Franchise Finesse
May 1, 2003 12:00 PM, By Robert Simpson with Richard DiChiara Jr.
How can a young franchise company secure Class A retail space in competitive real estate markets? As the “new kid on the block” with an unproven track record, a startup franchisor often has a difficult time convincing landlords that it is the retailer of choice for highly sought-after space.
To overcome this and other challenges, the franchisor must first get its foot in the door with landlords before it can make it to the tenant “A list.” This means teaching leasing agents about the franchisor's concept, points of differentiation and local marketing strategies. Specifically, it means demonstrating to the landlord the steps the franchisor will take to attract customers. This may require franchisors to provide landlords with a business plan, marketing plan and implementation strategies as well as statistical research that proves the size of the potential consumer market and the viability of the business concept.
Also, a franchisor, which typically has complicated income reporting and recognition criteria, must be forthright in responding to financial questions. The company's financial statements might show that, despite its growth potential, it is operating in the red because of a prohibition on income recognition for financial reporting purposes. This ensures an accurate representation of the facts and eliminate the risk of misinterpretation by the landlord or its professionals.
It's also essential to establish appropriate security. With a strong and viable location, landlords will typically require long-term lease guarantees. In some instances where a landlord seeks a larger security deposit, the franchisor might have to step in to provide an additional guarantee on the lease.
Many franchisors establish real estate subsidiaries to help franchisees secure Class A real estate. The corporate subsidiary enters into the lease agreement with the landlord and reserves the right to sublease the space to an approved franchisee, who is required to pay for the build-out of the retail space and the ongoing lease payments. The franchisor can structure additional cash security that gets “burned back,” or credited, against subsequent rental obligation, after the first lease year. Standby letters of credit and similar financial instruments can also be used if necessary.
By structuring the security this way, neither franchisor nor franchisee becomes overburdened with a long-term contingent liability. The franchisee is not required to make a large cash outlay for a dormant security deposit — monies that could be spent on marketing or working capital. It also provides the landlord with a comfort level in having adequate security from multiple sources and in multiple forms (a “hybrid” guaranty) in the event of a default. The bottom line is that with some creativity and cooperation, security should never be a deal breaker.
Finally, it's important to negotite existing “exclusive” agreements. Landlords, especially in older retail centers, often have “exclusive” agreements with existing tenants that restrict or prohibit leasing space to retailers in the same industry. In these instances, franchisors should insist on reading the exact language of the exclusive arrangements to determine the extent and limitations of the agreement. By carefully drafting the use clause so as not to be overbroad but to include clear and precise uses, franchisors can, in many instances, co-exist with other similar retailers even where those retailers have exclusives.
Who Robert Simpson with Richard DiChiara Jr.
Simpson is national real estate director and DiChiara Jr. is corporate real estate counsel for haircolorxpress International, a national franchisor of salons specializing in hair-color and custom-blended cosmetics
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