When setting up a franchise network, you will need to decide the leasing arrangements for your franchisees. Unless your franchisees are operating a mobile franchise or working from home, chances are the franchise will require a lease on a fixed premises. Although there is no “one size fits all” approach to franchising and leasing, franchisors and franchisees typically use one of three options to lease the premises:

  • The franchisee locates the premises, negotiates the lease and holds the lease.
  • The franchisor finds the premises, negotiates the lease, enters into the lease and then transfers the lease to the franchisee.
  • The franchisor locates the premises, negotiates and enters into the lease, and licenses occupation to the franchisee.

The following factors will ultimately drive what leasing method a franchisor (or franchisee) chooses:

  • nature of the franchise system;
  • risks that each party is prepared to take; and
  • the level of control that a franchisor wishes to retain over the premises/site of the business

We set out some of the advantages and disadvantages of each different type of leasing option:

Franchisees Holds the Lease

In this first option, the franchisee locates the premises, negotiates the lease and holds the lease.

Advantages Disadvantages
Level of Control The franchisee is less likely to “blame”
you for any issues with the site
chosen.
The franchisor does not have control of the premises if they are required to terminate the franchise agreement. It is always easier to terminate or transfer a franchise
if the landlord franchisor retains
control of the premises, particularly
mid-way through a lease.
Operational exposure The franchisor has the least risk and operational exposure of any of the options. If the tenant does not pay rent, it does not fall on the franchisor to pay it. If the franchisee stops paying rent, you may lose the site to a competitor without even being made aware by the landlord.  In addition, if the franchisee has a falling out with you and stops paying franchise fees it is not as easy to force them to stop trading given they have physical control of the site.  If they re-brand and continue to compete you rely on the restraint rather than being able to physically remove them from the site.  This legal action may cost significant sums if you want them to stop trading in competition with you (compared to being able to push them out if you control the site).
Finance There is no financial risk for the franchisor as the lease is in the tenant’s name and is the tenant’s responsibility. See above.  If you want to enforce the restraint it may be an expensive exercise to do so if you do not have control of the site

Franchisor Assigns the Lease to the Franchisee

In this second option, the franchisor locates the premises, negotiates and enters into the lease and then assigns the lease to the franchisee. The franchisor may also operate the store for a period.

Advantages Disadvantages
Operational Exposure There is increased exposure but also the opportunity for increased returns by selling an operating business. This has the greatest risk. You may not find a franchisee to take over the site in which case you may have to run it indefinitely. The franchisor may have increased liability for site selection, the lease terms etc. if they are not ultimately suitable.
Level of Control The franchisor retains control of site selection and sells the “package” to the franchisee. The franchisor is more likely to be “blamed” by the franchisee if the site does not work out.  Even if there is no legal issue, the franchisee may feel as though you should have known better, so it will be important to manage expectations and ensure you do not give them the impression you are guaranteeing anything with site selection.
Finance There is the ability to increase your returns should you find a willing and qualified buyer. There are significant costs of fit out and initial operation which may not be recouped on sale depending on the performance of the store.

Franchisor Licenses Occupation to the Franchisee

In this third and final option, the franchisor locates the premises, negotiates and enters into the lease and licenses occupation to the franchisee.

Advantages Disadvantages
Level of Control The franchisor retains absolute control of the transaction, site and lease. The franchisor can step in and terminate a franchise relationship and keep control of the site if this is required. This has the greatest degree of control so there are few issues here for the franchisor.
Operational Exposure The franchisor has a direct relationship with the landlord and therefore is directly liable for rent regardless whether the franchisee pays the franchisor. Clearly this is a significant disadvantage of this option – if the franchisee abandons you will be solely responsible for the rent for the remainder of the lease.
Finance The franchisor knows exactly what is happening with rental payments and will know if the landlord has an issue with payment. If the franchisee abandons the site, the franchisor will be responsible for rent and make good.  This is a significant risk.  The franchisee should pay a significant security deposit to cover these risks and even then you are still potentially exposed to loss if the franchisee abandons.

 

We generally recommend that the franchisor (through a separate leasing entity) sign the lease but the franchisee provide the personal guarantee.  In this way, you get the benefit of control without the risk associated with the personal liability of the lease.  Of course, there is still the responsibility of the leasing company to pay rent if the franchisee abandons the site, but at least there is no personal liability borne by the franchisor in relation to the lease.

The precise circumstances of your business should determine which option you adopt and your legal advisor can recommend the best option for your circumstances.

If you have any questions about setting up a franchise, or leasing arrangements for your franchise network, get in touch with LegalVision’s franchise lawyers.

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This article was an extract from LegalVision’s Franchisor Toolkit. Download the free 32-page toolkit featuring case studies from leading Australian franchisors.

Tim Mak
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