Many franchisors and their financial and legal advisors ask themselves if there is an ideal model for holding leases in a franchise network.
Several decisions rendered in the last few years have underscored the weaknesses and flaws of some of these methods, particularly of one method thought at one time to be the best, i.e., having the franchise leases executed and held by a corporation that is controlled by the franchisor and owns no other assets than those leases (a "shell corporation").
Before answering the question as to whether there is an ideal model for holding leases in a franchise network, here is an overview of the primary ways for a franchise network to hold the leases of its franchised locations:
Franchisor as Owner of Premises - Franchisee as Tenant
This model is used by several franchisors (typically larger franchisors) for at least some of their franchised locations.
Also a real estate investment opportunity for the franchisor, this model ensures that the franchisor retains a high level of control over each of the locations of its franchised network.
Franchisor as Tenant of the Premises - Franchisee as Subtenant
This model is also used by several franchisors.
While ensuring a good level of control over each location, under this model the franchisor becomes liable for all the obligations under each lease (a liability that must be reflected in the franchisor's annual financial statements).
Franchisee as Tenant with a Three-Way Agreement (Lessor – Franchisee – Franchisor) Under Which the Franchisor is Entitled to take back the Lease Under Certain Conditions.
Theoretically, this method might seem ideal since the franchisor assumes no liability to the lessor while benefiting from the option of taking back the franchisee's lease in the event the franchise agreement is terminated or of any default by the franchisee under the lease.
This method, however, can be difficult to sell to a lessor (who has no guarantee that the franchisor will assume the lease if the franchisee is in default) and requires injunctive relief if, once it has defaulted, the franchisee refuses to voluntarily comply.
Franchisee as Tenant Without a Three-Way Agreement
This model is used primarily (a) when the location is not that important for the franchisor, (b) for premises that the franchisor considers risky or not particularly attractive, and (c) when there are several alternative locations available nearby.
Franchisee as Owner of the Premises
Lastly, the franchisee (or any person related to the franchisee) may be the owner of the premises.
Clearly, this model provides the franchisor with very little control over the location.
This model, however, may be combined with the second or third model described above, for example, by having the owner-franchisee sign a long-term lease with the franchisor, who in turn then signs a sublease with the franchisee, the term of which may be the same as the term of the franchise agreement.
In this model, a franchisor may also obtain from the franchisee-owner an option to purchase (in certain circumstances, including termination of the franchise agreement) or a right of first refusal on the property.
There are many variations of each of these models and there are also others that are less commonly used (but appropriate in certain cases).
To return to our initial question, and as you might well imagine, there is no "ideal" model suitable for all franchisors.
Since several factors come into play and each franchisor should think carefully before choosing the model for holding its franchise network's leases. These factors include (a) the importance of the site for each establishment, (b) the appeal and commercial value of the site, (c) the franchisor's ability and willingness to take over a failed site, (d) the franchisor's financial resources, and (e) how important it is to the franchisor to control the locations of its franchised network as compared to the risk that might arise from being liable for the leases.
Keep in mind, however, that a franchisor is not required to use only one model for all the locations in the network.
By adapting its contracts accordingly, it is entirely possible that a franchisor might choose a different model for each premise. For example, a franchisor may own certain premises, be the primary tenant and sublessor for some, have a three-way agreement for others, and allow some franchisees to own their premises.
Regardless of the model(s) chosen, how well the agreements governing the premises (e.g., franchise agreement, lease, sublease, three-way agreement) are drafted is often the most important factor in preserving and protecting the franchisor's rights. Ensuring that the agreements are duly executed by all parties (including, for many, by the lessor of the premises) is equally important.
Unfortunately, often it is only when a problem arises that the franchisor is truly able to evaluate the quality of its contracts.