A franchisee will typically operate their franchise business from a fixed location. Both the franchisee and franchisor must then determine the most suitable strategy for securing a premises and entering into a lease. In particular, the franchisor will need to consider who holds the lease and how this will impact both parties if a dispute arises during the term of the franchise agreement. We explore how franchisors can structure the lease for their network.
What are the Lease Options?
Whether the franchisee or franchisor holds the lease is a commercial decision. The franchisor should consider the following:
- nature of the franchise system and size of the franchise network;
- risk and commercial factors regarding the premises; and
- potential exposure and liability.
The two most common strategies for leasing a premises are:
- The franchisee holds the lease; and
- The franchisor holds the lease and grants a licence to the franchisee to occupy the premises (with the landlord’s consent).
1. The Franchisee Holds the Lease
The franchisor may assist the franchisee to locate a suitable property and negotiate with the lessor to secure:
- control of the site selection;
- competitive rent;
- a rent-free period; and
- incentives for the franchisee.
Many franchisors provide this service and even charge the franchisee an additional fee. The franchisor, however, accepts the risk that they may be responsible if the site is unsuccessful. It’s good practice to reduce potential liability by obtaining a signed letter of acknowledgement from the franchisee stating that the franchisee will:
- conduct their due diligence concerning the premises;
- satisfy themselves that the location is suitable;
- enter into the lease as a result of their assessment of the premises; and
- not rely on any representations or statements the franchisor made relating to the suitability of the premises.
The franchisor is not responsible for fulfilling any obligations under the lease. If the business struggles, the franchisee (as lessee) will be liable for continuing to pay rent until the end of the lease term.
What Happens If the Franchisee Exits the Network?
With the franchisee as leaseholder, the franchisor will have no control of the site should the franchisee exit the franchise network. The franchisee may rebrand and continue to trade from the premises, exploiting the goodwill they acquired while operating under the franchisor’s brand. To avoid this, a franchisor should then request that the lessor:
- inserts a clause into the lease, which states that they will terminate the lease if the parties terminate the franchise agreement; and
- enters into a ‘step in deed’ which would be triggered should the franchise agreement come to an end.
A step in deed gives the franchisor a first right of refusal to enter into a new lease for the premises or have the franchisee assign the existing lease. This arrangement can be useful where:
- parties have terminated the franchise agreement, but the franchisor wants to retain control of the premises due to the success or prominence of the location; or
- the franchisee wants to sell the franchise.
Although this option limits a franchisor’s exposure, it’s important to remember that within a step in deed, the franchisor is vulnerable to losing the brand awareness the premises affords.
2. The Franchisor Holds the Lease
The franchisor can also act as the leaseholder and provide the franchisee with a licence to occupy the premises to conduct the franchise business. If the franchisee exits the network, the franchisor can take over the premises or grant franchise rights to a third party who can then trade from the property. The franchisor may also benefit directly from any rent reductions or incentives.
In this scenario, the franchisor maintains control of the premises throughout the term of the lease and franchise agreement. It gives them the right to access the premises and contact the lessor. These rights can be beneficial in many circumstances. For instance, if the franchisee doesn’t operate the business to standard or causes reputational damage to the franchise network, the franchisor can act quickly by entering and taking possession of the premises. They can also potentially terminate the licence to occupy the premises.
Well-known franchisors may be more appealing to a lessor, particularly when there may be an option to take multiple sites in various shopping centres. Lessors may be familiar with the franchisor’s rental history at another location and provide preferential access to new opportunities and premises as they arise or become available.
What is the Franchisor’s Responsibility Under the Lease?
The franchisor, however, will assume all liability under the lease agreement. Although the franchisor can pass these obligations on to the franchisee through the licence to occupy (e.g. payment of rent), the lessor has no contract with the franchisee.
If the franchisee fails to either pay rent to the landlord or licence fees to the franchisor (who then fails to pay the lessor rent), the franchisor would need to decide whether to:
- operate a corporate store from the premises,
- grant a franchise to a third party, or
- negotiate with the lessor to surrender the lease (this would be costly for the franchisor).
The franchisor may be able to recover these costs from the franchisee. However, the franchisor could find itself recovering unpaid rent from the franchisee through litigation and resolving any disputes with the lessor.
An effective strategy to reduce the franchisor’s liability is to have a director of the franchisee provide the personal guarantee required under the lease. The lessor could then commence proceedings against the franchisee director as there would be an existing contractual relationship.
A franchisor should also consider setting up a separate leasing entity to limit their exposure and liability under their leases. The franchisor should attempt to restrict the number of leases each leasing entity enters into, and any other functions that entity undertakes.
Both strategies present advantages and disadvantages for a franchisor. Franchisors must weigh up the risks versus the control they will exercise over the premises. This may vary on a case by case basis depending on the site. There are, however, steps a franchisor can take to increase control while minimising their liability.
If you have any questions or need assistance with your franchise lease strategy, get in touch with our franchise lawyers on 1300 544 755 or fill out the form on this page.
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