Forrest Gump and its Lessons for Lease Assignment Language
Source: Paramount Home Entertainment
Clients often ask us to help them draft covenants for potential lease assignments. One of the first questions asked of us is if a net worth requirement will be sufficient, and our immediate reply is often something to the effect of, “net worth is too broad and does not adequately measure the creditworthiness of an entity.” Net worth is a broad metric and all too often subject to definitions crafted by clever accountants, which brings to mind the story of Winston Groom, the author of the book turned movie Forrest Gump. As the story goes, Mr. Groom was entitled to 3% of the movie’s accounting profits. The studio’s financial reports indicated that in fact the movie lost money despite its runaway success in theaters. How could this happen? Simply put, accountants must consider the potential for future losses as part of a film’s business. Had Mr. Groom talked with TRA (or an accounting firm or reputable financial analyst), he would have been advised to structure his deal under more dynamic terms. Mr. Groom did not make money off the film adaptation of his book. TRA wants to ensure a scenario like this does not impact its clients.
So what is wrong with the net worth requirement? Without getting overly technical, Mr. Groom failed to recognize that accounting profits and actual profits can be two very different things. When TRA is asked to advise clients on structuring lease assignment conditions, we carry with us the knowledge and experience of these loopholes and recommend clearly defined accounting-based approaches.
Why is net worth so weak?
Let’s cover a few examples. Accounting net worth is a flimsy concept. It is a simple formula resulting from the difference between total assets and total liabilities; failing to capture the nuances of a balance sheet’s components. Most notably, assets can often be inflated by goodwill and intangible assets. These are not easily monetized assets for a creditor like a landlord, and the case could be made that these should largely be ignored by most creditors. A bank would almost never accept accounting net worth as a requirement due to its dependency on potentially weak valuation assumptions.
So what works?
Companies, like people, are more than their net worth. In order to ensure durable tr
ansfer or assignment language, a lease should consider both balance sheet and income strength. For example, a company’s leverage ratio (broadly defined as debt to operating income) is a balance sheet metric and income statement metric that measures total debt (and other non-debt financial obligations) and compares it to operating income. Savvy landlords may also want to consider liquidity metrics like an adjusted current ratio or fixed charge coverage ratio. Depending on the size of the lease, an adjusted operating income metric like operating margins or minimum EBITDA (earnings before interest, taxes, depreciation and amortization) are also very helpful.
The above is just a start. And of course, every deal is unique, so lease assignment conditions should be structured in a dynamic and thoughtful manner. Contact TRA to see how we can help you.