Franchising in the hotel-industry has become very prevalent in recent years. Because brand recognition has become more important within the industry recently, the benefits of purchasing a franchise, rather than opening a hotel independently, have become more formidable. However, hotel franchising does not come without challenges and risks for franchisees and dealers. Normally, a hotel franchise purchase involves a large company (the franchisor) negotiating with a smaller entity (the franchisee).
Accordingly, as would be expected, in negotiating these franchise or dealer agreements, franchisors, manufacturers, and suppliers often have enormous bargaining power relative to its franchisee or dealer. And, sadly, when hotel franchisees or dealers are left with unfair contract terms, they often lack a sufficient legal remedy. Unlike a service station or automobile franchise, a hotel franchise is not subject to any federal regulations that govern its specific industry. This means that on the federal level, no law specifically protects hotel industry franchisees or dealers from wrongful termination, non-renewal or encroachment by their franchisor, manufacturer or supplier. However, hotel franchises are subject to federal laws that regulate franchises in general. These regulations may require franchisors, manufacturers or suppliers to act in a certain way toward their franchisee or dealer; for example, a franchisor, manufacturer, or supplier must make certain disclosures to a potential franchisee or dealer before selling it a franchise. In addition, many states do regulate franchises generally, but these regulations are disparate and often do not provide sufficient legal protection for franchisees or dealer. While it may be beneficial for hotel owners to gain the brand strength, marketing tools and support of a franchisor, manufacturer or dealer, they may have an inferior legal position when negotiating the terms of the franchise or dealer agreement. This inferiority may make their investment riskier than expected if they do not take proper precautions and seek the legal advice of an experienced franchise lawyer. Hotel franchisees and dealers face many industry specific challenges. One of the biggest concerns facing hotel franchise owners is territorial encroachment. As a hotel franchisee, you must be cognizant not only of competing hotels that may spring up in your area, but other hotels of the same brand. Another issue, which frequently arises in the franchise relationship in the lodging industry, is that of remodeling and renovation requirements.
Hotel franchise or dealer agreements typically permit the franchisor, manufacturer or suppler to require the franchisee or dealer to perform certain improvements to their properties whenever they ask. Basically, many franchise or dealer agreements allow the franchisor, manufacturer or supplier to retain complete discretion as to the timing and extent of improvements to the dealer or franchisee’s property. These improvements may prove excessive, and overwhelmingly expensive. It is extremely important for someone considering a hotel franchise purchase to carefully review such provisions with an experienced franchise attorney before signing on the dotted line. Further, if you are already involved in a hotel franchise relationship you should not assume that if a franchisor, manufacturer or supplier failed to remind you about a remodeling deadline, that you are safe from termination or being forced to make the renovations in the future.
What To Do If You Are Contemplating Purchasing A Hotel Franchise
If you are considering starting a hotel franchise, you have to consider a number of concerns specific to the hotel industry. With an experienced franchise lawyer, by your side, you can rest assure your personal and business interests will be represented and protected.
Hotels need brands, and brands need hotels. For many years, hotel brands have been growing in importance for the success of hotels in the United States and abroad. The trend toward branding is quite a phenomenon. According to numbers we have seen, in the early 1990s, approximately 40% of the hotels in the U.S. were branded and the balances were independent. Now the number is probably closer to 80% or more of the hotels are branded or brand-affiliated. The branding is often accomplished by a franchise or license agreement from a company owning the brand. Other times it is accomplished by a branded hotel management company entering into a management agreement with the owner of the hotel, providing both the brand and management for the property. Over the years, we have found that hotel owners get into bad situations with their franchisors because they fall into one or more of a handful of traps for the unwary. While there are many issues facing franchisees, the following are what we think might be the biggest mistakes owners make when deciding on a franchise for their hotel, and the “famous last words” that accompany them:
It’s a Mistake to Focus on just one brand and letting them know you “have” to have them.
Even if the brand is perfect, the best way to get a great brand and a fair deal is to make sure there is competition, compare the results, and make sure each brand knows there is at least one other brand to “meet or beat.” The process isn’t an auction, but it is a controlled, selective competition that brings out the best deals from the brands and gives the owner the best choice.
It’s A Mistake To Try to do it yourself — it’s a false economy. You don’t know what you don’t know.
Finding a good brand is intentional, not accidental, and drawing out the best business and legal terms in a franchise takes someone who has been there before. Hotel executives make their living by negotiating hundreds of deals with amateurs. Unless you identify the real issues and realistically approach your project and its needs, your deal will get shopworn and tired before it is positioned. And if you let the franchisor drive the process, you are likely to find yourself with a letter of intent or term sheet before you have identified your needs and shaped the conversation.
For all intents and purposes, the letter of intent is the final agreement – unless you identify the points of negotiation, virtually every franchisor will demand that you sign their franchise agreement as-is. Franchise agreements are not like other commercially-negotiated agreements; franchisors demand uniformity and making changes, even changes which make business sense, must be identified early. It is true that letters are generally non-binding, but the only alternative to agreeing to the franchisor’s terms is often to walk away from the agreement, typically forfeiting a substantial (often six figure) application fee!
It is gratifying when a franchisor offers to help fund your project. However, their needs are never fully aligned with yours. Franchisors almost never have money at risk; instead, they provide “key money – forgivable loans – or credit enhancements which amortize over the life of the franchise. Franchisors can get their money back if you try to terminate the franchise, or default, or for a variety of other reasons, and their “investment” is often backed by a personal guarantee. Moreover, the relatively small amount of key money comes at a high price, typically a longer duration, more onerous terms, and less flexibility. Finally, an owner must always understand that the interests of brands always diverge from the interests of owners. Owners are concerned about the health, well-being and profitability of their individual property, while the brand is concerned about the value of the brand, regardless of the performance and value of the individual hotels in the chain.
Mistake #5: Relying on a third party manager to protect your interests.
Third party managers can help, but they are as interested in pleasing the brand as they are in pleasing the owner — in fact, franchisors typically require that the manager acknowledge that the franchise agreement overrides the management agreement! The principals and operators in management companies often are drawn from the ranks of the brands, and they get a substantial part of their business from the brands, and their loyalty can be diluted. The manager can help, and in particular can help comply with the franchise, but if there is a problem, the owner stands alone.
How to Avoid these Mistakes
Brands and owners need each other. While tension always exists in the relationship, if they share the same vision, they have a better chance of a successful relationship. On the other hand, when an owner enters into a franchise agreement without understanding its ramifications and without creating a level playing field, the likelihood of success is limited at best.
To reach an agreement that is successful for both the brand and the owner, there must be parity in the process. Owners need the same level of legal representation that the franchisor will have. The franchisor’s lawyers will have negotiated hundreds of these agreements. Your lawyer should have this level of practical experience, as well. The franchisor’s lawyers will understand the implications and ramifications of each sentence and phrase in the agreement. So should your lawyer. The franchisor’s lawyers will make sure the franchisor takes as little risk as possible — that’s the lawyers’ job. Your lawyer should do the same job for you. Negotiating a hotel management or franchise agreement is one of the most important things hotel owners will ever do for their hotel investment.
Things to Negotiate in Your Next Franchise Agreement
Most branded hotel properties are operated under franchise agreements which are long documents with lots of fine print. They are usually presented to owners as “non-negotiable.” This brand position is justified on the basis of need for uniformity in agreements and insuring that hotel guests will have a consistency of amenities, operations and experience in all hotels bearing the same flag. However, hotel owners seeking a franchise also have legitimate interests, and there needs to be some recognition of these needs and the unique circumstances of every situation. In fact, our experience shows that, within certain limits, key provisions of these franchise agreements can be negotiated to be more favorable to the franchisee. Franchise agreements are not nearly as negotiable as hotel management agreements, so owners are well advised to understand what can and cannot be negotiated in order to realize the greatest value from their relationship with the brand.
Here are the most common franchise terms we are seeing negotiated today:
• Franchise and Royalty Fees: While it’s unlikely that franchise fees will be reduced for the entire term of the agreement, a “ramp up” in fees over the initial years of the agreement, particularly for a newly built hotel, can often be achieved. While other chain fees are more difficult to negotiate, it can be possible to get some temporary relief there as well.
• Area of Protection or Non-Competition: Hotel owners are properly concerned about the brand opening a competing hotel within their property’s market area. If it’s not offered, a franchisee should ask during the negotiations for a geographic area of protection or non-competition. The length and breadth of the restriction varies, but some protection is usually granted.
• Ownership Transfer: Most franchise agreements are still based on a simple ownership model, contemplating a single owner (or investment group) of a single hotel. Our experience is that more complicated owners (including REITs, private equity groups, real estate funds and other institutional investors) are increasingly focused on hotel investments. As a result, the transfer provisions should consider the structure of the owner and flexibility for transfers to certain related parties. In that regard, while a sale of a hotel often precipitates a property improvement plan or PIP, the owners should not trigger a new franchise agreement negotiation, set of franchise application fees and PIP when the transfer is to a related corporate entity or to another family member or trust set up for estate planning purposes.
• Independent Management and Changes in Management: The essence of franchise structure is providing the power of a brand with the greater flexibility and responsiveness of an independent operator (i.e. an operator unrelated to the brand). A good independent operator can provide an owner with a valuable buffer to the brand’s demands for operating and capital expenditures, implementation of new and expensive brand standards, property improvement plans, and certain brand programs that may not make sense for a given property. While brands are, understandably, concerned that an operator must have the experience to run the property, the management company should be the owner’s choice, and should have primary loyalty to the owner, not the brand. Thus, it’s important to prevent a franchisor from having veto power over change in management of the hotel.
• Liquidated Damages: Liquidated damage provisions in the franchise agreement give the franchisor the ability to collect damages on the early termination of the franchise agreement. They can be a key inhibitor to the owner’s ability to maximize the value of the property on sale, because liquidated damages have ballooned in recent years to as much as five times the average combined franchise fees and reimbursements paid to the franchisor. There are usually ways to both reduce the amount of the damages as well as restrict the potential transactions that might trigger payment.
• Capital Investments: Franchise agreements usually give the brands the ability to require substantial additional capital investments by owners to meet new physical brand requirements. There are a number of ways to reduce an owner’s exposure, including restricting time periods and clarifying the types of capital improvements that can be required. This is particularly the case for a newly built property or an acquired property that may have recently undergone renovation.
• Personal Guarantees: Most franchisors require guarantees. Owners should seek to eliminate, or at least restrict the scope, of guarantees. As more and more owners are institutional, this requirement is less and less meaningful.
• Key Money: For the last several years, many brands have been willing to provide key money as a means of securing franchise agreements. While owners are typically excited about the prospect of getting additional funds, they should remember two things: First, key money is typically only paid after the hotel opens; it doesn’t provide funds for construction. Second, and more importantly, key money is probably the most expensive money an owner will get; in return for key money, brands typically will be even less willing to negotiate important franchise agreement provisions. While there are limited areas that an owner can expect to successfully negotiate with a brand in a franchise agreement, changes in these limited areas can make a big difference in the value of the brand to the owner. Our expertise in understanding how to implement these changes, and what other changes might be appropriate in a particular circumstance, has achieved significant value for our clients.
When you need a Hotel Attorney In Utah, please call Ascent Law LLC for your free consultation (801) 676-5506. We want to help you.
8833 S. Redwood Road, Suite C
West Jordan, Utah
84088 United States
Telephone: (801) 676-5506