Franchisees can be among the best tenants for a retail landlord. They tend to generate above-average customer traffic and revenue, and can increase property values and cash flow to other tenants. Franchisees are using a proven business formula and they can look to the franchisor for valuable assistance. Finally, to a greater or lesser degree, the franchisor will police the franchisee in matters of operations and finance in many areas where the landlord will benefit.
Often, however, the franchise agreement between the franchisor and the franchisee will have a direct influence on the franchisee’s property lease with the landlord. A usual provision required by franchisors is a “collateral assignment” of the franchisee’s interest under its real estate lease. This provision, which grants the landlord a security interest in the franchisee’s lease as security for any defaults by the franchisee under the franchise agreement, will spur a number of corresponding changes in the lease agreement itself, even though the franchisor may not be a party to the lease. The collateral assignment does not necessarily make the franchisor a party to the lease, and it does not mean that the landlord can hold the franchisor liable if the franchisee fails to perform. But it does mean that where the tenant-franchisee breaches the franchise, the franchisor can take possession of the leased premises and voluntarily assume the franchisee’s obligations.
Naturally, the collateral assignment needs to be written into the lease and will be the subject of negotiation -- sometimes intense negotiation--with the lessor. In exchange for creating these third-party rights through the collateral assignment, the landlord can negotiate for the franchisor’s guarantee of the lease, rights to approve any transferee-franchisees, or the franchisor’s agreement to perform specific obligations under the lease if the franchisee fails to do so.
Some franchise operations, in order to better control the franchisee, require that the franchisor be the lessee who will then, in turn, sublet the business premises to the franchisee. This kind of structure creates new negotiating and documentation complexities of its own, and a national franchisor will have far greater bargaining power than the typical franchisee.
- The franchisor’s involvement in the lease between the franchisee and the landlord can raise a host of related issues and problems that will be important to the landlord:
- The franchisor will be interested in making sure that the franchisee’s lease has a lease term at least as long as the term of the franchise agreement. On the flip side, the franchisor may demand that the lease terminate if the franchise agreement terminates.
- Some franchisors look for leases that account and accommodate for transformations of the franchisor and the franchise business, such as where one franchise operation merges with another. These will require drafting around potential changes in use, appearance or branding of the leased premises.
- Signage, advertising and “marking” rights to correspond to what is required of the franchisee in the franchise agreement. The franchisor will also want provisions giving the franchisor rights to enter the property to “de-mark” the premises, that is, to strip off the franchisor’s marks, if the franchise is terminated.
- Restrictions on the franchisee’s use of the lease premises and on the landlord’s rights to lease to other tenants that could compete with the franchisee.
- Provisions that restrict subletting, or allow subletting to the franchisor or another franchisee. Some franchisors will demand that the lease provide that the lease can be automatically assigned to another franchisee if the original franchisee loses the franchise.
- Requirements that the franchisor receive notices of default under the lease or giving the franchisor the right to cure, or to assume and assign the lease.
Leases with franchisees are usually more complicated than those that do not have to account for the interests of a franchise organization. However, the franchisor’s involvement can enhance the value of the lease to the landlord who understands the underlying franchise arrangement.
This post was written by attorney Rick L. Knuth