Franchise Tutorial 19: Intro to Head Leases and Subleasing from the Franchisor

Many franchises will require that their franchisees operate out of a retail, office or commercial location. In these circumstances, you, as a franchisee, would enter into a head lease or sublease agreement. It is important that you understand the agreement and contractual relationship that you are entering into.

A head lease is where you are in a direct contractual relationship with the landlord. The franchisor will typically require in the franchise agreement that such lease documents and the location are approved by the franchisor before signing. The franchisor wants to ensure that it is a viable location and that the terms are reasonable. However, the franchise agreement will typically state that the franchisor's approval of the site does not represent or warrant the success of the location. The franchisor cannot predict success, as there are many variables that will affect your business.

In many circumstances, the franchisee will sublease their space from the franchisor, with the franchisor on the head lease with the landlord. This is done when the franchise's success is very location-driven or where the landlord requires a strong covenant. A sublease arrangement allows the franchisee to have access to locations that they would not have access to otherwise. The franchisor will retain control over the site by entering into a lease directly with the landlord and then subleasing the location to the franchisee on principally the same terms and conditions. In the event that the franchisee is not successful or abandons the business, it is far easier for the franchisor to take over the location when they are on the lease directly.

A third situation is where the franchisor and franchisee go on the head lease with the landlord, making it a three-party, or "tripartite" agreement. In the event that the franchisee is in default of the lease, the franchisor would have the right to cure the defaults or take over the location. The agreement may also allow the franchisor to assume the lease in the event that the franchisee decides not to renew at the end of the lease term or the franchise agreement is terminated. From a franchisor's perspective, this gives them the ability to control the location without the obligation and liability. However, from the landlord's perspective, it limits their options and thus landlords are reluctant to sign three-party agreements. They often want to have flexibility to rent the space to someone else in the event of default.

These three different leasing options are a function of balance between control and risk. If a franchisor wishes to have control of a great location, it will assume liability and go on the lease and then sublease to franchisees. For a start up franchisor, this could be a substantial risk and the third-party agreement would provide a viable solution. For a well-established franchisor, risk is less of an issue and they will often want the ability to step in and take over the location in the event of the default, so as to preserve the great location and the established customer base.

A franchisor will typically have a "cross default" clause in the franchise agreement stating that a default on the sublease or lease agreement is a default of the franchise agreement.

Regardless of whether you are on the head lease or in a sublease or a tripartite agreement, be sure that you fully understand your legal and financial obligations under the lease. Typically, the total occupancy costs are different from the base rent that is quoted. Be sure you budget for the total occupancy costs for the space and not just the base rent.

Total occupancy costs will often include the following:

Base Rent – Usually quoted as an annual cost per square foot.
Common Area Maintenance (CAM) – Your business' share of such costs as security, snow removal in the parking lot or cleaning of the common areas.
Percentage rent – Some landlords in high traffic retail locations will request a percentage of your gross sales.
Property tax – Typically, you will pay your portion of the property tax, based on your square footage.
Merchants' association or marketing fund – Large shopping malls or complexes will have tenants share costs for mall promotions and events; again, the amount is allocated based on your square footage over the total amount of leased square footage.

Your rent payments are usually paid monthly directly to the landlord, with certain items, such as property tax, paid annually. The merchants' association or marketing fees are often paid quarterly. In sublease arrangements, the franchisor may require that you pay them directly and then the franchisor pays the landlord. In these cases, get clarity as to whether or not the franchisor is charging a fee or 'up-charging' for being on the head lease. This can sometimes be justified, for the franchisor is taking on added liability for you to access a great location, but it should be disclosed.

It is important that you fully understand your obligations under the lease or sublease agreement. Have a lawyer review and explain the documents before signing. Once you are open for business, work at maintaining the relationship with your landlord and franchisor so as to avoid difficulties down the road. If you foresee problems in making lease payments, don't hide this fact. Instead, communicate the issue to both your landlord and franchisor so that there are no surprises and work with them to find solutions for payment.

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Posted Date: January 2011