Selling a Business With a Commercial Lease: Best Practices for a Smooth Transaction
The terms of your commercial lease agreement can make or break the sale of your business.
Real estate costs are among the biggest business expenses. Potential buyers want to know how much rent they’ll pay if they buy your business and that their rental costs are locked in for the foreseeable future.
An existing, long-term lease allows buyers to predict their rental costs. It’s a business asset, like equipment or intellectual property, that sellers can trade on, and the right lease agreement can increase the business valuation.
On the other hand, a short-term or month-to-month lease can decrease the value of the business. Prospective buyers might even walk away from a deal that requires them to negotiate a new lease because they can’t know how much the lease will cost or even whether the landlord is willing to rent to them.
That’s why it’s a good idea to consider your lease terms when creating your exit plan. Premature as it might seem, the real estate lease you negotiate today can have repercussions far into the future.
Negotiating Lease Terms Favorable to Selling a Business
A real estate lease is a contract, and like any contract, it’s negotiable. A lease agreement that adds value to your small business when you’re ready to sell it should include:
- Long-term lease with the option to renew
- Right to assign or transfer the lease to someone else, or alternatively
- Right to sublet the real estate
Length of Lease and Option to Renew
Commercial lease terms typically range from three to five years and can be as long as 10 years. For purposes of selling your business (and even running it), the longer the lease term, the better. As long as the lease is in effect, even when it includes an escalation clause for rent increases, tenants know exactly what their rental costs will be.
A month-to-month lease leaves the amount and timing of rent increases entirely up to the landlord. Tenants can’t control or plan for their rental costs or even whether they can remain at the premises.
An option to renew a lease gives tenants the right to continue leasing the same premises they’ve occupied at a specified rental rate. An option to renew can extend a lease by 10 years.
At the start of the lease, landlords and tenants might be reluctant to enter into a long-term transaction. The landlord has no history with the tenant and can’t be certain they’ll pay the rent as agreed.
Tenants may have reason to avoid the risk of a long-term lease. For example, entrepreneurs launching a start-up business might worry that if the business fails to take off, they’ll be on the hook for the full term of the lease.
With an option to renew, a tenant with a short-term lease has the security of knowing they can extend the lease term should they want to. And if the current owner wants to sell the business, an option to renew a lease that can be transferred will also extend the lease term for the new business owner.
Transferring or Assigning a Lease
Most real estate leases include a clause about transferring or assigning a lease. The two terms are often used interchangeably, but the lease assignment usually occurs in an asset sale and for stock or equity sales, the term “transfer” applies.
When you assign a lease, you turn over the rights and obligations of the lease agreement to someone else. In the sale of a business with a commercial lease, the new owner becomes the lessee of the real estate and assumes the responsibilities and rent payments required under the lease agreement.
The lease transfer usually occurs when the business being sold is a corporation, a limited liability company (LLC), or some type of partnership. In these cases, the tenant/lessee doesn’t technically change—it’s still the company that entered into the lease in the first place—only the LLC members or the corporation executives have changed.
Either way, transferring or assigning a lease ensures that a new owner gets the same lease terms the seller enjoyed.
Most state laws require landlords to agree to lease assignments, but landlords are usually free to impose conditions on the assignment or transfer of leases. They often want to approve the buyer and get other assurances about the buyer’s ability to fulfill the terms of the lease, such as:
- Financial statements to determine the new tenant’s credit-worthiness
- Background on the new tenant’s business experience and their plans for operating the business
- Personal guarantee from the current tenant and/or
- Payment of fees and expenses to the landlord
In some cases, landlords might also require the seller of the business to remain on the lease as a backup.
Right to Sublet
When you’re unable to negotiate the right to assign or transfer your commercial lease, asking for the right to sublet might be the next best option.
To sublet a property, the seller has to execute a separate business transaction.
- Sellers must enter into a sublease agreement with the buyer. The buyer becomes a sublessee and pays rent to the seller.
- The seller remains responsible for the terms of the master lease and paying rent to the landlord.
Subletting a property may not be as advantageous to a seller as assigning or transferring a lease. Not only do sellers also have to act as landlords, they can be held liable for the property and the rent if their sub-lessee causes damage or defaults.
But when you don’t have another option for including the commercial space your business occupies in a sale, having a right to sublet can prevent the deal from derailing.
Fees for Transferring a Commercial Lease
Landlords usually charge an assignment fee, sometimes referred to as attorney’s fees, for assigning or transferring a commercial lease.
Remember that a lease agreement offers little to no benefit to the landlord. They’re trading a tenant they know for one they don’t and foregoing rent increases they can impose under a new lease agreement. They’ll look to be compensated for the additional risk they’re taking.
Depending on the landlord or property management company, the terms of the lease, and the relationship between the current tenant and the landlord, assignment fees can range from $500 to $5,000 or more. In some instances, landlords might ask to see the purchase contract and calculate the assignment fee based on a percentage of the sale price.
In addition, some states impose processing fees for lease assignments.
If you sublet your commercial real estate at a rate higher than the rental rate of your lease, your landlord might also require you to pass along some or all of the additional rent you’ll be receiving.
How Security Deposits Are Handled
Whether an additional security deposit is required and the amount is usually also up to the landlord’s discretion. It’s a good idea to ascertain your landlord’s deposit requirements before the sale closes so you can collect any additional monies due from the buyer.
Negotiating With the Landlord
When you want to exercise an option to assign or transfer a lease, it’s important to remember that landlords hold most of the cards. Unless you are operating in a tenant’s market where there’s more commercial space available than tenants to fill it, the landlord will probably want to have considerable control over the process.
In most cases, the landlord’s main objective is to ensure the new tenant will pay the rent on time and won’t cause undue damage to the property. They’ll want to examine the new tenant’s creditworthiness and their experience running a business. Some might even want a piece of the action—a percentage of your purchase price—reasoning that they are taking on additional risk with a new tenant.
The better the relationship between the seller and the landlord, the easier it will be to negotiate the conditions of the lease assignment. Keep in mind, too, that if you are behind on the rent or the purposes for which you’re using the business are outside of the permitted use rules, the landlord can make it very difficult to transfer your lease.
Even an easy negotiation, however, takes time. It’s best to notify the landlord as soon as you decide to sell your business so you have the time to work through any issues the landlord raises.
If the time remaining on your lease is short, you’ll want to negotiate a renewal before a sale takes place. Buyers who use SBA financing are required to have a 10-year lease term. Even if you anticipate your sale will be a cash transaction, a 10-year lease term or option to renew will help attract buyers.
Should You Hire a Broker to Sell a Business With a Commercial Lease?
Business brokers can add value to the sale of the business by assisting with business valuations, qualifying prospective buyers, marketing the business, and other tasks.
When selling a business with a commercial lease, the sale process can be even more complex.
Engaging a real estate broker, a business broker, or both can be invaluable for:
- Understanding your current lease
- Negotiating assignment fees
- Screening and qualifying prospective buyers so they pass muster with the landlord
- Negotiating the time frame for landlord approvals, and
- Negotiating a new lease or renewal if insufficient time remains on the current one
Remember that landlords and property management companies negotiate real estate contracts all day long. Most small business owners don’t have the same level of experience and knowledge. Using a broker will put you on equal footing and help ensure a smooth transaction and that you’re aware of your options for your commercial real estate.
Visit the BizBuySell Broker Directory to find a business broker to help guide you through the process of selling your business with a commercial lease.