ChaPter 7: insiGhts into LeasinG

ChaPter 7

insiGHts into LeAsinG

samuel rees | sole owner and Principal IP PARTNERShIP LAwyERS

About the Author

Sam has practised exclusively as a commercial lawyer with a focus on franchising and Intellectual Property since 2013. Sam and his law practice predominately act for Franchisors and other small to medium business owners located Australia wide. Sam takes pride in his pragmatic and no-nonsense approach to providing tailored legal services. Sam is the sole owner and principal of IP Partnership Lawyers, a modern boutique law firm based in Queensland specialising in franchising, intellectual property and commercial law. Sam’s passion for Intellectual Property stemmed from his life prior to law, as a song writer and musician. Sam values the strong and ongoing relationships he has with his clients and his firm, IP Partnership, is a reflection of that ethos.

There are risks getting in the ocean for a swim, getting on the road and driving a vehicle, or hopping on a plane. In Australia we mitigate the risk of drowning in the ocean by swimming between the flags, we wear a seatbelt while we drive and we, often begrudgingly, wait on the tarmac - on captain’s orders - if the weather is too treacherous to fly. As a solicitor that practices solely in commercial law with a focus on franchising and leveraging intellectual property, part of my job is to mitigate risks my clients’ face in business. Just like getting in the ocean, a car or a plane there are – albeit not life threating – risks that need to be considered when buying a franchised business. Perhaps one of the most overlooked - but also potentially most risky - contract, is a Lease.

Potential Franchisees who are considering buying, what is colloquially referred to as, a ‘brick and mortar’ franchised business, one or more of following three documents will be necessary:

a) A Lease;

b) A Licence to Occupy (or sub lease); and/or c) A Step in Deed.

This chapter will provide some insights to potential franchisees if faced with the requirement to sign a Lease, Licence to Occupy and/or Step in Deed.

leASe

If the Franchisor does not own the freehold property or does not hold the head lease on the premises, a brick-and-mortar Franchisee will be required to enter a Lease with the Lessor (the owner of the premises).

It is mind boggling that a Franchisee will often have a solicitor review their franchise agreement however will enter a lease without a second thought. The lease is a contract that is just as important to a franchisee, or perhaps even more so, than the franchise agreement.

Picture the analogy earlier in this chapter of the plane waiting on the tarmac for the bad weather to pass. Consider this chapter as a storm warning; matters with potentially dire implications for an ill-informed franchisee. In other words, the captain - which is you - should not take off from the runaway, on the flight to destination ‘operating your franchised business’ until you are satisfied the following common lease clauses are not an issue:

1. rent review

A standard lease will contain, in general, three different methods of increasing rent during the term and renewal terms of the lease:

a) CPI;

b) Fixed percentage; and/or c) Market review.

Cpi

Most Lessors find it difficult to come to terms with the fact that it is no longer the “glory days” of years gone by. The Consumer Price Index (CPI) at the time of publication of this book is …………… and it is for this reason new leases rarely increase rent by CPI. It is however the most fair method to increase rent. If, very crudely, inflation goes up, and the costs of goods and services goes up, so too should rent. If, as a franchisee, your lease increases annually by CPI, consider this one less storm front to worry about in the sky.

FiXed review

A fixed percentage review is most common; however lessors need to be careful of increasing rent using a percentage that exceeds inflation. Generally, the most common fixed percentage rate is 5%. It is common, and certainly acceptable, for a franchisee to request the fixed increase be reduced to 2% or 3% in today’s market.

Often a franchisee’s eyes will completely gloss over contemplating the fixed percentage rent review. Perhaps when talking in terms of 1% or 2% it sounds insignificant and perhaps conceptually the amount of money this equates to is insignificant too. This is not the case. Over the full term of the lease (that is, for example, 5+5+5 = 15 years) the difference between a 2% annual rental increase and 5% increase can be many thousands of dollars.

Often franchisees will attempt to avoid incurring legal costs to have their lease reviewed. They fail to realise, however, the benefits – sometimes as obvious as the amount paid in rent over the full term - far exceed the upfront legal costs. But I digress. The point I am making is a franchisee often will save money, by initially spending money having a commercial solicitor review their lease.

marKet review

A lease will typically contain a Market Review clause at the exercise of each option. Market Reviews are generally a good thing; however a franchisee must ensure the lease does not contain, what us lawyers refer to as, a ‘Ratchet Clause’. Picture a Ratchet Clause as a black storm cell in your flight path.

A Ratchet Clause will prohibit the rent from being less than what a franchisee is currently paying prior to a Market Review. This is not in the best interest of a franchisee. If the market has changed, the rent should change to reflect the market - whether that be higher or lower.

In short, Market Reviews are excellent and should occur, at least, every five years and certainly no less than at the exercise of every option. Further, and to repeat the above, if there is a Market Review clause in the lease it must not be accompanied by a Ratchet Clause; rent should be able to go down if the market is down.

2. Guarantors

It is industry standard for lessors to require directors of the lessee entity to be personal guarantors on the lease, however just because ‘that’s how it has always been done’ does not mean you cannot attempt to depart from the old way of doing things. We always ask for the individuals of our franchisee clients to be removed as guarantors on leases. A franchisee does, however, need to consider their leverage when making such demands. If the premises is a popular spot, a franchisee will need to consider their bargaining position before making these types of unusual demands.

Consider all the clever structuring you may have put in place to operate your franchised business and protect your personal assets. In terms of asset protection, this is all redundant when you enter a lease in your personal name. When you enter a lease in your personal capacity (as a Guarantor), all assets in your individual name (including your family home, cars and personal savings) are now at risk if you default on the lease. That said, its important to understand it is industry standard to enter a lease in your personal capacity if signing a Lease as a company or trust. This means you either need to be in a great bargaining position – that is, there is not a lot of competition for the premises – or you need to offer a higher bond or bank guarantee, to avoid being personally liable.

3. make good

The make good clause is so important to understand before entering a Lease. A franchisee comes to mind who entered a lease for an already fitted out premises. They walked into a $700,000.00 fit out and were able to start operating the franchised business with low capital outlay. The franchisee could not wait to sign the lease (and signed it without advice). Walking into a fit out suited this franchisee because they had very little capital. Unfortunately, the franchised business was unsuccessful (perhaps it should have been a warning sign that the last franchisee went under and left the fitout behind). The franchisee stayed in the premises until the end of the term of the lease and went to hand the keys back. The lessor pointed out the Make Good clause in the lease and demanded the franchisee strip the premises back to bare walls, repaint the walls inside and out, and resurface all flooring. It is important to understand a lease may contain a clause requiring a lessee to strip the premises back to bare walls even if it were not bare walls when you signed the lease.

The best Make Good clause for a franchisee, is to leave the premises in the way it was found, fair wear and tear excepted. Had the above franchisee realised it would be liable for putting the premises back to bare walls, which came at a significant cost, the franchisee would not have entered the lease, despite the ‘free fit out’ at commencement.

4. Assignment

I had a client who told me, “Every time we try to sell the business the lessor rejects the buyer.” It was the client’s third attempt to sell his business. He had people wanting to

purchase, however the lessor was simply not willing to release him from the lease and allow someone else in. This client had operated the business for over fifteen years and the lessor simply was not prepared to take the risk on someone else.

Unfortunately, whilst his lease contained the standard provision stating that the lessor must act reasonably when considering a potential assignment, it also contained a number of other clauses in the lessor’s favour. They were impossible hurdles to overcome unless selling to a buyer with the same fifteen years’ experience. This was not so much an issue of dangers in the flight path, but rather, the guy could not get off the plane!

A lease should clearly specify what the lessor requires in terms of a buyer. This way, if a buyer is found who meets those requirements, there can be no reasonable excuse for the lessor to refuse to assign the lease.

5. Structural works to premises

I recall acting for a multi-site franchisee who operated an unusual franchised business. In order to operate the franchised business significant structural changes had to be made to the premises. The franchisee had been advised lessor approval was required prior to commencing structural works, however did not think much of it. I assume they thought, ‘the lessor knows the business I am going to operate in the premises, surely they would not enter a lease with me if they did not understand significant works need to be carried out’. They were wrong.

After signing the lease, the franchisee starting drilling holes into the slab excited to start operating their franchised business. The lessor immediately issued a breach notice for failing to obtain approval for the works. The franchisee was unable to operate their franchised business and was liable for rent on a seven-year lease. It was a unique premises so it would take time for the Lessor to mitigate its losses and find a new tenant. The franchisee was liable for rent under the lease until the lessor could locate another suitable tenant.

This unfortunate situation could have been easily avoided by taking the time to discuss the structural works intended to occur in the premises before signing the lease.

PermItteD uSe

Finally, but perhaps most importantly, before entering a lease a franchisee should ensure the premises has the necessary approvals to operate the franchised business, and it is suitable. All too often this is not the case. A franchisor will often assist a franchisee to locate a suitable premises, however it is important to not rely on the franchisor to conduct searches and do due diligence. At the end of the day, it is you, the franchisee signing the lease who will be liable.

This happens a lot with gym franchise businesses. A client comes to mind who located their own premises and negotiated their own lease. The franchisee fell in love with

the location and assumed, based on the fact that a gym was already in the premises, that council approval would be easy. The assumption was incorrect. The franchisee signed the lease (against our advice) and started operating the franchised business. They played music loudly, ran around the car park, and neighbouring tenants (picture ballerinas doing pirouettes) grew tired of hearing “give me another 10 push ups!” over the thumping bass of the techno beats.

The franchisee received a breach notice from the lessor for making too much noise (incurring the lessor’s solicitors’ costs for each breach). The council approval was not forthcoming and this was used as leverage against the franchisee. Lessors will literally (and legally) enter a lease where the permitted use is stated as ‘a gym’ and then rely on clauses in the lease stating, in layman’s terms, ‘the lessor makes no warranty the premises is suitable for the permitted use’.

The franchisee tried everything; taking numerous decibel readings and sweet talking the ballerinas, however long story short, the franchisee was required to vacate the premises. It came at a cost. This could all have been avoided by ensuring, prior to entering the lease, the premises was suitable and had council approval.

lICenCe to oCCuPY

If a franchisee is not required to enter a lease a franchisee will be required to enter a licence to occupy. This occurs when a franchisor enters the head lease and grants the franchisee a sub-lease (right to occupy the premises). The reason a Franchisor does this is to maintain control.

Restraint of trade clauses are difficult to enforce and the recent Franchising Code of Conduct amendments have made it even more difficult for a franchisor. If, however, a franchisor holds the head lease on the premises where a franchisee operates, when a franchisee goes ‘rogue’, a franchisor will simply terminate the franchise agreement and terminate the licence to occupy. A franchisee is required to vacate the premises. The franchisor does not need to rely on a restraint of trade clause to stop a franchisee operating a competing business from the premises, the franchisee is simply kicked out of the premises.

There is a large risk for franchisors holding the head lease on premises where franchisees operate. This is because if a franchisee stops paying rent, the lessor will look to the franchisor.

About five years ago, a franchisor called me on my mobile phone on New Years Day. During the busiest time of the year a franchisee, who occupied the premises pursuant to a Licence to Occupy, had failed to open their store in a popular Shopping Centre. The franchisee had stripped the premises of any valuable stock and abandoned the franchised business. Abandonment is an immediate termination provision under the franchise agreement and Code (The 2021 Code amendments now require seven days’

notice). This was incredibly stressful for the franchisor, however when two more Franchisees did the same thing in the following days, it went from being incredibly stressful to financially crippling for the franchisor. The franchisor was liable for rent on three premises in three different busy shopping centres.

Holding the head lease is the ultimate way a franchisor can control the situation where a franchisee terminates the franchise agreement; The franchisor can kick the franchisee out, operate the business, and sell that location to a new franchisee as a going concern. When this is done in an unethical way by franchisors it is what is referred to as ‘churning and burning’ franchisees. It occurs when franchisees are unaware of the many failed franchisees who have come before them at a particular premises (when it is obviously not a suitable location) and the franchisor churns through numerous franchisees at the same location where the franchisor holds the lease… a number of readers may recognise the well-known franchise who was alleged to have done this exact thing.

A franchisor does takes on a lot of risk holding leases on numerous locations. If Franchisees all vacate at similar times, this can be devastating for an entire franchise.

In short, a franchisee really does not have the ability to request that the lease be in its name, if a franchisor holds the lease, however in the writer’s opinion it would certainly be in the franchisees interest for this to be the case.

SteP In DeeD

Finally, if a franchisee does hold the lease in its own name it is likely the franchisor will also require the franchisee to sign a document called a ‘Step in Deed’. The Deed is a tripartite agreement entered into by the lessor, the franchisor and the franchisee. The document is for the benefit of a Franchisor only. It is certainly prudent for all franchisors to ensure their franchisees sign a Step In Deed if the franchisee holds the lease. In a nutshell, it provides the franchisor with all the benefits of a Licence to Occupy (as stated above) but without the franchisor being required to take on the risk of being bound by the lease if it elects not to.

A Step in Deed operates like so. When a franchisee’s franchise agreement is terminated, for whatever reason, the Step in Deed gives the franchisor the option (but not the obligation) to kick the franchisee out and take on the lease. A franchisee may have built a good customer base at a particular location but has decided it no longer wants to be a franchisee. The franchisee may give notice that it does not wish to renew a franchise agreement, or may even blatantly breach it and attempt to ‘de-badge’. In this fact scenario, the franchisee has the intention of operating under a new brand from the same location. Such intentions, if a Step in Deed exists, are futile. The Franchisor will simply exercise its right under the Step in Deed to have the lease assigned from the franchisee to the franchisor. The franchisor is then able to continue supplying goods or services to the established customer base until such time as a new franchisee can

be located to purchase the business as a going concern. Essentially the franchisor can decide whether or not they want the lease, and if they want it, they have the right to have it assigned to them.

A key piece of pragmatic advice to franchisees who may wish to avoid entering a Step in Deed, is to simply develop a good relationship with the lessor. This is not difficult if the franchisor is not involved in the lease negotiation. Ultimately, it is the lessor who decides whether or not to enter a Step in Deed with the franchisor. There is absolutely no benefit to the lessor. If a franchisee can convince a lessor not to enter a Step in Deed, there is no Step in Deed.

ConCluSIon

In conclusion, swim between the flags, wear a seat belt and just as you would not feel comfortable taking off in a plane in horrible weather, it is important for franchisees to ensure you have the ‘all clear’ before entering a lease.

SAmuel reeS | Sole owner and Principal IP Partnership lawyers

07 5591 2522 sr@ippartnership.com.au www.ippartnership.com.au