Nina Eldred is Senior Counsel in our Washington D.C. office.
As the current economic recession continues, with the hospitality industry being particularly hard hit, more and more hotel owners are recognizing the benefit of being associated with a strong brand. The value of a recognized flag and a well-run system are more important now than ever before as hotel owners take steps to increase their bottom line. Consequently, more hotel owners may be looking to change flags or convert their unbranded hotels to a recognized brand by entering into franchise agreements.
While these are certainly challenging times, a recession can often create opportunities. As hotel deals become fewer due to lending constraints and other negative circumstances such as lower RevPAR, brand companies may be more flexible in negotiating franchise deals than during robust economic times.
There are certain key elements that should be considered when negotiating a hotel franchise agreement. As these agreements are typically long term and involve an expensive asset, namely a hotel building, they should not be entered into lightly. Advice on negotiating a franchise agreement runs the gamut from, "They're not negotiable – you just sign them as is" to "Negotiate everything, start high and be aggressive with an opening position. This way you have room to maneuver when the other side asks you for a concession." The truth, of course, is somewhere in between and depends on a myriad of factors.
What Do You Want vs. What Do You Need?
As in all negotiations, know the difference between what you want and what you need. This is an important distinction we have all had to make with our own consumer spending during this recession and it's no less important when negotiating a franchise agreement. Questions to consider include:
- Why have you decided to enter into a franchise agreement instead of a management agreement?
- Why did you decide to brand your hotel versus operating an unbranded hotel?
- Why did you select this particular brand?
- What are your long-term goals for this asset?
- Who is going to manage?
The answers to these questions will help you to stay focused during your negotiation.
Review The Franchise Disclosure Document
As part of your decision to enter into a franchise agreement and which flag brings the most value to your hotel, it is important to thoroughly and carefully review the Franchise Disclosure Document (FDD, formerly the Uniform Franchise Offering Statement (UFOC)) that the franchisor is required to provide to franchisees by law. The FDD provides a wealth of information about the franchisor, its parent company, and the costs and services associated with the brand and the system. Review it thoroughly with experienced counsel to understand the services provided, the costs and the ramifications for your business.
Letter Of Intent Or Term Sheet
Prior to executing the franchise agreement it is advisable to enter into a letter of intent (LOI) or term sheet with the franchisor. Although your LOI or term sheet will be non-binding, it's at this stage in the process that you want to seek counsel to assist in structuring the business deal. While you don't need to address all the details of the franchise agreement in the LOI you do need to identify and spell out the key business points that are important to you. For example, after the LOI is signed it may be too late to ask for a ramp-up in fees or key money. Your franchisor representative may have already had the "deal" approved by his or her internal committee and it may be difficult to have the deal resubmitted for further approval. You have a much better chance of getting the deal you want if you include the key business terms in an initial LOI or term sheet rather than wait until the actual negotiations of the franchise agreement.
Key Provisions To Consider
- Fees and Royalties – Fees include the initial application fees, royalty fees, advertising or marketing fees, reservation charges, frequent traveler programs and others. Before making a decision regarding which brand to use, make sure you are comparing apples to apples in comparing fees as each brand has its own fee structure and many brands charge for items differently. One brand may include an accounting fee as part of a centralized charge while another brand may charge a fixed fee per room. Also, make sure you understand which fees and services are mandatory and which are optional. Depending upon the market and how many other potential franchisors are interested in and have control of a site or hotel in the market, you may be able to negotiate a modification of some of the fees. You may be able to obtain a waiver of fees or a ramp-up of fees until the hotel stabilizes.
- Key Money – Key money is a financial contribution made by the franchisor to the franchisee. Depending upon how much the franchisee wants your particular deal, it may be willing to provide some key money to you. Key money may or may not be required to be repaid provided the franchise agreement doesn't terminate prematurely.
- Property Improvement Plan – As a requirement for branding or re-branding a hotel, a Property Improvement Plan (PIP) will be required to bring the hotel in compliance with brand standards. A PIP may include upgrades to life safety, furnishings, fixtures and equipment – all of which will be subject to the prior approval of the brand. The scope and timing for completion of a PIP will be a negotiated point for any franchise deal, particularly in a down market. With a conversion, bringing the hotel up to current brand standards will be an important factor for integrating the hotel into the system and bringing the full value of the brand to the franchisee. However, given the current financing constraints of the market, the franchisee should consider how much financing it can reasonably obtain and whether it's possible to phase in the improvements over a period of time rather than as a requirement to obtaining the flag. It may also be possible to offset some of the costs for the PIP through a ramp-up or deferral of other fees or by obtaining key money from the franchisor.
- Timing – Timing for acquisition of a site, construction of the hotel or completion of a PIP is an even more important factor during a recession or uncertain times. In a difficult market such as now, you may want more time to secure your financing or complete improvements. It may also be important to have some relief from penalties if you are unable to meet certain milestones through no fault of your own, but due to market conditions.
- Early Termination, Default and Liquidated Damages – If your goal is to sell the hotel in a short period of time it is important to have the right to terminate the franchise agreement prior to expiration. The early termination or breach of the franchise agreement will typically result in the payment of liquidated damages by the franchisee. The amount of liquidated damages may be subject to negotiation. Also consider requesting some relief from payment of liquidated damages upon a default or failure to meet certain conditions if the default or failure is due to circumstances outside of your control such as market conditions, the inability to finance a PIP or governmental delays.
- Assignment and Transfer – The importance of the right to assign the franchise agreement depends upon whether your goal is to hold the hotel for a long time or to sell it within a relatively short period and assign the franchise agreement. At a minimum, most franchisees should seek the ability to transfer the franchise agreement to an affiliated company or to family members for flexibility. A franchisee should also attempt to negotiate the fees and requirements for this type of transfer upfront although it is not uncommon for any transfer or assignment to be subject to "then current" requirements and fees.
- Trade Area Restriction – There is an implied covenant of good faith and fair dealing which prohibits a franchisor from opening or granting a license to a competing business proximate to the franchisee's business, however, it is better for both the franchisor and franchisee to agree upon a specific geographic area and time period for this restriction. The restriction should include a sufficient period of time for the franchisor's hotel to ramp up and reach stabilization or an agreed level of occupancy before a competing hotel of the same brand is introduced into the market. (In most franchise agreements any restriction will be limited to the specific brand and will not apply to any other brands controlled by the franchisor). In the current down market it may take longer for a hotel to reach stabilization than in the boom years. A thorough knowledge of the specific market will help the parties determine whether the size of the restricted area should be two blocks or two miles. This is clearly a case where one size does not fit all, and the parties should be careful before agreeing to a general radius restriction that does not adequately address the specific market.
- Personal Guaranty – Depending upon the type of entity entering into the franchise agreement the franchisor may require personal guaranties from the equity participants. This requirement is subject to negotiation depending upon the leverage between the parties and may be more likely to be waived when there is less competition for franchised hotels in the market.
- Comfort Letters – A comfort letter is a letter from the franchisor to the lender assuring the lender that in the event of a foreclosure the franchise agreement will stay in place provided the lender or subsequent owner satisfies certain requirements. This provides the lender "comfort" that it will retain the value the brand brings to its collateral. Some franchisors will charge a fee for comfort letters which can be negotiated up front.
How Much Is Too Much?
Why Not Getting Everything You Ask For Could Be A Good Thing
Some attorneys will advise you to ask for everything on the theory that this will provide you some negotiating room and you'll end up with more in the end. This strategy is a bit like playing the "claw" game at an amusement park. You might end up with "more" but will it be the issues that matter to you? Most likely this will not be the case.
As Groucho Marx once said, "I don't want to belong to any club that will accept me as a member." If you ask for the world and get it think about what kind of franchise system you're buying into. Part of the reason you have chosen this hotel brand and this franchise system is because of what it brings to you in the marketplace – a clearly defined, consistent brand. If the franchisor is willing to negotiate too many of the provisions in its franchise agreement then it's likely they have done so for others as well (again, a careful review of the FDD will reveal many of these issues). Particularly with respect to brand standards, a lack of enforcement either in the initial PIP or in ongoing maintenance will cause both the system and the franchisee suffer. A better approach is to consider what issues are important to you because of your business goals in this particular transaction and negotiate hard for those points. Not all issues are equally important and you can waste time, money and leverage negotiating issues that are unlikely to impact your business.
Franchise Associations
While a brand may not make every revision you request in their form franchise agreement there are other protections for franchisees. Many of the national brands have either independent franchisee associations or franchisee councils comprised of a group of owners, typically franchisees with a large number of hotels and therefore a vested interest. New initiatives and revised brand standards are typically run by the franchise association for feedback prior to being rolled out to all franchisees. Determine if the brand you are considering has a franchise association, how its members are chosen and how much input it has with respect to issues important to franchisees.
Don't Win The Battle And Lose The War
While some people view all negotiations as a war with individual battles to be won, a more useful approach is to view the negotiation of a franchise agreement as the first step in a long-term relationship. The goal is to have a successful hotel that benefits both the franchisor and the franchisee. With a clear sense of your business objectives and the assistance of experienced counsel you can successfully negotiate a franchise agreement with a strong brand while obtaining the concessions you need. You will also have established the foundation for a long-term relationship that will serve you over time as you work through the numerous unexpected issues that will arise during the term of your franchise agreement, in good times and in bad.
Reprinted with permission of HOTELS magazine, a Reed Business Information publication, a division of Reed Elsevier.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
