Franchise Bulletin: March 2015 – Premises based franchising – choosing the right model for the outset?

For any franchise which is premises based, it is crucial to ensure that the right premises model is chosen by the franchise from the start. In England and Wales there are two separate models which tend to be used and which for the purposes of this article are referred to as the Sub-Lease model and the Direct Lease model. Which model is chosen will be dictated by the franchisor but the choice of model revolves around the answers to three basic questions. These are:

1. Who wants to have the control of the premises?
2. Who is going to carry the greater risk in relation to the premises?
3. What level of financial resources does the franchisor have?

Sub-Lease Model

Under this model, the landlord grants a head lease to the franchisor with the franchisee then taking a sub-lease direct from the franchisor.

The main advantage of this model to the franchisor is that it enables the franchisor to retain a greater degree of control over the premises. This model will often be used where the location of premises is a significant factor in the success (or not) of the franchise. For example, restaurant franchises where securing a prime location is crucial with the franchisor not wanting to lose that location by giving too greater control to the franchisee.

This model does depend though on the resources of the franchisor. The landlord will need to be comfortable that the financial covenant strength of the franchisor is sufficient and they are happy for the premises to actually be occupied by a franchisee rather than by the franchisor. This model is therefore traditionally used by the large household names where securing that franchise as a tenant is a big positive for the landlord. The franchisor will tend to have terms in the leases that they require and that they essentially impose upon landlords in return for the landlord getting a tenant of secure covenant strength. This model therefore allows the franchisor to have the primary control of the premises but also provides the landlord with what they hope will be a secure source of income.

The control over the premises for the franchisor is also contained in two further documents. There will obviously be obligations as to how those premises are run by the franchisee in the franchise agreement. It is also common that in the sub-lease of the premises between the franchisor and the franchisee, a forfeiture (i.e. termination) provision is included so that the sub-lease also terminates if for any reason the franchise agreement ends. The franchisor is therefore able to regain possession of the premises in those circumstances and hopefully find a new franchisee to take them on.

The one downside of this model for the franchisor is that if the franchise does not succeed in this location, then unless it has a break clause within its lease that it can activate, the franchisor potentially retains what could be a significant liability. If the premises are empty, the franchisor will still retain liability for rent, business rates, service charge and insurance rent etc together with any other outgoings that relate to the premises.

Direct Lease Model

Under this model, the franchisor does not have a direct involvement in the premises. The lease of the premises is granted by the landlord direct to the franchisee. From the franchisor’s perspective, this has the advantage that any risk in relation to the premises rests solely with the franchisee. If the franchise does not succeed in that location, any liability for rent and service charge and other outgoings will remain with the franchisee.

This model is commonly used for franchises that are new to the market in this country. If they do not have significant resources or covenant strength, using the Sub-Lease model is often not possible or desirable and the potential risk for the franchisor is significant. Therefore, passing that risk to the franchisee can be preferable for the franchisor.

From the franchisee’s point of view, this actually gives greater control to the franchisee. There may be a provision in the franchise agreement which states that the franchisee needs to offer to assign the premises to the franchisor or another franchisee in the event that the franchise agreement is terminated. However, that is a contractual arrangement between the franchisor and franchisee and is not a matter that the landlord would want to get involved with. You can include provisions within the lease that in the event the landlord attempted to forfeit the lease, they would first have to serve notice on the franchisor giving the franchisor an opportunity to remedy any breach of the terms of the lease. However, that is something that we find landlords are reluctant to agree as if the franchisee is in breach of the terms of the lease, if they wish to forfeit, the landlord just wants to get the premises back.

The downside of this model for the franchisee is that the franchisee will often set up a new company to be the tenant of the premises. The landlord will often require a rent deposit or personal guarantees to also be provided so as to give it greater security. For a rent deposit, the franchisee will therefore need to have cash available at the start and will need to accept that it may not see the return of that deposit for some considerable time.

A further risk for the franchisor is that under the terms of the lease, the consent of the landlord will probably be needed to an assignment but there will be nothing in the actual lease which will stop the franchisee assigning the premises to a competitor. Although this would inevitably be a breach of the terms of the franchise agreement there is nothing that the franchisor could actually do to prevent the assignment and so premises that it may have worked hard to secure could easily pass into the hands of one of its primary competitors.

Conclusion

There is no perfect solution for either party as both of the above models have their advantages and disadvantages. For a franchisor, if it is an established franchise where location of the premises is crucial and control over the franchisee is therefore important, the Sub-Lease model is the model which they would be advised to adopt. However, where the franchisor is new to the market or where the location of the premises is not of such crucial importance, there are advantages to the franchisor in adopting the Direct Lease model. For the franchisee, the Sub-Lease model is probably preferable as there will not be the requirement for so much direct investment up front in the form of possible rent deposits and personal guarantees etc. However the form of model used will largely be dictated by the franchisor and therefore being aware of these issues is something that the franchisee should take into account before signing up to its franchise agreement.

Taking legal advice at the outset is best not only for the franchisor but also for the franchisee so that both parties go into a transaction fully aware of what the potential advantages and disadvantages are.

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The content of this page is a summary of the law in force at the date of publication and is not exhaustive, nor does it contain definitive advice. Specialist legal advice should be sought in relation to any queries that may arise.