Many franchise opportunities require a brick-and-mortar space, and for most franchisees, this means entering into a retail lease directly with a landlord, or a sublease with the franchisor, which is subject to a head lease with the head landlord.
More and more franchisors are moving away from the subleasing model, and may require their franchisees to (a) find a proposed site for the franchisor to approve, (b) negotiate the lease (directly) with the landlord, possibly with franchisor support, and (c) enter into the lease themselves in the capacity of tenant. From the franchisor’s perspective, this approach reduces some of its disclosure obligations and exposure to liability from the landlord. Accordingly, a franchisee’s understanding of a tenant’s monetary obligations is of paramount importance.
During lease negotiations, many prospective tenants tend to focus primarily or exclusively on the fixed monthly amount payable under the lease. However, this is only one element of a tenant’s financial obligations. There are various types of rent, and you should consider their cumulative effect on your bottom line.
- Minimum rent. Basic, base, or minimum rent is the fixed amount of rent that the tenant is obliged to pay over the course of the term, typically in equal monthly installments. This type of rent is usually expressed as a dollar per square foot ratio.
- Additional rent. Additional rent, common area maintenance rent (CAM), and/or taxes, maintenance and insurance (TMI) refer to all of the extra amounts the tenant must pay to the landlord, and typically includes the tenant’s proportionate share of common area expenses, taxes, utilities, maintenance costs, insurance premiums, administrative fees, and general operating costs and expenses incurred by the landlord.
- Percentage rent. Percentage rent is an additional type of rent found in retail leases that is specific to the tenant and its business operations. This type of rent is based on a percentage of the tenant’s gross sales, usually over a specific breakpoint.
Breaking down the breakpoint
There are two types of breakpoints: natural and fixed.
A natural breakpoint is calculated by dividing the minimum rent by the percentage rent rate. For example, if the annual minimum rent is $100,000 and the rate is 5 per cent, then the breakpoint would be $2,000,000 in gross sales. The percentage rent is paid on any gross sales achieved over the breakpoint. In this example, if the franchisee obtains gross sales of $3,000,000 in one year, the franchisee must pay the landlord $50,000 on account of percentage rent being 5 per cent of $1,000,000.
A fixed or artificial breakpoint can be higher or lower than the natural breakpoint, and will be negotiated by the tenant and the landlord. A higher breakpoint is preferable from a franchisee’s perspective because it is more likely to be triggered once the franchise is performing well.
Special considerations for the franchisee tenant
Lack of certainty: As a new franchisee, it may be difficult to estimate your gross sales over the course of the lease, especially in the first few years of operations, making it difficult to predict how much percentage rent you may be required to pay. This lack of certainty with respect to your monthly and annual leasing costs will leave a gap in your business plan and budget.
Reporting obligations: Since percentage rent is based on gross sales, the franchisee will likely be subject to specific reporting and accounting obligations. Moreover, the landlord often preserves certain inspection rights to enter into the premises for the purposes of reviewing the books and records of the franchisee. The franchisee may incur additional costs in the preparation of such financial reports.
Gross sales: Royalty payments are often based on gross sales; however, the definition of gross sales in your lease and your franchise agreement may differ (sometimes materially). This means you must take extra care to ensure any reports or payments calculated on the basis of gross sales are made in accordance with the appropriate definition.
Timing: Unlike minimum rent and additional rent, percentage rent may be payable on a monthly, quarterly, or annual basis. Consider the timing of this obligation in relation to other rent payable under the lease, and your financial obligations to the franchisor, trade creditors, and suppliers.
Approval of franchisor: If you are entering into a lease as tenant, it is likely that the franchisor has reserved its right to approve the lease prior to its execution. If the lease for your proposed site includes percentage rent, be sure to verify early on in the negotiations whether the franchisor has any issue with this additional form of rent.
There are a number of provisions in a lease that will be of particular importance to a franchisee; however, understanding the basics of rent is a good place to start.
Cassandra Da Re
Associate, Corporate and Commercial Law
Dale & Lessmann LLP