It’s not uncommon to lease the property your business operates on. In fact, this is perfectly normal and even encouraged in some cases.
But lease agreements are also one of the most common reasons that otherwise good businesses fail to sell.
In this article I’ll explain why lease agreements play a major role in selling your business.
We’ll go over the most common reasons your lease can derail the selling process.
Then I’ll explain a strategy to buy the real estate your business occupies – avoiding all the potential headaches a lease agreement can cause.
Let’s dive into a few ways your lease agreement can throw a wrench in the gears when it comes time to sell your business:
Lease Agreements Can Mess With The Valuation of Your Business
Valuations aren’t just based on how much your business made in the past. Future earnings are a big factor so buyers want to know what changes or new expenses are on the horizon.
Basic business expenses are fairly predictable – you can figure out what your operating costs are, factor in inflation, and get a pretty good picture of expenses as a whole… But one of the most important expenses is also the most unique (and potentially unpredictable): Rent.
You might have a lease agreement where you’ve enjoyed a fixed rent for a number of years…but what happens when you sell the business? Does the buyer inherit the rent arrangement…or will they have to negotiate with the landlord and ink a new deal from scratch?
The same worry applies if you’re nearing the end of your lease:
Do you think a rent increase is coming up? If so, this is a big factor in your business’ valuation.
It’s tough to paint an accurate picture of what your business is worth without a solid understanding of future rent expenses. And if the market is telling us businesses with similar earnings to yours are selling inside a certain price range, a dramatic increase in rent can mess up the numbers…fast.
If your rent goes up but business stays steady? Earnings go down. And your business’s value takes a hit as a result.
One of the best ways to get ahead of this problem is to talk with commercial real estate brokers who specialize in your area – and consult them on what they think is a fair rate for your space.
The further your rent is from this number the more likely it is that the landlord is going to raise your rent if they get a chance.
Selling your business – unless it’s spelled out in the original lease agreement – gives them the perfect opportunity to renegotiate rent.
Consulting with a commercial real estate broker can give us a good idea of where the landlord’s head might be at – and adjust numbers to reflect what rent might look like going forward. If we don’t have this info we can’t accurately estimate future earnings and we won’t be able to arrive at an accurate valuation.
Lease Agreements Directly Influence A Buyer’s Ability to Finance
You might think your buyer’s financing situation is their problem – and this is true to a certain extent…
But understanding the lease terms that lenders will require from a potential buyer is a useful tool on your end as the seller of a business.
The reality is this: Full cash buyers are rare.
Buyers often look to finance a big portion of the entire purchase cost.
A buyer may love your business, but if they’re short on funds and can’t qualify for financing, you won’t get paid in cash.
Ideally you should negotiate a lease upfront so it doesn’t pop up later and become an obstacle to a future buyer’s ability to secure financing. But lease agreements that allow a business to be sold without some form of support or approval from the landlord are rare. And there are a few issues that can severely hurt the process or even kill the whole deal.
Here are some common issues we encounter with lease agreements:
Matching Lease & Loan Term (and why 10 years is often the magic number)
A lot of banks require buyers to obtain a lease covering the loan’s entire term.
The SBA-7A loan is the most common type of financing used to buy businesses valued below $5 million – and the SBA lender will ask the buyer to secure a lease equal to the loan’s term which is commonly 10 years.
This is logical. If a bank is lending money for 10 years, they want to make sure the business has a place to operate with predictable rent during the loan’s repayment period.
This means your buyer will have to ask the landlord for a 10-year lease upon closing. If the landlord agrees the buyer can secure the loan. But if the landlord doesn’t cooperate it can jeopardize the deal.
The landlord may realize they have significant leverage here and try to raise rent, affecting the valuation.
This is why knowing where you stand with your landlord, understanding how you can potentially secure a 10-year lease, and accounting for unexpected rent increases are all important things to consider when it comes to your business’s sale price.
Right to Lien on Business Collateral
If the buyer defaults on their loan, who has the right to claim the tangible assets (AKA “your stuff”) located on the property? In the case of SBA loans, the lenders insist on having first rights to collateral. This means they have the right to claim anything within the property as theirs – and sell it to recoup the defaulted loan.
This can cause a major issue if the lease agreement has already given this right to the landlord.
This isn’t uncommon – if a tenant defaults on rent a lot of times the landlord does have the right to step in and repossess anything located on their property.
And convincing a landlord to relinquish this benefit can be a big challenge.
If the landlord is unwilling to give first rights to the business collateral over to the SBA lender, it could kill the deal.
The best way to approach this is to be upfront with the landlord early in the process. Make it clear that this is a requirement from the bank and then explore other incentives on the landlord’s side.
The obvious argument is that they get a highly creditworthy tenant for 10 years. But there are other incentives to explore like possibly increasing the buyer’s security deposit or (as a last resort) negotiating an increase in rent. In some cases, the landlord may request that the current owner provide a personal guarantee on the lease for a certain time period until they gain confidence in the new tenant.
In certain situations the business collateral is insignificant anyway. This is obvious with more “asset light” service-based businesses. If the business falls into this category it’s important to point this out to the landlord (who may have an inflated view of the business’s asset value).
For example, repossessing all the furniture and computers at a CPA firm isn’t going to put much money in the landlord’s pocket at the end of the day.
Rights to Assign or Sublease
Even after you’ve negotiated a lease that complies with all the lender requirements there’s still one major hurdle that trips up a lot of deals: Buyers must be permitted to “take over” your lease.
They need to have the right to utilize the space your business occupies under the same terms and conditions as the existing lease.
There are 2 options here:
- An “assignment”
- A sublease
An assignment implies that the new owner takes over the lease and you as the seller are no longer involved in the relationship. The new owner makes payments to the landlord and assumes all financial responsibility.
A sublease implies that you the seller are still responsible for all lease payments – but the new owner can use the space. The new owner pays you and you pay the landlord.
A sublease is less favorable for an obvious reason: If the new owner fails to pay you, you still owe the landlord.
For both of these situations it’s not uncommon for landlords to insist on having the right to sign off on a new buyer’s use of the space. There are a few different ways to phrase this in a lease. You can check your current lease for this sort of language as it relates to new tenants or the sale of the business:
- Landlord’s consent will not be “unreasonably withheld” – this language is a bit “loose” and open to interpretation. It can be difficult to determine where the line of “reasonable” actually ends. However, if a landlord demands a 100% rent increase above the market rate, you have a strong legal case for them being unreasonable.
- Landlord is given “sole discretion” to approve new tenants in the event of a sublease - in this case, you don’t really have an agreement. “Sole discretion” means that the landlord can essentially do what they want and they may view the sale of your business as a chance to increase rent or renegotiate terms.
So How Do You Avoid Dealing With ANY of This in the First Place?
The answer is simple but not necessarily easy: You need to own the real estate your business operates from.
If you don’t own the property your business occupies you’ll start to feel as though you don’t fully own your business when it comes time to sell. And when you approach the landlord and explain that you’re trying to sell, they’re likely to ask the obvious question:
“What’s in it for me?”
And from that point, the things we’ve talked about in this article start to become real problems. Even if the landlord isn’t looking to squeeze you dry or milk the sale for their own benefit, it’s still difficult to get them to act with urgency. If you aren’t talking about higher rent or a longer lease term your requests will be viewed as an inconvenience.
One strategy to address this is by making sure your lease includes language that gives you as an owner the flexibility to buy the real estate your business occupies.
This could be a “purchase option” where a fixed price is stated to buy the property. It could also be a “first right of refusal” meaning that before a landlord can sell you get first dibs on the property before any outside buyers.
Even if you’ve already signed a lease without any of this language it never hurts to approach your landlord and ask if they have any interest in selling the property.
If you’re running a profitable business, the ability to buy the property your business occupies might not be as far out of reach as you think.
The SBA 504 program which helps business owners buy the property their business occupies is a great option here.
504 loans generally require a down payment of only 10%. For the sake of comparison, a conventional loan will require around 25%.
Buying the real estate your business occupies gives you a ton of flexibility when it comes time to sell your business.
You can sell the business with real estate and command a premium price.
You could also sell the business itself and then lease the property to the new owner. And since you’d be the landlord you’d be able to design the lease around lenders requirements and make sure your buyer can get funded to buy the business.
All things considered understanding how lease agreements can affect the sale of your business is a big lever. Even if you don’t own the property right now, you can set yourself up for a much simpler sales process by thinking about these things before you’re ready to sell.
If you’re looking to sell your business within the next 2-3 years – or you need advice on purchasing the property your business occupies – send me an email (sean@tws-advisory.com) and we’ll solve your problem.