Monday, 30 November 2009

Buying a Business - Checking the Lease

Despite stringent disclosure rules which aim to even things up between the supposedly rapacious seller and the innocent purchaser, it's very easy for a buyer of a small family business to be caught by buying a dud.

If you're stuck with a dud business as a result of being deliberately deceived you certainly can take them to court. But you don't need me to tell you of the costs of litigation, the time it takes (years!), and the very real chance you may not succeed anyway.

Trap: The Demolition Clause

Before I left the shop I had asked the owners for a copy of the lease. They told me it still had 4 years to go and there was an option to renew for another 5. Good.

I read the lease and found it had a demolition clause in it. This allows the landlord to terminate the lease with minimal notice if they planned to demolish and redevelop the mall. And there is no compensation to the unfortunate lessee.

The trouble with a demolition clause is that it can be triggered at any time by the landlord and usually with very short notice. You might assume (or be told) that it would only be used to periodically give the center a makeover, which is not necessarily a bad thing. You have a lovely new shop and traffic through the center increases.

But a demolition clause does not in any way guarantee that you will get a new shop or that an office block (or whatever) will not be built on the site with no room for your shop.

So, in essence, you could lose everything. Where I have seen businesses with this clause in the lease, I usually say don't buy it - just walk away.

Trap: The Refurbishment Clause

I then discovered a clause that said the shop had to be refitted and refurbished every 7 years to a minimum standard dictated by the landlord and at the lessee's expense. The 7 years was up in two years time and I estimated it would cost about $100,000.

Retail shops do have to be refurbished from time to time, otherwise they may lose customers. But it should be the owners decision when to do this and how much to spend on it. This clause does not necessarily mean you should not buy. But it certainly gives you grounds for negotiating a lower price.

This type of clause is not restricted to retail shopping malls. I know of an owner of a business operating out of a commercial shed who got badly burnt when he had to repaint the whole shed shortly after he bought the business and took over the lease.

Trap: The Compounding Rent Increase

The formula for the annual rent increases was the higher of the inflation index or 7%. That doesn't sound too bad, but it means the rent would nearly double in about 10 years.

It sounds innocent enough when inflation is high, say 8%. In that case a 7 or 8% increase is neither here nor there because the $ is decreasing in value by the rate of inflation. The problem is when there is a recession and inflation drops to (say) 1% or even zero. Now you are being hit with a real increase of up to 6 or 7%, which can be crippling.

To make it worse, the increase is compounded each year. Say the rent in year1 was $3,000 a month, or $36,000 a year, that it was a 5 year lease with an option for another 5, and that it went up by 7% each year. After year 10 it would be over $66,000 Do the maths!

This type of clause is banned in some states and countries, where it has to be one or the other, but not both. In other words the rent must increase either by the rate of inflation, or a fixed rate.

Always choose the inflation rate when negotiating a lease.

Trap: The Hidden Rent Increase

And finally, this lease from hell said that once my gross sales reached a specified level I would have to start paying 1% of the excess to the landlord.

This type of clause is often found in Food Courts in shopping malls, especially when the landlord fits out the shop at their expense and the shop owner just moves in.

You probably can't do much about it, but you need to do the figures before you accept it. It can soon add up to a lot of money.

Trap: The "Market Review" Clause

Another thing to watch in leases is that on the expiry of the rental period there is usually a "market review". This means the landlord gets the chance to catch up with any general rise in rents in the area. So if the lease has say six months to go before another five-year renewal, you could be faced with a sudden, unexpected hefty increase.

Check with an independent Real Estate Agent. They will know whether a big increase is likely. If it is, tell the seller that you want to negotiate a new lease directly with the landlord, rather than being "assigned" (transferred) the old one. That way you will see what the new rent is going to be before you sign up.

Be aware also that it is up to the tenant (the seller) to exercise an option for renewal of the lease and that this usually has to be done at least 3 months before the expiry date of the old lease. If the seller forgets to do this the landlord is quite within their rights to refuse to renew.

Lookup the appropriate clause in the lease. If the seller should already have exercised the option, verify directly with the landlord that they have done so.

Trap: The Lease is up for Renewal

Say there is 6 months to go on the lease and no option for renewal. The seller assures you there will be no problem as the business does well and they are model tenants who have always paid the rent on time.

Don't take their word for it. You need to check three things with the landlord. First, that the lease will be renewed. Second, what the new rent and share of outlays will be, and third, that you comply with their minimum requirements for a suitable tenant.

Better still, make it a condition of the buy contract that you want a new lease commencing immediately and don't settle until you have it.

Trap: Not Being Allowed to Offer New Products or Services

This is a shopping center thing. You buy the business full of enthusiasm because you have a secret plan. You are going to introduce a new line of products or maybe start selling coffee.

As soon as you do Center Management descend on you. They point out the clause in your lease that says you can't do that because they have an agreement that there will only be one coffee shop in the mall.

Always check the fine print in a lease, and use a magnifying glass! And when you think you have the business you want, get a lawyer to check it again.

But don't just rely on the lawyer, check it out yourself too!


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