An endemic can impact land-control decisions for restaurant operators

Location, location, location. Historically, this factor has been every bit as important as a predictor of success for a restaurant as it is considered to be in the selection of a personal residence. Yet, the best location in the world cannot overcome lockdowns and reduced capacities (and in some cases, may be detrimental given the higher rents that are often associated with premium locations). Against that backdrop, and for any government programs that might help reduce the impact of closures, the effect of having to pay some or all rents during a lockdown has proven devastating to many restaurants.

In the franchising context, one fundamental decision that a would-be restaurant franchisor makes is who will hold the lease for the business. There are typically four options: the franchisor; the franchisee; an affiliate of the franchisor, which holds leases for the entire system and sublets premises to its franchisees; or a single-purpose affiliate of the franchisor that holds an individual lease, which it sublets to a particular franchisee.

There are traditional considerations, pro and con, impacting franchisors’ decisions for the land-control aspect of the design of their systems. These considerations are re-examined below in light of the approaching endemic.

Direct or indirect franchisor control
Franchisors looking to maximize control over their franchisees’ premises typically enter into leases directly or through either a leasing affiliate or single-purpose affiliate. In situations where the franchisee may be terminated or abandon the system, having land control is useful because it prevents the franchisee from remaining in possession of the premises and operating from a location previously affiliated with the system. In these circumstances, land control also helps to minimize the likelihood a franchisor will need to sue to enforce any applicable covenant not to compete.

Landlords may require franchisors to provide an indemnity, or limited indemnity in duration or amount, if they are prepared to accept a franchisor’s affiliate as the tenant because these affiliates, typically speaking, are mere holding companies with no meaningful covenant to offer themselves. In this scenario, it’s the franchisor or its affiliate who is directly responsible for fulfilling the tenant’s obligations under the lease. To that end, franchisors often face the situation of funding rental payments when they terminate a franchisee’s sub-lease, pending their ability to re-franchise the location.

In the age of an endemic, this strategy of holding leases, whether directly or indirectly, can create tremendous financial hardship on a franchisor where the sub-tenant franchisee may not itself be able to maintain its payments under its sub-lease and any franchisee indemnifier does not have the wherewithal to make good on any indemnity given under a sub-lease/franchise agreement.

Franchisee Control

The immediate reaction to the potential financial burden on a franchisor resulting from holding leases, whether directly or indirectly, is to instead require franchisees to lease their premises directly from their landlords. The decision to have franchisees lease directly as a matter of system design is not a standalone decision, but involves several other critical decisions:

Is the franchisee or the franchisor primarily responsible for seeking out suitable premises and negotiating the lease?
Is the franchisee or the franchisor responsible for the build-out of the premises?
Who will receive any tenant allowance which may be available to the tenant?

Leaving these considerations aside, allowing franchisees to lease premises directly from a landlord creates the following dynamics:

The franchisee will have the primary relationship with the landlord. The franchisee may not have the necessary gravitas or skill to negotiate with its landlord during an endemic;
There is a greater likelihood of a default occurring if the franchisee cannot sustain its rents with no, or limited, business;
If the franchisee is seeking to terminate its obligations with its franchisor, it will have control at first instance of its location and may have a positive relationship with its landlord who may support a de-identification;
A franchisee may be behind in their obligations for some time before the franchisor becomes aware of the default; and
It may be more difficult for the franchisor to negotiate for its receipt of tenant allowances or inducements.

The experience from this endemic has overwhelmingly suggested that franchisors need to design their systems with the least exposure to lease liabilities and cross-defaults under their leases as possible. Funds that must be paid to landlords are needed for other purposes — innovation, franchisee support, wage support for key employees and maintaining corporate locations. Paying rent on closed or partially open locations can create a significant risk to the health and future of a franchise system very quickly.

Assuming the endemic is here to stay, with the prospects of future variants and renewed partial or total closures, along with the unpredictability of government-support programs, the choices for franchisors on the matter of land control are narrowing. At this time, franchise systems should approach land control with the following design features:

Franchisees should be responsible for finding locations within the territory agreed to, subject to the franchisor’s approval. If suitable locations are not found within a specified period, franchisees should be entitled to a return of the initial franchise fees, in whole or in part;
Franchisors should provide guidance to franchisees on lease terms, and should either consider providing franchisees with an approved form of a letter of intent to be utilized by franchisees or take responsibility for the negotiation of the letter of intent and lease on behalf of the franchisees;
Franchisors should be entitled to approve the form of an offer to lease and lease, which the franchisee intends to enter into if they have not undertaken the negotiations themselves;
Franchisees will take the ultimate responsibility for the terms of any offer to lease or lease they enter into;
Franchisors should require franchisees as a term for their approval that they be given the following rights:

To notice by the landlord if a breach of the lease occurs;
to have the lease conveyed to the franchisor upon a termination of the franchise agreement;
To have time to re-franchise upon a conveyance of the location and, during that intervening period, to be “dark” if necessary;
To occupy the location under the franchise agreement in the event of a large group of defaults by a franchisee and to operate the business for the account of the parties as set out in the franchise agreement;
To receive any tenant allowances to support construction;
To control the construction at the franchisee’s expense;
To take security over the tenant’s assets (to the extent permitted by any loan which a franchisee may need to procure to support the construction and store opening); and
To act as the franchisee’s agent for an additional fee to negotiate with the landlord where necessary.

These guidelines require a great deal of understanding on the part of franchisors and significantly impact the drafting of the default agreements utilized within the system.

Lease Terms

Franchisors will want to pay particular attention to the following matters if they allow their franchisees to lease their premises directly.

Force Majeure: As a result of the pandemic, most landlords and franchisors re-visited the wording of the force majeure/unavoidable-delay provisions of their leases and other agreements. For a franchisor, to the extent possible, it will not want the tenant to be paying rent if the tenant is not receiving revenues of any significance or governmental assistance. More specifically, the franchisor will want to ensure that these provisions, which would suspend the tenant’s obligations to perform, include government lockdowns, whether formal or informal, and specifically do not require the tenant to pay rent during this time.

Use Clause: Franchisors should confirm that the use clauses in their leases are limited to the activities of operating the system’s business but allow for sufficient flexibility to permit them to modify the business as they may need to.

Insurance: Franchisors will want to ensure that the franchisee/tenant is carrying sufficient and appropriate business-interruption insurance.

Formal Lease: If the franchisors’ entitlements are to be more specifically included in the formal lease rather than the offer to lease, they will not want their franchisees taking possession of the premises under the franchise agreements until the subject lease is fully executed.

Landlord’s Work/Tenant’s Work: Whether in an offer to lease or lease, franchisors should ensure that they have approved all work that is expected to be performed by the landlord and the tenant. A franchisor’s form of letter of intent that its franchisees either utilize or are guided by should include these provisions.

Land control is one of the most difficult pieces of franchise system design that a franchisor must understand, appreciate and gain expertise in. The decisions made around land control and the execution of these decisions can make the difference between system success and failure during a pandemic/endemic.

Allan Dick, Sotos LLP

Sotos LLP assists many franchisors in the design of their systems. Many of the aforementioned leasing considerations are also applicable to single unit or multiple unit non-franchised restaurant operations. If you have any questions about your leases or land control issues, please contact the author at adjdick@sotos.ca or 416-805-8989.