Three Agreements That Can Make Or Break Business Value: Part 1 The Lease
Three Agreements That Can Make or Break Business Value
Business owners understand that having good agreements can reduce the likelihood of being sued and having to pay lawyers to defend the company.
What is less understood is how good agreements can enhance business value, and how bad agreements – or no written agreements at all – can harm business value even if there isn’t a lawsuit.
For well performing businesses, business value is a function of cash flow and a number called ‘the multiplier.’ This multiplier is determined from a number of factors, including prior market sales, total revenues, overall business performance, and soft factors.
The multiplier is in reality an expression of the likelihood of the cash flow continuing into the future. The lower the risk, the higher the multiple. However, as risk increases, the multiplier (and therefore the value) decreases.
Therefore, to grow business value, the owner must, in addition to growing revenue and cash flow, also reduce or eliminate other risk factors.
Risks that can be controlled come in different ‘flavors.’ One of them are the terms and conditions of four key agreements that almost every business should have.
These key agreements are:
· Employment Agreements
· Sales and Service Agreements
Though these are complicated documents, there are a few major considerations for each that significantly reduce or increase risk for the business.
I was recently a speaker at a ‘Selling Your Business’ seminar with a business intermediary who told the audience that he reviews the lease of each business before he lists it.
He’s discovered too many times after putting a sale together that the wrong lease kills the deal. He won’t accept a listing from a business with a lease he believes will ultimate hinder a sale.
In other words, this broker’s experience is that a lease can make a business unsalable. I agree completely.
And this is the case even if you don’t have a retail business. In order to sell, the lease must be transferrable. Otherwise you won’t be able to sell until the end of the lease. Plus, the cost of moving the business will reduce the business value.
The biggest problem with leases in general is a lack of specificity. You want the mechanics of the relationship between tenant and landlord to be as detailed as possible, and
to limit the ability of the landlord to exercise its complete discretion or to change the arrangement over time or as a result of a business sale.
For example, leases will typically provide for landlord approval of signage and construction plans. To make the lease more specific you would want the requirements for
approval of signage and construction plans described in detail in documents attached to the lease at the time it is signed. This enables you to understand how to comply and prevents the landlord from changing requirements after the deal has been inked.
Lease clauses that can have a significant negative impact on business value include:
Rent Adjustment Upon a Transfer. This provision allows the landlord to change the rent to the higher of the current rent or a market rate when the lease is
assigned to a buyer. Because business value is tied to cash flow, increasing the rent reduces cash flow and, therefore, reduces business value. In short, the
landlord gets part of the value of your business through the increased rent.
Right to Terminate Lease Upon Request for Assignment. A variant to the rent adjustment provision, this gives the landlord the right to terminate the lease if an assignment is request. Unfortunately the negative effect on the business is dramatic, usually resulting in the loss of the deal at hand, and often all or most of the business value.
In the best case scenario, the owner relocates the business and builds it back for several years before being able to sell.
Fee for the Assignment. With a fee for assignment provision, the landlord either gets a specific fee – usually expressed as an amount of rent – or a portion of the business price for granting the right to make the assignment. This differs from a rent adjustment clause because the fee is in addition to rent for the location.
While it is not unreasonable for the landlord to want its expenses paid in the event of an assignment, the fee should be reasonable and based on the work that has to be done.
So, where the landlord is going to have the buyer’s financial statements reviewed by an accountant, or the consent to assignment and assumption agreement prepared by an attorney, those expenses should be paid by the tenant.
However, the sale of the business should not be a reason for the landlord to get a windfall.
Rent Adjustment for Optional Terms. Leases often provide the tenant with the option to renew the lease for additional time after the initial term. Once the tenant builds out a space and moves in, it wants to utilize the space for a significant period of time.
However, the landlord doesn’t want the space to be rented below market rate after the initial lease term. Therefore, the rent is often subject to an adjustment for that additional time that is more than the typical 3% or 3.5% per year increase.
These arrangements work for both tenant and landlord, but can be a problem in two situations:
1. Where there is no objective standard for determining the rent during the additional periods (e.g., the landlord sets it to the “market rent”); and
2. Where the tenant doesn’t get notice of the new rent until after the date to make the election passes.
Moreover, without these issues resolved, a buyer won’t know the rent after the initial term, increasing risk and reducing the business
The first can be resolved by establishing an objective process utilizing third party data to determine market rent. The rent should never be determined by the landlord without reference to actual area market rents. Rather, there should be an objective process to compare rents for similar properties in the area.
The second is a timing problem. The new rental rate must be established so the tenant: (1) knows the amount before having to commit to the additional term; and (2) has enough time to consider alternatives if the rent is not acceptable. Of course, other options may not be as big a concern if there is an adequate process to establish a true
market rental rate.
Conditions for Approval of Assignment. Leases almost always give the landlord the right to approve an assignee tenant. This is certainly appropriate.
What is, however, problematic is where the assignment provision gives the landlord complete and absolute discretion whether or not to accept an assignee.
Rather than be at the risk of the whims of the landlord, the lease should provide certain minimum standards that the assignee should meet in order for an assignment to be approved, and the landlord should be obligated to provide the approval in a reasonable time and without unreasonable conditions added to the approval.
Because a lease is a key agreement for almost every business, it should be thoroughly and professionally reviewed and, where appropriate, negotiated. It represents both a significant liability and a significant opportunity for the business, directly impacting business value.
I’ll review the other key agreements in the next newsletters.