A Hidden Danger in Lease Assignments and Restaurant Sales

hidden-danger-remodelingWe have written here before about important things to consider when purchasing a restaurant, and we have also written about exclusivity provisions in restaurant leases. A recent deal we were working on, however, has highlighted how those two topics work together – and demonstrated a hidden danger for restaurant purchasers that can be hidden in restaurant leases.

As part of our legal assistance of any restaurant purchaser one of the most important things that we do is review the existing lease that will be assigned to the buyer. The quality of the restaurant’s lease, after all, bears an outsized relationship to whether the restaurant succeeds, and how bad things can be for the owner if it does not. Understanding the lease you are inheriting in a restaurant purchase is therefore critical.

In this case, our client was purchasing a restaurant that specialized in a specific type of food – for the purposes of this discussion, let’s say it was a Korean restaurant. We were therefore initially pleased to see that the lease contained an exclusivity provision whereby the landlord was restricted from leasing space in the shopping center to any other restaurant that sold Korean food. That initial pleasure wore off, however, when we noted two other provisions: first, that the tenant would lose that right of exclusivity upon any event of default; and second (and of particular importance in our case), the exclusivity would not survive assignment of the lease. We were able to quickly confirm and get assurance (supported by the appropriate documents of course) that there had been no prior defaults, but we still had to address the assignment issue or our client would be buying a Korean restaurant, but would be taking over without a built-in advantage that the current owner enjoyed.

Thankfully, in this case, the landlord agreed – as part of the assignment – to extend the same exclusivity provisions to the buyer that it did to the seller. It should provide a cautionary tale, however, on the importance of a detailed lease review by a knowledgeable attorney. Had we not reviewed the lease, and paid attention to this provision, our client would have been exposed and vulnerable were this landlord (or a subsequent landlord) to later decide to lease space in the shopping center to another Korean restaurant — perhaps a national chain or hot new fast casual place. Maybe it would never have happened, but when you are investing in the purchase of a restaurant, especially a particular type of restaurant, there is no reason to take that chance.

In Restaurant Sales, its You and Me and the Landlord Makes Three

img_broken_handshake_540x360When involved in a restaurant transaction, the parties (understandably) spend much time and effort on examining the health of the business and the terms of the deal itself. The buyer will, among other things, study the restaurant’s revenues and operating expenses, any potential liabilities, and the condition of the equipment involved. On the other side, especially if there is seller financing, seller will examine the creditworthiness and financial wherewithal of the buyer, as well as their experience in running such a business. And both sides (of course) will focus great energy on negotiating the purchase price.

Often forgotten in this exchange of information and examination of risks is the landlord. The landlord is a necessary party to almost all restaurant deals, because almost all restaurant leases contain provisions that require the landlord’s consent to the assignment of the lease from the seller to the buyer. If the landlord does not provide that consent, the deal is off – even if the seller and buyer are in complete agreement on all terms.

For this reason, if you are considering listing your restaurant for sale, you should consult with your landlord to determine (or at least get a sense of) the conditions it might place on any such assignment. Is there a restriction on a change of format (e.g. the type of food)? Will the landlord require the new tenant to meet some threshold of financial strength? Determining these factors early on can save you from wasting time with a prospective buyer that has little or no chance of being approved by the landlord. And if you are a prospective buyer, among the first things you should ask the seller is if he has had these conversations with the landlord.  That question may save you from spending time and money (i.e. lawyer’s fees) to negotiate a transaction that will be snuffed out by the landlord down the road.

So the lesson here is that, while it may take two to tango, it often takes three to finalize a restaurant deal.

Don’t Even Think About Buying a Restaurant Without Answering These Four Questions.

menu-restaurant-vintage-tableFor generations, owning and operating a restaurant has been a common dream for would-be entrepreneurs. Unlike many other businesses, most of us think we understand how restaurants operate (we all eat at restaurants, don’t we?), and there is a certain charm and allure to the idea of welcoming our friends and neighbors to a place all our own. Beyond that, while individual failures are plentiful, the restaurant industry as a whole has been remarkably resilient, even in tough economic times.

Still, we all have heard the legendary statistics regarding new restaurants’ failure rates, and wonder if there is a way to mitigate that risk and still pursue the dream of restaurant ownership. For many, the answer is to purchase an existing restaurant, which may have a reliable customer base, an established location, a proven concept, and a well-known name. If you decide to pursue that route, however, we encourage you to ask yourself (or your lawyer) a few questions early on in the process:

1.     What, exactly, am I buying?

Yes, you’re buying a restaurant. We know that. But it’s really not that simple. In most cases, if you are buying a single restaurant, you will do so through what’s called an asset purchase agreement (APA). In such a case, you will buy all the assets of the restaurant business, including both tangible (tables, chairs, kitchen equipment, point-of-sale system, etc.) and intangible (trade name, intellectual property, good will, etc.). When restaurant deals are accomplished this way, the buyer takes over all the operational aspects of the restaurant, but does not (generally speaking) assume the debts and liabilities of the prior owner, as the buyer would if they simply bought the company that owned the restaurant outright. Moreover, regardless of the structure of the deal, all buyers should conduct their due diligence such that they assure themselves they are not “buying” anything they didn’t bargain for, such as long term payment obligations, liabilities to employees or vendors, or pending regulatory violations and associated fines,

2.     Do I need a new lease?

Often, when a buyer purchases a restaurant, they simply take over the existing lease of the prior owner through a process called an assignment. An assignment, however is not always possible or advisable. In most instances, for example, a landlord will have the right to approve any proposed assignment and may not wish to engage with the new owner on the same terms as the prior one. In that case, the landlord may insist on a new lease with more terms more favorable to the landlord than those of the existing lease. Conversely, the buyer may object to certain terms in the existing lease – a demolition clause, or the lack of renewal options, or simply that there is not enough time remaining on it – and request a new lease as a condition of proceeding with the sale. Whatever you case may be, any agreement to purchase a restaurant should include a contingency that the buyer be afforded time to secure either an assignment of the existing lease or a new lease altogether.

3.     Am I able to transfer the liquor license?

For many restaurant sales, the transfer of the existing liquor license is essential, especially in jurisdictions where the issuance of new licenses is limited in some way. In such instances, buyers must take appropriate measures to ensure there is nothing that could prevent the restaurant’s liquor license from being transferred from the seller. Such things could be a poor compliance record that could cause the transfer to be protested, a pending violation that could lead to revocation, or some other factor related to the buyer himself that might cause local authorities to deny the transfer. Investigation into such matters should be part of any buyer’s due diligence, and appropriate contingencies should always be included in any agreement.

4.     Will I have full rights to the restaurant’s trade name?

Here we have the very simple matter of ensuring that, if you are buying “McFinley’s Tap House,” you can still call it “McFinley’s Tap House” after you take over. As stated above, most asset purchase agreements will include the restaurant’s trade name and other intellectual property as being among the intangible assets of the business.   In some cases, however, a third party may have granted the seller the rights to use a restaurant’s name, and may still be entitled to assert some control over who uses that name. Any seller should therefore be required to demonstrate that he has the right to transfer the trade name to you, and that no third party licensor has any ability to prevent you from using it.