(Photo by Dan Paluska, via Flickr)
When a tenant enters into a long-term lease obligation, all of the thoughts and questions are generally positive: “How much money will I make?” “How will I expand my business?” “How will I add new employees to my business?” However, equally as important are questions that are slightly more negative, such as, “Will I be able to terminate the lease if my sales are less than expected?” “Will I be able to assign this lease to another entity if I want to sell my business?” “Will I be able to terminate the lease if there is a casualty, including a fire, in the premises or retail facilities near the end of the term, so that I will not need to rebuild the premises following such casualty?” This article addresses different ways that these types of questions and issues can be addressed by tenants in order to create “exit strategies” for their lease obligations.
The Failing Business
Since most lease obligations for tenants entail long-term obligations, a tenant should consider negotiating a provision that would allow it to terminate the lease in the event a certain level of sales was not achieved. While landlords often resist providing early termination options in the lease, most notably because:
1. The value of the lease is based upon the certain term and lenders will devalue or completely eliminate from consideration a term that exists beyond an early termination right.
2. If the landlord is investing funds in the construction of the premises, it wants a sufficient amount of time to amortize its contribution.
3. The belief that the landlord has little control over the sales that the tenant would be able to achieve.
Notwithstanding the foregoing, landlords may consider incorporating an early termination right in the lease if:
1. The early termination right is negotiated up front as part of the business terms negotiation.
2. The termination rights are clearly established with protections for the landlord if the tenant fails to operate in accordance with the terms of the lease.
3. The landlord is made whole for contributions that the landlord may have made to the construction of the premises and in brokerage commissions for the obtainment of the tenancy.
A typical provision that may be negotiated would read as follows:
Provided that the tenant is not in default of the lease beyond any applicable notice and cure period, and provided that tenant has continuously and uninterruptedly operated the Premises for business during the Measuring Period (as hereinafter defined), then if Tenant fails to achieve One Million Five Hundred Thousand and 00/100 Dollars ($1,500,000.00) (“Sales Limit”) in Gross Sales during the period from the thirty-seventh (37th) full calendar month of the Term through the forty-eighth (48th) full calendar month during the Term (the “Measuring Period”), Tenant shall have the right to terminate the Lease upon one hundred eighty (180) days written notice to Landlord, provided that any such notice shall be provided within sixty (60) days after the last day of the Measuring Period. Tenant shall continue to operate its business in the Premises through the termination date and Tenant shall surrender the Premises to Landlord in the condition required by the terms of the Lease as of the termination date. If Tenant terminates the Lease, as provided herein, Tenant shall reimburse Landlord on or before the termination date, for the unamortized portion of the Tenant Allowance provided by Landlord to Tenant for the construction of the Premises, as well as the unamortized portion of the brokerage commissions paid by Landlord in connection with this Lease. For purposes of calculating the amortization period, the amortization shall be made over the entire Term of the Lease and shall be amortized through the termination date.
Sale of a Business
In the event the tenant elects to sell its business to a third party, the tenant wants to make sure, up front, that the landlord cannot prevent the sale of its business by rejecting the prospective assignee as a viable tenant under the lease. The resistance from the landlord’s side is that the landlord has determined with whom it wants to do business, how that business is conducted by the particular tenant and what the landlord should expect to be derived from the tenant’s business. By substituting a third-party assignee, the landlord is taking a risk that:
1. The business may not be operated in the same first class manner as the original tenant conducts its business.
2. Percentage rent may decline (if percentage rent is payable under the lease obligations).
3. The landlord may have had a bad experience or knowledge within the industry that the prospective assignee will not conduct its business operation with the same level of care and competency as the original tenant.
Since, generally, leases will not allow the original tenant to be released from its lease obligations, even if the lease is assigned, and generally, the lease will not allow the permitted use to be modified in the event of an assignment, the landlord generally focuses its concern regarding an assignment on the financial viability of the prospective assignee. Typically, a landlord and tenant will reach an agreement as to the tenant’s ability to assign the lease, in the event the tenant sells its business (for all or substantially all of its assets or all of its corporate stock or interests) upon the prospective assignee having a certain tangible net worth and a certain amount of tangible assets. The level and amounts of these net worth and asset tests generally will be tied to a level that will assure the landlord that the prospective assignee has enough financial ability in order to satisfy the lease obligations and to continue to offer the same level of products and services as the original tenant. In any event, a tenant should be certain to negotiate in its lease the ability to assign its lease obligations in the event of a sale of its business to a third party.
In addition, landlords often want the tenant to agree that if it collects any rent in excess of the rent payable under the lease, then such excess amounts shall be payable to the landlord. While this concept can be negotiated with the landlord, a tenant should be careful to provide that the only amounts payable to the landlord are “excess rent” and not “consideration,” since the purchase of assets could be considered consideration as part of the assignment and sale of the tenant’s business.
The exit strategies as they relate to a casualty normally fall into two categories:
1. A casualty where the tenant is closed for business and such closure extends for a lengthy period of time (and the tenant is out of business during this period of time).
2. A casualty near the end of the term, where the tenant is not certain whether it will renew its lease obligations.
In the event of a casualty where the landlord is obligated to rebuild the retail shopping facility, the tenant should attempt to negotiate a provision whereby if the landlord does not rebuild the retail shopping facility within a certain period of time (e.g., 12 months following the date of the casualty), then the tenant will be provided the right to terminate the lease. This is necessary for several reasons, including the tenant’s ability to maintain its employees while the premises is closed due to the casualty and also the tenant’s ability to maintain a viable business, once it has been closed for business to the public for an extended period of time. If requested, this type of termination right is often agreed to by landlords, with the caveat that most landlords want the right to nullify the tenant’s termination of the lease if the landlord is able to deliver the premises to the tenant fully constructed within 30 days after the tenant terminates the lease. Whether this nullification provision is included in the lease is a matter of negotiation.
Further, near the end of the term, generally within the last two years of the expiration of the term, a tenant will want the right to terminate the lease, in the event of a casualty, if it is closed for business based upon a casualty, and the premises needs to be rebuilt. The thought process behind this termination right is that the tenant does not want to rebuild its premises, only to be in a position of not renewing its lease (or not having its lease renewed) once the premises has been rebuilt. If this type of termination right is contained in the lease, it generally forces the landlord and tenant to negotiate either an extension of the lease at the time of the casualty, or to allow the tenant to relocate its business operations to another location without waiting until the landlord has constructed its portion of the construction obligations and the tenant has rebuilt its portion of the construction obligations in the premises.
By carefully evaluating certain “exit strategies” at the inception of the lease negotiations, a tenant can be placed in a much better situation to address concerns regarding the viability of its business, the sale of its business or events following unforeseen events like casualties. All of these early termination rights or assignment rights will be considered by landlords during lease negotiations; however, if they are not raised by the tenant during the lease negotiation, they will often be left silent, since the typical landlord form will not address these types of “exit strategies.” As a result, a tenant would be wise not only to consider the “upside” of a business venture but also the potential “downside” or “exit strategies” when entering into a lease obligation.
Glenn A. Browne, a member of the Commercial Leasing Law & Strategy newsletter’s board of editors, is a shareholder in the law firm Braun, Browne & Associates, Riverwoods, Illinois.