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In our work brokering businesses, we see first hand the effect of lease agreements on the selling price and transferability of businesses. In my experience, most companies lease their premises, and those business owners who enter into lease agreements with their exit strategy in mind generally achieve more successful exits. This article covers some of the basic lease issues that impact business value and transferability.
The easier it is to relocate a business, the less influence the lease usually has on business value and transferability. However for retail and other location-dependent or facility-intensive businesses, the lease agreement can be a big deal. Usually, the more difficult it is to move a business, for any reason, such as risk of customer retention, business disruption or high cost of tenant improvements (which can’t be moved), the more the lease is scrutinized by buyers and the greater impact it can have on business value. This article pertains to these types of businesses.
Rent. Business values are mainly driven by the likelihood of a business producing future earnings, after rent expense. Lower rent means higher business value and vice versa. For a profitable going concern business with below-market rent and a long-term, transferrable lease on a suitable facility, business value is increased.
Conversely, above-market rents reduce value and become problematic in business transfers, causing many potential buyers to move on to the next deal. A percentage rent clause bases rent on a percentage of your gross sales. It changes rent from a fixed to a variable cost, which is usually undesirable if you want to grow the business. Percentage rent and other landlord participation clauses are carefully analyzed when forecasting profits and determining value.
Expiration. I recently provided an independent appraisal of a retail chain with multiple short-term leases and landlords that were unwilling to negotiate extensions.
Which would you pay more for: a successful business with reasonable rent and 18 months remaining on the lease and no opportunity to extend (say the landlord has other plans for the property), or an otherwise identical business with a 15-year lease term? In the first case you will heavily discount any projected earnings beyond two years.
There probably isn’t much of a market for the first business since buyers can only count on 18 months of income and lenders won’t finance. In the case of a distressed business or a business with an undesirable facility, a short lease can have a positive affect on value, if a buyer can eliminate the facility or has a better place to relocate the business. Of course, an astute buyer will consider the cost and risks of relocation.
Options to extend. It’s good to have options. The best options usually have fixed rents or specific formulas that determine rent for the renewal periods. The problem with many renewal provisions, however, is that they are vague with respect to future rents or amount to little more than agreements to agree on future rents, which are both tough for potential buyers to rely upon.
Some option provisions specify the higher of market rent or the rent immediately before the option period, which means even though market rents have declined recently, these businesses are stuck with above-market leases. Until a few years ago it was common to see businesses paying higher percentages of annual revenues in rent. Renewal options with pure market rent adjustments have recently become value adders.
Landlords are more open to renegotiation at this time under any lease circumstances.
Assignability. Most leases say that the landlord shall not unreasonably withhold consent to assign the lease to a new business owner. However, some leases place more restrictions or give the landlord a great deal more latitude in this area, effectively reducing the number of potential buyers for and the transferability of the business. Business owners should be sure that the assignment and subletting provisions of their leases are reasonable and don’t give too much discretion to the landlord.
Restoration clause. A requirement in the lease to restore the premises to its original condition is a significant liability for a business with major, difficult to remove tenant improvements. This liability is often overlooked by business owners when entering into lease agreements. Environmental clean up can also represent a major expense at the end of a lease. For one chemical processing business that we worked with, the estimated cost of shutting down the facility actually exceeded the value of the business.
Properly structuring your facility lease now can help you make a profitable and seamless exit when that time comes. Even if you are 20 years from retirement, consider your contingency plan when entering into a lease. There are more lease issues to watch out for ? these basic issues are just a start. Be sure to get help from the appropriate professionals.
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Al Statz is president of Exit Strategies Group Inc., a business brokerage, mergers, acquisitions and valuation firm serving closely held businesses in Northern California. He can be reached confidentially at 707-778-2040 or alstatz@exitstrategiesgroup.com.
