Although intellectual property is often at the heart of a franchising relationship, the franchise will usually require premises from which to run the business. All the parties involved (the franchisor, franchisee, landlord and any guarantor) should be aware of potential property-related risks and how they can be managed.
The franchise relationship
In exchange for making a lump sum and/or periodic payments to the franchisor, a franchisee may be allowed to use the trading name and marketing materials of the franchisor and to benefit from ongoing know-how and support such as staff training and access to the franchisor’s operating manual.
By allowing the franchisee to use its intellectual property, the franchisor is accepting a degree of risk, since poor performance by the franchisee could seriously damage the brand. As a result, the franchisor will typically insist on having a high level of influence and control over the franchisee.
Covenant strength and lease structure
New franchisees are typically very motivated but they can lack financial covenant strength or an independent trading history. As a result, landlords may be wary of taking a franchisee as a direct tenant without additional security, such as a substantial rent deposit or guarantee.
Alternatively, the franchisor may be willing to pledge its own covenant by taking a lease directly from the landlord and then subletting to the franchisee. By acting as an intermediate landlord the franchisor is accepting a further layer of risk. The franchisee will be in actual occupation and there is potential for breaches (particularly of the repairing covenant in the lease) to go unnoticed for some time, leading to an accumulation of liability.
On the other hand, acceptance of additional risk and unlocking access to prime real estate can make the franchisor a more attractive proposition and allow it to demand a higher level of financial contributions from the franchisee, whether as part of the franchise package or as sublease rent. Acting as an intermediate landlord will also allow the franchisor to add lease remedies to those already available to it under the franchise agreement.
Property-specific obligations
If the franchisee is to take a lease directly from a third party, excluding the franchisor’s direct involvement in the property relationship, the franchisor will still wish to insert provisions relating to property matters into the franchise agreement. These might include:
? restricting the franchisee to trading from specific premises;
? reserving rights of entry to allow the franchisor to inspect the premises and establish if the terms of the franchise agreement are being complied with;
? requiring that any fit out of the franchise premises is approved by the franchisor in advance;
? compliance with signage and branding requirements.
Headlease terms
If the franchisor agrees to act as an intermediate landlord, it will need to ensure that the terms of the head lease allow it to grant an appropriate underlease to the franchise business.
In particular, the headlease should expressly permit the underlease to contain any key or unusual obligations on the franchisee, such as a duty to keep the premises open and/or to comply with the provisions of the franchise agreement.
Provisions allowing a landlord to review and approve underlease terms are standard, but they should be treated with a degree of caution as they may cause difficulty in the event that a landlord’s consent is subsequently delayed or refused.
Carbon Reduction Commitment (CRC)
Subject to certain criteria being met, it is possible for energy consumed by a franchisee business to be included within the franchisor’s consumption for the purposes of the CRC. Compliance with the CRC regulations will impose an administrative and regulatory burden even if the franchisor falls beneath the threshold for full participation and is just required to report. If compliance is an issue, the franchisee should be obliged to provide consumption information and to contribute toward the cost of participation.
Rights and remedies
Franchise agreements will contain a set of remedies to deal with the possibility of default by the franchisee. These might include financial penalties, increased supervision or, in the case of a more serious breach, a right for the franchisor to terminate the arrangement.
The range of potential controls is not restricted, so a franchisor will seek the highest level of protection that it can achieve without deterring potential franchisees. Only strong franchisees will have the bargaining strength to renegotiate the franchisor’s standard terms.
The lease itself will give a landlord additional remedies for breach of tenant covenants, which can be extended to include an obligation to comply with the terms of the franchise agreement. In general, these are:
? Damages: An application (or threatened application) to court for damages can be an effective means to compel compliance, but the landlord will incur professional costs in preparing and serving any claim and could expose itself to liability in costs if unsuccessful.
? An injunction: The court will look beyond the contractual rights of the parties to the wider circumstances of the situation when considering whether to grant an injunction, as it is an equitable remedy. The professional costs involved tend to mean that injunctions are only pursued in connection with high-value breaches where a money payment would not be sufficient to undo the damage done to the landlord’s interest.
? Forfeiture: Forfeiture of the lease through peaceable re-entry is low-cost and may be appropriate in some situations, but not where the landlord wishes to keep the lease alive. The tenant has a right to apply to court for relief from forfeiture.
? Distress/commercial rent arrears recovery: Depending upon the nature of the tenant’s business, the old common law remedy of distress for recovery of rent arrears was often a very effective and low-cost self-help remedy available to landlords. Part 3 of the Tribunals, Courts and Enforcement Act 2007 has replaced distress with a more limited statutory remedy – commercial rent arrears recovery (CRAR). Implementation of CRAR was scheduled for this month, but has now been postponed to 2013 at the earliest.
? Termination: If the lease is to be excluded from the security of tenure provisions of the Landlord and Tenant Act 1954, an unconditional rolling break clause can be an extremely effective remedy for a landlord with a defaulting tenant. A franchisee tenant, particularly one who anticipates spending a significant amount on initial fit out, is well advised to resist such a clause.
Key points for a franchisee
? Pilot scheme: There is an increasing trend for new franchise models to be brought to market without having been through an extensive pilot period during which problems can be ironed out. As a result, early adopters of the franchise are paying for the privilege of trialling the franchisor’s operational procedures before they have been perfected. This is a particular concern where the investment of the franchisee is substantial and the franchisor’s commitment to the project relatively low. Risk averse franchisees should consider carefully the duration and scope of any pilot project before committing.
? Advice: One of the attractions of entering into this sort of arrangement is that the franchisor has the bargaining position, experience and professional support to negotiate appropriate lease terms with third parties. While the franchisee can avoid spending time and money on taking separate advice, it should be wary of certain points where the best interests of the franchisor and franchisee conflict.
? Exit routes: The franchisee should consider options to bring financial obligations under the lease to an end before the term expiry date in the event that the premises are unsuitable, the franchise business fails or the franchise relationship is terminated. These would include a right to break, assign or sublet to a third party. The conditions attached to any tenant break right should be kept to a minimum so as to avoid uncertainty.
? Rights granted: The terms of any lease should be reviewed to identify any trading restrictions, such as limits on the range of goods sold, permitted use, or hours of trading. In addition, if the franchise business has specific requirements in relation to energy supply, water, air conditioning or trading hours, these should be taken into account at an early stage in negotiations.
Franchising agreements and letting documents should be reviewed together, and with care, to ensure that they meet the expectations of the parties during the course of their relationship and, importantly, in the event of termination of it.
Why this matters
The franchise business model is becoming ever more popular. A 2010 NatWest/British Franchise Association survey estimated that the total turnover attributable to franchising businesses in 2009 was £11.8bn. While the car and brewing industries were the earliest examples of franchises in the UK, there has been a dramatic increase in the number of “business format” franchises across a wide range of industries.
By comparison with other jurisdictions such as certain US states, the degree of regulation of franchise agreements in the UK is remarkably low. This can make the model an appealing vehicle for overseas businesses looking to manage the risks and costs associated with breaking into the UK as a new market.
Inward investment into the UK is clearly a good thing; franchisees tend to be entrepreneurial and good generators of employment. Landlords will also be grateful for any increase in demand. However, franchising arrangements have peculiarities which must be considered from a real estate angle. Covenant strength is always a concern, but landlords must be careful not to be swayed by the brand strength of a franchise if the covenant that they will receive will only come from the franchisee.
Although many franchisees have a great deal of trade experience, allowing them to evaluate a franchise proposal, some do not and will require assistance from professional advisers to ensure that they understand and have taken steps to manage real estate-related risks.
Tim Allen is real estate associate at Bristows
