1. Introduction
Inevitably a core decision for any pharmacy business is where it decides to trade from. When choosing to lease premises the terms of your lease can be critical to the success of your business.
In many cases a pharmacist will sell or acquire a pharmacy business with an existing lease, which brings with it added complications where the incoming purchaser will assume a sub-lease of the premises.
This article deals with some of the key issues that sellers and purchasers of pharmacy businesses should be aware of when conducting their due diligence of a business purchase and negotiating the terms of any sub-lease. It should be noted that this article does not address additional considerations that will apply where the proposed sub-lease is for a premises in a retail shopping centre.
2. Assignment or Sub-Letting – the need to obtain consents
In almost all commercial leases any tenant of leased premises must seek the consent of their landlord to either assign their obligations under their lease directly to an incoming purchaser, or enter into a sub-lease with the incoming purchaser.
Under the Retail Leases Act 2003 (Vic) (Act) a landlord cannot unreasonably withhold their consent to an assignment of a lease. However, in respect of sub-leasing the Act states that a landlord may absolutely refuse a sub-lease, if the lease contains a provision to that effect.
Consequently, when conducting due diligence on a business purchase it is important to review the lease to determine what rights of refusal the Landlord has in respect of sub-leasing and what additional requirements may need to be met to satisfy the terms of the lease. These should be clarified early during due diligence to avoid a potentially fatal break-down in the purchase process and to reduce all parties’ costs.
From the perspective of business owners that enter into leases directly with landlords (that may wish to sell their business down the line) negotiating a clause of the lease that allows the tenant to sub-lease with the landlord’s reasonable consent can represent a value-add to the tenant’s business down the line (for example, defining what conditions need to be satisfied to procure the landlord’s consent can reduce the transacting parties’ costs at the time of sale, and avoid opportunistic behaviour from landlords such as demanding unreasonable security or consent fees).
The Act prevents a landlord from passing on their costs of negotiating and preparing a lease with a tenant directly. However the Act does permit a landlord to pass on the reasonable costs of providing their consent to an assignment or sub-lease of premises to the tenant. When considered in light of the fact that a landlord can generally refuse a sub-lease absolutely (i.e. without having to be reasonable) what is ‘reasonable’ in the case of consenting to a sub-lease (where the landlord has absolute discretion to refuse) will be broader than for an assignment. Consequently, the obligation to pay a landlord’s costs to consent to a sub-lease can be significant. Amongst other things, additional costs that may be incurred by a tenant in obtaining the landlord’s consent to sub-lease can include costs incurred in procuring greater security (for example, where the landlord requires greater security from the tenant to cover risks asserted with the sub-tenant’s business).
From the perspective of a seller the optimal outcome in a sale situation is for the incoming purchaser to pay the tenant/seller’s costs in obtaining the landlord’s consent to the sub-lease. From the perspective of a purchaser any costs that are passed on from the tenant in obtaining the landlord’s consent should be limited to ‘reasonable costs’ and ideally should be factored into a reduction in purchase price for the business (or apportioned equally between tenant/seller and future sub-tenant/purchaser).
3. Understanding the Sub-Lessor’s Obligations under the Head Lease
In addition to obtaining a landlord’s consent to sub-lease (which is one of the core considerations in a sale of business with leased premises) a prospective business purchaser should also be aware of what other terms of the lease will restrict the purchaser’s operation of their business.
Where parties are negotiating a sale the terms of the head lease (between landlord and tenant/seller) will generally dictate how much flexibility the seller and purchaser have in negotiating occupation of the premises. Notwithstanding the issue of requiring the landlord’s consent, a tenant cannot (or at least should not) enter into a sub-lease that would create a conflict between their obligations to the landlord and to the sub-tenant. Typically, where a sub-tenant’s actions contravene a provision of the head lease the tenant becomes liable to the landlord, which may result in a default under the head lease. In most cases a landlord will have rights to terminate the lease on the basis of default and retake possession of the premises (notwithstanding that the sub-tenant may not have done anything wrong under the sub-lease).
As a prospective purchaser sub-tenants need to be aware of the head lease obligations, and reconcile these with what a seller is proposing in a sub-lease.
Some of the most common issues in respect of head lease obligations for a sub-tenant relate to fit out, advertising (including erecting signage) and ordinary hours of business. These can seriously impact the value of a business to a purchaser. If there is any conflict between what the purchaser requires and what the head lease permits, it will be prudent to discuss any proposed changes with the landlord directly, and ideally enter into a deed of amendment to the lease, or at a minimum obtain the landlord’s written consent to any term of the sub-lease that might result in breach.
4. Security of Tenure
Another potential pitfall for a purchaser of a business is ensuring that they have security of tenure. Under the Act, a new lease must be for a minimum term of 5 years. This minimum term can include options to renew the lease for further terms (for example, a three year lease with 2 options of 1 year’s further term each).
However, where a head lease has less than 5 years left (including options to renew) a sub-lease can only be entered into for the remainder of the term of the head lease, less one day. This presents several concerns for an incoming purchaser – first, if the purchaser intends to operate out of the premises for the entire term of the head lease, and this would require renewal by the tenant, the purchaser should seek to include a clause in the sale of business agreement that the tenant must exercise its right to renew the head lease, and will indemnify the purchaser against any loss resulting from a failure to do so.
Additionally, where a sub-tenant requires occupation of the premises beyond the term of the current head lease, it is prudent to enter into an agreement with the landlord and tenant directly that if for any reason the lease is terminated (either on expiry or for default of the tenant) the sub-tenant will have a first right of refusal to enter into a new lease with the landlord directly. The Act would require that any new lease have a minimum term of 5 years.
5. Making Good the Premises and Refurbishment – Pitfalls for the Sub-Tenant
One further common concern that purchasers of a business should be aware of is the tenant’s make good obligation under the head lease. Generally, whilst it is the tenant that is required to make good the premises at the end of the head-lease these requirements are usually passed on to the sub-tenant. If a make good clause in the sub-lease is poorly drafted (or drafted to the disadvantage of the sub-tenant) the sub-tenant may unknowingly be required to restore the premises to the state they were in at the commencement of the head lease (and not the sub-lease). This can involve considerable expense, particularly if the tenant has been in the premises for some time prior to sub-tenant, or if the tenant’s fit-out was substantial.
Any purchaser of a business should ensure that their obligations to make good the premises extend only as far as the condition of the premises at the commencement of the sub-lease, or otherwise the sub-tenant’s obligations should be reflected in the business purchase price. As a practical matter, it is important that the sub-tenant take detailed records of the condition of the premises at commencement of the sub-lease, and ideally define these obligations in an Annexure to the sub-lease (for example, by delineating each of the tenant’s and the sub-tenant’s obligations in a plan of the premises).
In addition to make good obligations (which apply at the end of a lease), a tenant may have obligations to maintain or refurbish the premises periodically during the lease. If the head lease contains a vague or demanding refurbishment clause a sub-tenant should seek appropriate indemnities from the tenant in regard to its compliance with these obligations. From the perspective of a seller, the sub-tenant’s liability for refurbishment should also be clearly stated and reflect the sub-tenant’s use of the premises. Any actions of the sub-tenant that result in increased costs to the tenant should be dealt with in the sub-lease by way of appropriate indemnities to the tenant.
6. Obtain appropriate advice
The terms of sale of a pharmacy businesses and associated leasing negotiations can be critical to the success or failure of an enterprise. Pointon Partners regularly advises clients in the pharmacy industry on all aspects of sales and purchases of businesses, including leasing and property acquisition.
If you would like to discuss your next proposed sale or purchase Please contact Michael Bishop or Matt Curnow on (03) 9614 7707 for further information.
Matt Curnow, Lawyer, Pointon Partners