Lease Due Diligence FAQ: Answers for Buying or Selling a Business
By Katrina Loftin, CBI, M&AMI - Co-Founder of M&A Business Advisors
There are numerous steps involved when buying or selling a business, with several parties involved—from the lender, the landlord, escrow, and sometimes a franchisor and broker. There are many moving parts that need to work simultaneously to complete the transaction. The lease is one of the most critical components when buying a business. It is very important to know how the lease affects both the buyer and the seller. Below, you will find some frequently asked questions and important considerations when working with a landlord, from both the buyer’s and seller’s perspective.
When Should you Contact the Landlord About a Lease Transfer?
Buyers: Once you have an accepted offer in place, you should start talking to the Landlord during the due diligence phase. If there are any issues, you need to know as soon as possible. You should be prepared to show the landlord your resume, financial statement, and your credit report. Typically, landlords like to see experience in the industry and financials on the business as well.
Sellers: Once you decide to sell the business, you should reach out to the landlord. Almost all leases call for any assignment, transfer, or sub-lease to be approved by the landlord in writing. It is important to make them a team player early in the process. Let them know the sale is confidential and ask for an NDA if you think you need it. Find out what info they will want from the buyer and explain that you may need additional options for their loan if it is appropriate. Most landlords will request to see your P&L’s and a balance sheet on the business as it needs to support the lease payments.
How Does the Length of the Lease Impact the Business Sale Process?
Buyers: For an SBA-financed transaction, the buyer will need a 10-year lease, which could consist of a 5-year lease with a 5-year option or any other combination thereof that equals the length of the loan. Even if you are utilizing seller financing, you will want to make sure you have an adequate lease for at least the length of the loan.
Sellers: Make sure you have enough lease extensions so that you do not encounter surprises like an increase in rent or, even worse, the loss of the space. An increase in rent or a move could impact the value of the business. If you plan properly, you should have at least two to three 5-year options, preferably with lease rates at any given time.
How is the Lease Transferred?
Buyers: Most leases are personally guaranteed, be prepared for that. On occasion, the landlord will give the buyer a new lease. Make sure you understand what changes that new lease or assignment may have on the cash flow of the business and make sure you can afford the lease and debt service and have enough cash flow left for yourself.
Sellers: Most leases are assigned, and typically the original lessee or seller would be on the hook if the buyer defaulted on the lease. If you plan properly, you can avoid this by having a clause in the lease that if you sell to a qualified buyer, you can be removed from the lease liability. The landlord may ask you to stay on as a guarantor for a year or more, make sure you have a qualified buyer and that there is enough cash flow for the buyer to make the lease payments. In rare instances, you can do a sublease, but the original lessee would stay on as the primary guarantor. This is often not a wise choice for a seller and typically only used when the buyer is taking a portion of the space.
Both Parties: The landlord may charge a fee for an assignment. It should be stated in the lease. Make sure you know what that is and who is responsible for paying for that.
What Happens to the Lease Deposit?
If the transaction is structured as an asset sale, which is how most sales are handled, the seller will ask the buyer to be reimbursed for the security deposit. Sometimes the landlord prefers to charge the buyer a security deposit and they will return the seller’s once a lease assignment is executed. In either situation, make sure that the condition of the property is acceptable and if it is not, you may ask the landlord to view the property and charge the security deposit accordingly.
If the transaction is a stock or interest sale and the buyer will inherit the assets and liabilities, the security deposit stays in place.
What if the Seller is the Landlord?
Buyers: The business should be properly valued based on factoring in market rent. All Cash Flow Statements and Profit & Loss Statements should be adjusted to show market rent properly expensed. If you are buying a business where the Seller owns the real estate, make sure you know what the cash flow will be after you factor in the lease payment.
Sellers: Many sellers pay themselves less or more than market rent and if the business owns the property, they pay no rent. Make sure you consider that when you value the business. Any P&L’s or cash flow statements should be adjusted to reflect market rent.
Additional Considerations
Whether you are the buyer or the seller, you will want a good relationship with the landlord. Communicating with them early in the process is the best way to assure a smooth transaction. Lease assignments or obtaining a new lease may hold up the transaction. You typically need to contact the landlord a minimum of 30 days before the close of the transaction.
The landlord typically does not have to accept just anyone on an assignment. The buyer should be qualified and have adequate cash flow and cash on hand to be able to assume the lease. Leases vary vastly from property to property, and almost all of them have an assignment provision. Make sure you understand what that is.
Most business brokers will guide you through the lease process, but not all of them. Make sure you know what services you are getting when you hire a broker and ask them if they charge additional compensation for the negotiation of a new lease or existing lease. Many brokerages do charge for this service. It is also important to note that the negotiation of a lease requires a real estate license in most states, and many states require a license for business brokerage as well. Visit the BizBuySell Broker Directory to find a business broker to help you navigate buying or selling a business with a lease.
By Katrina Loftin, CBI, M&AMI - Co-Founder of M&A Business Advisors