Why grant a business lease?
Franchising agreements are often part of a wider relationship between a franchisee and its franchisor, involving related agreements on the conduct of the franchised business. Some franchising networks include a business lease granted by the franchisor or one of its affiliates. The combination of a franchising agreement and a business lease may seem odd at first, as the principle of a business lease is that the lessor remains the owner of the business throughout the agreement, while the franchisee is deemed to be the owner of its clientele (at least at a local level). This update describes the circumstances under which a business lease is entered into alongside a franchising agreement and highlights some specific issues that franchisors should consider.
Under the franchising principle, a franchisee bears responsibility for all investments relating to the creation and running of its business with the franchisor's assistance and support. In some sectors – such as restaurants, hotels and food retail – the initial investment to create or acquire an existing business (eg, the lease, tangible assets and equipment) may be particularly high. In such sectors, franchisors may have an interest in acquiring businesses and leasing them to their franchisees. This is particularly the case where the franchisor wishes to retain ownership of certain retail outlets located in strategic places. A business lease allows the franchisor to recover the business – including the value added by the franchisee during the lease – without having to pay indemnity to the franchisee. Conversely, the franchisor may wish to give the franchisee the option to buy out the business on the lease's expiry, subject to financial terms to be agreed in advance.
A business lease allows franchisees to pay, on average, three times less than if they had to establish or acquire the business; in the food retail sector, franchisees are often previous employees (eg, shop managers) who may not be able to afford to buy a convenience store, but wish to become independent from their employers. The combination of a franchise agreement and a business lease means that a franchisee will have to pay two royalties: one to the franchisor and one to the business owner (which may be the franchisor or one of its affiliates in the same group). The rent for the business lease is generally calculated in such a way as to provide the franchisee with a minimum profit, which can be capitalised to finance the acquisition of the shop or outlet at the end of the lease (generally three to five years).
Prior operation of business
Under Article L144-3 of the Commercial Code, an owner can lease its business only if it has operated the business for at least two years. However, it is possible to seek a court waiver of this condition if the owner can demonstrate that it is not in a position to operate the business itself or via its own employees. In practice, a waiver is relatively easy to obtain if the owner's intention is not purely speculative. Further, Article L144-5 specifies that a business lease is exempt from the prior operation condition if its main purpose is to sell on an exclusive basis the products manufactured or distributed by the owner in retail shops.
Liability of franchisor
As a protection to its creditors, the franchisor that owns the business is jointly and severally liable with its franchisee for all debts incurred by the franchisee in the operation of the business for six months from the date on which the business lease was filed with the commercial court. In respect of direct taxes, such joint and several liability applies until the lease expires. The franchisee takes over the personnel attached to the business on the entry into force of the business lease and, on its expiry or termination, the personnel return to the franchisor (unless the business is bought by the franchisee).
The combination of a franchise agreement and a business lease means that the franchisee must receive full and accurate information on the duration of each agreement and their terms of renewal. In a case involving the famous Paul bakery brand, the Paris Court of Appeal held that the franchisor had complied with its pre-contractual disclosure obligation in respect of the franchise agreement, but not the business lease. The business lease had been entered into for one year (which was subject to tacit renewal), while the duration of the franchise agreement was five years. Although the franchise agreement provided for the termination of the agreement on the termination of the business lease, the franchisor had failed to provide the franchisee with the business lease agreement before signing. Hence, the contents of the pre-contractual disclosure file given to the franchisee were not sufficiently clear for the franchisee to understand that:
- there was uncertainty about the continuation of the agreements after one year; and
- the amounts it had to pay (ie, an entry fee, a franchise royalty and an annual rent for the business lease) could not be amortised over such a short period.
A franchise agreement and a business lease are mutually interdependent, meaning that they must have the same expiration date (for further details please see "Macron Law and franchising: much ado about (almost) nothing").
Recent French Federation of Franchising data shows that approximately 75% of franchisees are former employees of their franchisors. If they cannot afford the initial investment, these franchisees may start their business via a business lease. This may be a win-win situation for both franchisors and franchisees, as the lease period may be used to determine whether the relationship is viable in the long term and whether it makes sense for the franchisee to buy the business at the end of the lease.
For further information on this topic please contact Raphael Mellerio at Aramis Law Firm by telephone (+33 1 53 30 7700) or email ([email protected]). The Aramis Law Firm website can be accessed at www.aramis-law.com.