Does Your Lease Agreement Affect Business Value?
Business owners generally understand that their business needs to have contracts and agreements in order to protect itself from being sued and having to pay lawyers to defend the company.
What is less understood is how business contracts relate to business value. Well-written contracts and agreements can enhance overall business value, and poorly-written or non-existent contracts can harm business value even—if there isn’t a lawsuit. They do so by decreasing or increasing the risk factors inherent in the business.
Factors of Business Value
For well-performing businesses, business value is a function of cash flow and a “multiplier,” which is derived from a number of factors, such as prior market sales, total revenues, overall business performance, and some soft factors.
The multiplier is, in reality, a numerical expression of the likelihood of the cash flow continuing into the future. The lower the risk, the higher the multiplier. However, as risk increases, the multiplier (and therefore the value) decreases.
The owner will try to grow the business by increasing revenue and cash flow, but she also shouldn’t do so with reckless abandon. Any risk factors that can be controlled for and mitigated, should be, as this will further increase the value of the business.
Various contracts and agreements fit the bill as risk mitigators, but these are three key agreements that almost every business should have:
Though these are complicated documents, there are a few major considerations for each that significantly reduce or increase risk for the business. We’ll look at the first of these here.
At a seminar I attended recently, I heard a business broker explain to the audience the rationale behind his policy of reviewing a business’ lease before he agrees to list it. Too many times he’d put together a sale, only to have the deal tank because the business’ lease was problematic. Now, he said, he won’t accept a listing from a business with a lease he believes will ultimately hinder a sale.
In other words, this broker’s experience is that a lease can make a business entirely 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 must wait until the end of your lease to sell. If this is the case, the cost of moving the business or renegotiating the lease will reduce the business value.
The biggest problem with lease agreements 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 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.
Certain lease clauses can have a significant negative impact on business value and should be given special attention. Below is a general overview of what these clauses are and what they mean. If you run into any of these clauses in a commercial lease, you should hire professional legal counsel to review the lease.
Rent Adjustment Upon a Transfer
This provision allows the landlord to change the rental rate when the lease is assigned to a buyer to the higher of the current rent or a market rate. 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 requested. Unfortunately, the negative effect on the business is dramatic, usually resulting in the loss of the deal at hand and 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 her 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 line his pockets.
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, he 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 if:
1) There is no objective standard for determining the rent during the additional periods (e.g. the landlord sets it to the “market rent”), or
2) The tenant doesn’t get notice of the new rent until after the date to make the election passes.
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 both knows the new rental amount before having to commit to the additional term and has enough time to consider alternatives if she thinks 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 since it is her property. What is problematic, however, is when the assignment provision gives the landlord complete and absolute discretion to accept an assignee.
The lease should provide certain minimum standards that the assignee must 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.
Contracts Affect Business Value
A lease is a key agreement for almost every business, and 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.
There are other contracts that will affect the value of your business—your employment agreements, your customer agreements, your supplier contracts—but the lease is obviously one that plays a major role. Not only can it affect the growth and value of your current business, but certain provisions in the lease agreement can restrict or entirely inhibit the salability of your business and reduce your business value.
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