REAL ESTATE ISSUES
By Mark D. Shapiro
I. FRANCHISOR CONTROL OF SITE1
A common characteristic of successful franchise systems is establishment in great locations. The investment of time and energy for site selection is significant. Site selection specialists examine geography, visibility, demographics, accessibility, competition, and price, among other considerations. The objectives are to lock up and retain choice locations, ensure continuous operations, and preserve locational goodwill. A franchisor may employ different forms of direct and indirect methods of control to achieve these objectives. Each method comes with corresponding risks and rewards. When considering the method of control a franchisor wishes to exercise, it typically evaluates its goals, financial conditions, and risk tolerance. Franchisors are usually interested in continuing the operations of the franchised business at favorable locations after a failure, either as a company-owned unit or through refranchising efforts. The reason for continuation is to prevent the former franchisee or a successor competitor from operating a similar concept, under a different name, while capitalizing on the franchisor’s locational goodwill, especially if the location is good. Sections I.–VI. examine the methods of direct and indirect control franchisors employ to retain sites and their relative effectiveness, benefits, and detriments. Section VII. discusses operation manual considerations. Section VIII. deals with real estate financing issues. Section IX. addresses bankruptcy issues, and Section X. identifies areas of exposure from the franchisor’s involvement with its franchisees’ real estate.
II. LEASE PROVISIONS
The most popular method of providing a franchisor control over a location is by obtaining the landlord’s written agreement to certain key clauses. A franchisor will often provide the franchisee with a standard form of lease rider (the “Rider”) for a shopping center or mall space, which it requires its franchisee, the tenant under the prospective lease, to attempt to cause the landlord to make a part of the lease agreement. It is usually not easy to achieve agreement fully on the Rider terms and negotiation will be necessary, that may or may not directly involve the franchisor. In any event, it is best that the Rider be presented to the landlord early in the lease process. It is problematic if the lease has been fully or almost fully negotiated, and then the Rider is presented to the landlord for the first time for approval. When that happens, the landlord will become frustrated and likely, less flexible. The following are some of the typical Rider provisions to include in the lease agreement to be acceptable to the franchisor.
A. USE CLAUSE
A use clause limits the tenant’s permitted use of the premises to the specified type of business to be operated under the terms of the franchise agreement and for no other purpose; sometimes it even specifies the trade name of the business. Without the Rider, the typical use clause will restrict the use of the leased premises to a generic description of the type of business to be operated. Limiting the use to the actual franchised business provides another check to the franchisor that its franchisee will not operate in violation of the franchise agreement, by, for example, selling unauthorized products or services, violating the noncompete provisions, or using nonpermitted marks or trade dress. This assumes that the landlord will also monitor and enforce this provision, but this is not guaranteed. A carefully constructed use clause will also aid in the event of the tenant’s bankruptcy. If this lease clause is enforced, the lease may only be assigned, in a bankruptcy case or otherwise, to the franchisor or an approved franchisee, since those are the only parties permitted to operate under the lease’s use clause. This is one of the most valuable Rider provisions.
B. NOTICE AND OPPORTUNITY TO CURE
A notice clause provides that the franchisor is to receive copies of all letters or notices sent by the landlord relating to the premises at the same time the notice is sent to the tenant. This way, the franchisor may monitor the status of the lease and tenant’s compliance with its terms. Coupled with a notice provision is the franchisor’s opportunity to cure alleged defaults. Detailed provisions provide that if the notice involves a default, landlord must advise the franchisor of the failure to cure before it may exercise its remedies. The franchisor also has a period of time to effect a cure following receipt of the default notice. This cure right is an option and not an obligation, and if cure is made by the franchisor, it will not be deemed to have assumed the lease obligations unless it expressly agrees to do so in writing. Franchisors usually will not step in to cure technical defaults. They are obviously more concerned when there is a likelihood of the default resulting in a termination notice. The right to receive notice allows a franchisor to prevent the landlord from terminating the lease. By curing a default giving rise to termination, a franchisor avoids eviction and the prospect of a replacement tenant capitalizing on the locational goodwill.
C. LEASE ASSIGNMENT
The Rider will almost always provide that the tenant will assign its rights under the lease to the franchisor in the event that the tenant has defaulted under the lease or the franchise agreement, and the franchisor elects to take an assignment of the lease. The assignment right may also be triggered if the tenant fails to exercise a renewal option under the lease. Note though that franchisors usually require that the lease term and the franchise agreement term be coterminous and if that is the case, there can be no option right. In practice, some retail lease rights are granted only for five-year periods, with multiple five-year options. If that is the case, the franchisor should mandate exercise of option terms to match the franchise agreement term in duration and forbid the franchisee from exercising an option right without franchisor’s consent. If the franchisee does not comply by, for example, not renewing after an initial term, that would be a default under the franchise agreement, triggering Rider rights and remedies under the franchise agreement. A franchisor should be careful to preserve the right to exercise option rights when the franchisee has failed to do so. Sufficient lead time needs to be built into the Rider so that franchisor may elect to exercise an option right after franchisee fails to do so, but before the time to exercise has expired.
If there is an assignment, franchisors try to limit the amount of arrearages due from it to the landlord. Examples include capping the amount of monetary defaults at two months’ rent or at arrearages incurred from and after thirty days before franchisor’s receipt of a notice of default. Landlords resist, arguing that a condition of assignment must include the cure of all outstanding defaults—monetary and nonmonetary. The right to pursue the franchisee for reimbursement of funds paid is reserved by the franchisor. Another contentious assignment issue is franchisor’s ability to designate a replacement franchisee and refranchise the unit without the franchisor directly assuming the lease. Landlords justifiably seek to retain approval rights over who its tenant will be. Just because the franchisor approves the franchisee does not mean that the landlord will be satisfied with the designee’s experience, character, and creditworthiness, especially if units in the system are regularly refranchised. A compromise is that landlord pre-approves a new franchisee that meets described net worth requirements or is an existing operator within the system and has a few years of operational experience.
A franchisor may face successor liability issues if it exercises its right to take an assignment of the lease and related operating assets. In addition to curing lease defaults, exposure may include third-party liabilities, such as tax liabilities, utility charges, vendor liens, and other obligations. These same concerns exist for the next franchisee as well. Research on applicable state successor liability laws is warranted to assess the risk of becoming responsible for the prior franchisee’s liabilities. The practical issues of being able to continue to receive products, services, and utilities at the premises, in light of possible delinquencies, needs to be addressed too. The analysis of whether to exercise an assignment right also includes an assessment of the value of the location, whether the failure was more the result of poor operational performance than site selection or a negative change in the area, and whether the right replacement operator can be identified and timely inserted in the premises. A related issue is the importance of maintaining continuous operations. If the tenant/franchisee is removed or has vacated the location, is the franchisor prepared to take over immediately, even if only on a temporary basis to continue operations until a more permanent operator is selected? Some franchisors are hesitant to place themselves into the chain of title even for a short period of time, for the fear of successor liability or a claim for breach of contract from the next operator. Where the franchisor places itself in the chain of title, old creditors see a potential deep pocket for recovery, regardless of the merits of the claim.
D. THIRD-PARTY BENEFICIARY
If the franchisor is not a party to the Rider or other lease documentation, it must be clearly stated in the lease agreement or Rider that the franchisor is an express intended third-party beneficiary, with the ability to enforce the beneficial rights granted to the franchisor in the lease documentation. Some franchisors, as support for the third-party beneficiary designation, will enter into a separate collateral lease assignment agreement with the franchisee/tenant.2 The landlord would also consent, in writing, to the collateral assignment. Some franchisors have a policy against signing lease agreements and Riders. The theory behind the policy is that by not signing the Rider, its exposure for potential liability under the lease is limited. But, carefully drafted documentation can make clear that the franchisor will not have any liability, unless it expressly assumes lease obligations.
E. NO AMENDMENT
When expending considerable time and effort creating an acceptable form of lease, the franchisor needs assurance that the lease cannot be amended—or at least not in any material respect or in any respect that may adversely affect its negotiated rights—without the franchisor’s consent. Without a no-amendment provision, the protective rights could be undone without the franchisor’s knowledge. Further, the tenant may not be allowed to renew or terminate the lease, or extend or shorten the term without the franchisor’s consent. For most franchisors, the term of the lease (including renewal options) must match or be coterminous with the term of the franchise agreement. This ensures that the franchisee has a physical location from which to operate during the entire franchise agreement term and precludes the tenant from being able to operate at the premises following expiration of the franchise agreement.
F. RIDER SUPERSEDES
This clause provides that in the event of inconsistent provisions between the lease and the Rider, the Rider, with its protective provisions, will control.
G. ACCESS TO PROTECT SYSTEM
Most franchise agreements provide that the franchisor has the right to inspect the franchised business to ascertain compliance with the franchise system’s requirements. To bolster this right, the landlord is asked to acknowledge that the franchisor has the ability to gain unrestricted access to the leased premises without being guilty of trespass. This inspection right is especially important if the franchisor has effected a termination and needs to ensure a proper de-identification of the premises, including the removal of signage and fixtures. Landlord responses usually include an obligation of franchisor to repair any damage to the structure or other property caused by franchisor’s entry. Some landlords will also permit entry only if the franchisor has in fact assumed the lease obligations with permission. In any event, franchisors reserve the right to pursue the tenant for reimbursement for any costs incurred from franchisee’s failure to effect de-identification properly.
Franchisors, especially those who are not inclined to operate company-owned units, seek to reserve the right to refranchise a unit where the tenant has lost the right to occupy the space, either through termination of the franchise agreement or the lease. As described above, disputes occur over the qualifications of the next franchisee who, according to the landlord, should at least meet the same requirements as the originally approved franchisee. The landlord likes to keep the franchisor on the hook for the lease obligations and will want to conduct a due-diligence investigation of the experience and creditworthiness of the replacement franchisee. The franchisor, in turn, seeks to be released from any obligations under the lease that arise after its assignment to a new franchisee, and will want the landlord to approve any franchisee that has been pre-approved by the franchisor.
I. APPROVAL OF USE AND MARKS
As part of due diligence for the opening of a new unit, the franchisee and franchisor need to confirm that the lease and applicable law permit: (1) the use of the franchisor’s trademarks and signage; (2) the actual business use; and (3) the construction and trade dress required by the terms of the franchise agreement. In advance of lease execution, the landlord’s written approval should be obtained acknowledging the use of the trademarks, the desired signage, the build out, and trade dress. Some municipalities have zoning ordinances that may restrict the franchisor’s signs and trademarks to be displayed in the manner used by the system generally. See Section VIID for further discussion of this potential conflict.
J. REMODEL RIGHTS
Franchise agreements typically require the franchisee to remodel or renovate the premises at one or more points during the term of the franchise agreement. The landlord is asked to agree that such activities are permitted from time to time and that it will not unreasonably withhold consent to such remodeling. Further, the tenant under the lease should not be held liable under any continuous operation covenant if it is required to close for a reasonable period of time to complete the renovations.
K. RIGHT TO RECEIVE REPORTS
Some franchisors seek to obtain a franchisee’s revenue or sales information that may be submitted to the landlord, although this is not a primary Rider provision. If there is a percentage rent clause in the lease, gross sales figures will be required to be submitted by tenant to landlord to calculate the amount of the percentage rent. Franchisors appreciate an additional check on the reporting information being submitted in connection with its collection of the franchise agreement’s royalty fees. This is an administratively cumbersome requirement for a landlord and most are not willing to take on the responsibility of forwarding the gross sales reports to the franchisor.
L. NO ASSIGNMENT OR SUBLETTING
If the use under the terms of the lease agreement is restricted to the franchised business, this provision is less important, but a no-assignment or subletting provision states that the premises, or any portion of it, may not be assigned to a third party or sublet without the prior written consent of a franchisor. Again, the franchisor is protecting against the loss of the locational goodwill, so it will want to prohibit the lease of the premises to a competitor or otherwise to a party that the franchisor would find objectionable. An easily overlooked diligence item is confirmation that the tenant entity on the lease is the same entity that is the franchisee under the franchise agreement. From the franchisor’s perspective, the same person or entity must be the tenant and the franchisee.
M. RADIUS RESTRICTIONS
The tenant’s lease agreement may impose a radius restriction. A radius restriction is a covenant that the tenant will not operate a similar or competitive business within a certain distance, usually expressed as a radius of miles from the leased premises. The purpose of the clause is to focus the tenant on succeeding, and driving traffic exclusively to the landlord’s center. The franchisor and franchisee should make sure that this covenant is limited only to the franchisee so that if another operator in the system—a different franchisee or the franchisor itself—opens another unit within the radius restrictions it is not a default under the franchisee’s lease. Especially if broadly worded, this clause also may impose an unreasonable restriction on the franchisor, who may ultimately take an assignment of the lease. As franchisor, it may operate company-owned units or be in the business of licensing additional units in close proximity of one another, which may be a violation of the lease’s radius restriction. Franchisors do not want to be restricted in their territory development by a franchisee’s lease covenant to a landlord. Accordingly, franchisors who may have units in close proximity to one another seek to have this clause automatically deleted should the franchisor take an assignment of the lease.
N. EXCLUSIVITY RIGHTS
One of the areas in which a franchisor can be particularly helpful to its franchisee is in crafting a broad exclusivity provision. A franchisor should know what types of businesses and what lines of products are competitive with its franchised business. Exclusivity clauses generally fall into one of two categories: (1) an exclusive right to conduct a specified business, which is not literally directed against specific products, and (2) an exclusive right to sell specified products.3 A right to be the only pizza shop in the shopping center may permit other restaurant or food-providing tenants to sell products also sold in the pizza shop, whereas, the exclusive right to sell pizza and pizza-related products would be a true exclusive. When the lease specifically lists the restricted items, the franchisee has greater protection. An aggressive franchisee may propose that it receive an exclusive right to sell the items then being sold by the franchise system. The problem with evolving or expanding use provisions is that they limit the landlord’s future leasing possibilities and increase the possibility of a violation. And, the problem with very specific exclusivity provisions may be that the related use clause is narrowed in a way that may impair a franchisee’s ability to offer new franchise system products. Landlords are generally more willing to limit any restrictions to the primary or core items being offered by the franchised business at the time of lease execution. When the landlord is flexible and permits a future expanded exclusive, expect the landlord to insist on advance notice of the new items and no exclusivity rights for items already protected in another tenant’s existing exclusivity clause.
III. COLLATERAL ASSIGNMENT OF LEASE
While some systems seek to include a collateral assignment of the lease agreement directly in the Rider, it is recommended that the collateral assignment be a separate tri-party written agreement among landlord, franchisor, and franchisee/tenant. The collateral assignment is a present assignment of the franchisee/tenant’s interest in the lease, conditioned upon an event of default or other triggering event and the franchisor’s express consent to take the assignment. In addition to default, the franchisee’s failure to renew or extend the lease term will trigger the assignment right. In such an event, the franchisor is appointed as franchisee’s attorney-in-fact to exercise the extension or renewal options in the name of the tenant. A collateral assignment agreement states that the franchisor’s cure of the franchisee’s defaults under the lease will not excuse the franchisee from liability for the amount expended by the franchisor to make a cure. Franchisors also preserve for themselves the right to pursue the franchisee for the outlay of these payments. Obtaining landlord’s consent for the collateral assignment at the inception of the lease is preferable to avoid the landlord from extracting payment for its consent to the assignment right at a later date. There is no requirement that a collateral assignment of lease be recorded, but if recorded, it places third parties on notice of the franchisor’s rights and will prevent landlord from ignoring the right and leasing to another in violation of the agreement. Further, it may be difficult to enforce the agreement if the landlord is not made a party to the collateral assignment. (See Section IV. below.) The lease assignment only conveys the rights to possession and other rights under the lease, but not the operating assets of the business. Separate provision must be made, by the franchisor, for the acquisition of equipment and other hard assets. This is typically accomplished with a purchase option in a franchise agreement, but may also be voluntarily agreed upon between franchisor and franchisee at the time of lease assignment.
IV. ENFORCING TERMS
Once the effort is made to negotiate a Rider successfully, the franchisor needs to know its beneficial rights will be enforceable. To enforce its rights, the franchisor must have standing. Franchisors create standing by either: (1) being a party to and executing the Rider or a separate collateral assignment of lease, or (2) being designated as an intended third-party beneficiary with the right to enforce the lease and/or Rider in its own name. The collateral assignment agreement should be signed by the tenant/franchisee, landlord, and franchisor.
Courts will generally enforce lease assignment provisions in favor of franchisors, especially when the franchisor’s enforcement rights are acknowledged by the landlord. The leading case on enforcing lease assignment provisions is Snelling & Snelling v. Martin.4 The Martin court upheld a franchise agreement provision that required the franchisee to assign its lease to the franchisor upon termination of the franchise agreement. The court recognized the importance of protecting the franchisor’s locational goodwill and granted preliminary relief. The court stated, “the lease assignment provision in this case is apparently intended to allow Snelling to retain clients who are familiar with the precise location of the business; if defendants remain in the premises and Snelling is forced to operate elsewhere, it loses the intangible benefit of that location.”
The Martin case also directed the defendants to cooperate as necessary for the transfer of the telephone numbers associated with the franchised business to Snelling. Lease assignment provisions are particularly useful to franchisors in California, where covenants not to compete are unenforceable. Without the lease assignment provision, breakaway franchisees have an easier time capturing a favorable location for a competitive enterprise.
Other courts have also enforced lease assignment provisions. In Dunkin’ Donuts, Inc. v. Dowco,5 the court determined that a lease option agreement between a franchisee and its landlord, which prohibited the landlord from leasing the location to a competitor and granted the franchisor the right to assume the lease, was enforceable. The court ordered specific performance even though it was a unilateral option contract not signed by the franchisor.6 Similarly, in Dunkin’ Donuts of America v. Middletown Donut Corp.,7 the supreme court of New Jersey affirmed the enforcement of a lease assignment provision and compelled a terminated franchisee to turn over the leased premises to the franchisor.
In contrast, the court in Trient Partners I, Ltd. v. Blockbuster Entertainment Corporation8 permitted a franchisee to sell its leases freely, together with its video store assets, to a third party upon the expiration of the franchise agreement, despite certain of the leases provided the franchisor the right to assume the leases upon default. The court first noted that the franchisor’s right to assume would only be triggered upon a default by the franchisee, Trient, and not upon the expiration of the franchise agreement. The court, applying Texas law, found real estate to be unique. Even if the agreement gave franchisor, Blockbuster, the right to assume the leases in the absence of a default by Trient, Blockbuster would not have equitable title because there was no privity of contract between Blockbuster and Trient’s landlord.9 This case underscores the practical advice that if the franchisor is not a party to the lease, the franchise agreement must provide that the lease identify the franchisor as a third-party beneficiary under the lease, with the express right to take an assignment of the lease. This strategy creates privity between the landlord and the franchisor and clearly allows the franchisor to enforce the lease terms against the landlord in the future.
In Cottman Transmission Systems, Inc. v. Hocap Corp.,10 the franchisor sought to enforce the collateral assignment provision in its Rider against the landlord. After the franchisee defaulted, the landlord did not provide franchisor the mandated twenty-day written notice before the landlord repossessed the leased premises. The appellate court overruled the trial court’s finding that the franchisor had no standing to enforce the Rider. The landlord argued that the assignment was conditional and that the franchisor had not perfected its rights under the assignment. The appellate court agreed with the franchisor’s position that it had the twenty-day period within which to exercise its option to make the conditional assignment effective. When the landlord repossessed the leased premises and altered the space in a manner making it unfit for the operation of a transmission repair center, the landlord had committed an anticipatory breach of the contract.
The importance of having a landlord acknowledge and consent to the collateral assignment is highlighted by Danbury Mall Associates Ltd. Partnership v. Mazel Enterprises, LLC.11 Mazel was a franchisee of Candy Express Franchising, Inc. The franchisee opened a store in a mall in September 2001 and abandoned the space in November 2002. The franchisor guaranteed the lease on a one-year rolling basis. Following the abandonment by the franchisee, the franchisor tried to take over the space by virtue of a collateral assignment executed by the franchisee. However, the franchisor offered no evidence that the landlord had consented to the assignment. Despite the franchisor’s willingness to cure and continue operations, the landlord rejected the assignment. Had the landlord consented to the collateral assignment, the franchisor would likely have been able to enforce it.
V. FRANCHISE AGREEMENT TERMS
The Rider requirements and other lease-related obligations imposed by the franchisor are found in the franchise agreement. This section describes how the franchise agreement is used by a franchisor to exercise control over the franchisee’s leased unit.
A. GRANT OF LICENSE AND SITE SELECTION
The first step is the franchisor’s right to approve the location of the franchised business, the design and improvement specifications, signage, and any alterations to be made to the site. From the grant provision through post-termination obligations, real estate control provisions are interwoven throughout franchise agreements. Typically, a franchisee is granted the right to operate the franchised business at a designated location. Assuming the franchisee intends to sign the franchise agreement before the site is selected, the parties will set forth a time period and process for locating a mutually acceptable location. This may be accomplished by way of a location addendum to be executed within a set period of time following the effective date of the franchise agreement. If the parties fail to agree on a location in a timely manner, the agreement typically provides the franchisor with the right to terminate the franchise agreement and retain the initial franchise fee or a portion of it. Alternatively, the franchise agreement may not be signed until a specific location has already been agreed to by the parties.
Franchisors work to limit exposure for claims that the franchisor selected or approved a bad site. Warranties concerning profitability or success at the site are specifically disclaimed. An example of this protective language in the franchise agreement is: “Franchisor’s approval of the lease, sublease, or purchase contract does not constitute a warranty or representation of any kind, express or implied, as to its fairness, suitability, or profitability or as to your ability to comply with its terms.” The franchisor’s acceptance of a lease and approval of a site is merely an indication that the criteria for each have been met, but there is no guarantee of success simply because the form of the lease and the site have been approved. Depending on the franchise system, franchisor involvement in site selection varies dramatically. Mature, sophisticated, and successful franchise systems employ significant in-house expertise to identify and approve sites. They may work with national or local brokers to aid in the analysis and with comprehensive software programs that are able to generate a variety of data on the prospective site and the surrounding areas. On the other end of the spectrum, a franchisor may simply accept or reject the site that a franchisee identifies based on unpublished ad hoc site selection criteria. To distance itself from allegations that it negligently identified or approved a site, franchisors typically require the franchisee to select a site subject to franchisor approval. Many factors, including the following, are considered for approval: demographics, parking, competition, and tenant mix in the shopping center or area. A franchisor’s real estate professionals understand the types of demographics that match the concept and are able to identify and analyze the competition, zoning restrictions, traffic patterns, and similar factors. Where the franchisor’s general strategy includes taking over or refranchising locations from weak operators, it should devote sufficient resources to the approval process.
Typically, a franchisee has no right to relocate the site without the franchisor’s consent. When the relocation decision is left to the sole discretion of the franchisor, courts tend to hold that there is no breach of the franchise agreement if the franchisor refuses to permit relocation.12 In the case of Precision Enterprises, Inc. v. Precision Tune, Inc.,13 in which an automotive franchisor refused to allow a franchisee to relocate, the court found that the franchisor did not breach its obligations to deal with the franchisee in good faith under the Washington Franchise Investment Law14 because the franchisor had no contractual obligation to consider relocation by the franchisee.
Automobile dealers (as opposed to automotive parts dealers) have special protection in this area. The Automobile Dealers’ Day in Court Act15 and analogous state statutes provide protection against arbitrary decisions by manufacturers. If a manufacturer withholds its consent to a relocation, courts have held that the decision may not be arbitrary. Courts examine whether the manufacturer withheld its decision for legitimate business reasons. An accepted legitimate reason is that the relocation would lead to additional (and negative) intrabrand competition in product lines (or same line makes).16 Accordingly, the automotive franchisor must carefully analyze the Dealers’ Day in Court Act, state statutes, and applicable case law before withholding its consent to the relocation of one of its dealers.
C. DIRECT CONTROL
The prior sections discuss the scenario in which the franchisee contracts directly with an unrelated landlord for the lease of space, and the franchisor indirectly works to control the space. This section explores the issues related to the franchisor’s decision to control the premises of the franchised business directly. Before implementing any policy to own or control its franchisees’ real estate, the franchisor must carefully consider the importance to its system of locating and controlling the real property on which each franchised unit will be operated. The franchisor must also determine whether it has the financial ability to lease or purchase property itself or whether it will have to rely on the finances of prospective franchisees to acquire the real estate. If the franchisor has the financial ability to locate, acquire, and develop a site itself, direct control provides many advantages to the system, but with a substantial degree of contingent risk. If this is not a possibility and the franchisee will directly acquire possession of the property, the franchisor must revert to indirect controls to protect the unit from, among other possibilities, the franchisee’s intention to convert the unit to a competing enterprise. As the franchise system grows, a prudent franchisor should reassess its earlier decisions pertaining to real estate control, given the status of the franchisor’s financial strengths and the importance of each particular location. When a franchisor employs a direct control technique, there are advantages and disadvantages to both the franchisor and franchisee that must be weighed by each party.
1. BUILD OUT AND SITE SELECTION
One advantage is that the franchisor can independently select and develop a location, at its own pace, before leasing or otherwise transferring the property to the franchisee. The franchisor can develop a standard process of site selection and construction specifications, creating a uniform appearance among the units to the public without initial interference from a franchisee. Additionally, the franchisor can negotiate permits needed for the site and all signage with the municipal authorities without the franchisee’s involvement, thereby expediting municipal approval.17 The franchisor can systematically develop an expertise in the selection and development of multiple prime locations that can be brought to task more effectively than may be accomplished by a franchisee for a single-unit operation. Being responsible for this huge undertaking is a signal to a prospective franchisee that the franchisor is committed to each location. The establishment in a good location is one of the most important factors in the success of a business and a prospective franchisee frequently does not have the real estate expertise to locate and develop a site on which the franchised business will thrive. It therefore benefits from the franchisor’s expertise and relationships with various brokers, site selection specialists, property owners, and municipalities, and the franchisor’s use of site selection software programs.
2. EFFECTING CHANGE AT THE UNIT
After a unit is open, the franchisor with direct control can more easily implement and control required changes to the franchise system. Examples of these changes are alterations to the trade dress and signage. If the current franchisee exits the franchise system, the franchisor can either operate at the site or place a new franchisee into the site without landlord approval. This way, there is a continuity of service to the franchisor’s customers and preservation of customer loyalty built at the site regardless of the operator at the unit, without the need to enforce a Rider or collateral assignment of lease. Finally, the franchisor can better manage unforeseen events such as fire, other casualty, or condemnation proceedings affecting a unit.
3. SUPERIOR BARGAINING STRENGTH
If the franchisor has the financial resources to acquire the properties needed for the growth and operation of its system directly, the franchisor’s financial strength will typically allow it access to more prime locations than a single franchisee’s financial resources will allow. This financial strength will also place the franchisor in a position to negotiate more advantageous financial terms under a lease or purchase of the property, which may also be an advantage to the franchisee ultimately operating the location under a sublease with the franchisor. Even if the franchisor cannot directly acquire the real property and instead controls the real estate by other indirect methods, a landlord may agree to more favorable lease terms with the franchisee if the franchisor will be ultimately responsible for the lease in the event of a default by the franchisee.
4. VALUABLE ASSET
Where the franchisor purchases the real estate, it creates a source of income and an appreciating asset base. Growing equity can be used to finance future growth of the system. Additionally, rental payments received from the franchisee may offset costs of leasing or purchasing the site and may be a source of revenue for the franchisor. At the same time, the franchisee’s initial investment is lower since the franchisee does not have to fund the acquisition of the property.
5. EFFICIENCY IN TAKING BACK THE UNIT
In the event of a default under the franchise agreement, a franchisor that controls the real estate will most likely be able to remove the franchisee more quickly. Eviction proceedings may often be commenced as summary dispossess actions, which are usually quicker than an action to enforce a Rider. A franchisee may also be more likely to cure its default under the franchise agreement knowing it will lose its right to operate a business at the particular location in the event of a franchise termination. With a direct lease or ownership, the franchisor can also more effectively bring about the required de-imaging following a termination.
6. BANKRUPTCY LEVERAGE
In the event of the franchisee’s bankruptcy, the franchisor is better positioned as the franchisee’s landlord than as either a secured or unsecured creditor. Additionally, the franchisor enjoys greater flexibility to assist a franchisee experiencing financial difficulties when it controls the real estate. For example, a franchisee may be permitted to postpone or restructure rent payments owed to the franchisor, whereas a third-party landlord or mortgage holder may not be as willing to assist a financially troubled franchisee. Furthermore, an unrelated landlord may seek to renegotiate the favorable nonmonetary lease terms in exchange for a rent reduction or a rent deferral deal. See Section IV