligation, to cure its franchisee’s default.  

Vacant stores can do irreparable damage to brand image. A careful franchisor will seek the rights to “de-brand” the leased premises at the expiration of the lease term. All franchised businesses have brand specific signage, furniture, fixtures and equipment, as well as other marketing materials, within each franchised unit location. When a lease or franchise agreement expires or terminates, the franchisor must be allowed to enter the premises and reclaim signage, furniture, fixtures and equipment in order to protect brand image. The landlord may want to claim such items at lease termination; however, the franchisor must have superior rights to brand specific items. In “de-branding” the premises, franchisors should be careful not to agree to restore the premises to the condition the franchisee was required to surrender it to the landlord. 
All franchisors must do their due diligence in reviewing lease agreements for either itself or its franchisees. If not, there is a good chance that the brand will suffer. A properly negotiated lease protects not only the franchised business, but also the franchise network and the brand. 
Matthew Brandt is an Associate at Greenberg Traurig’s Chicago office. 

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