Hospitality + Leisure Trend Watch February 28, 2018

How to Effectively Negotiate a Hotel Franchise License Agreement

Summary

At some point in the course of investing, owning and operating hotels, most hotel investors will be faced with the prospect of entering into a franchise license agreement with a hotel brand. Hotel brands continue to push an asset light philosophy, expanding the franchise model to more and more markets (including Europe, the Middle East, Africa and Asia) with an ever-increasing offering of hotel brand products. As such, investors must be well-versed in the nuances and negotiability of franchise agreements. 

While many experienced investors and legal practitioners, as well as the brands themselves, may assert that the franchise agreement is non-negotiable and must be accepted as presented, investors should not view the franchise agreement as merely a “take-it or leave-it” situation. There are certain discrete, but valuable, provisions that can be negotiated. However, to successfully negotiate these points, prospective franchisees should have upfront discussions with the franchisor to ensure the negotiated modifications are approved as part of the brand’s approval and awarding of the franchise license agreement (the FLA).  

 

Navigating the Negotiation of the FLA 

The negotiability of a franchise agreement of any type – whether a hotel, restaurant, spa, coffee shop or fitness facility – is typically very limited. Furthermore, unlike most other commercial agreements that are common to hotel ownership, franchise agreements are governed by both state and federal regulatory and statutory regimes designed to create uniformity and transparency for franchisees.

The following terms and provisions in the FLA are among the most tightly controlled by the franchisor: 

  • Operating Standards and Furnishing and Fixture Requirements
  • Term Length and Franchisee Termination Rights
  • Assignment of the FLA to a Successor
  • Application Fees and Franchise Licensing and Other Related Fees 

Understanding the franchisor’s perspective on these critical areas will help franchisees avoid wasting time and money (including legal fees) trying to negotiate components of the FLA that are not open for discussion. 

Operating Standards

Given that the franchisor is not involved in the day-to-day operations of the hotel, the brand has less control over the hotel’s adherence to brand standards as compared to those directly managed by hotel brands. An FLA will contain dozens of provisions that might be interpreted as onerous to the franchisee, especially with respect to operations, inspections, design, construction, furnishing and equipping of the hotel. However, these provisions help ensure brand consistency across hotels. Investors are advised to accept these terms with the understanding that, as an industry, franchisors typically do not actively monitor franchisees for strict compliance with the terms of the FLA as it relates to hotel brand standards and operations.  Instead, franchisors closely monitor guest satisfaction survey scores and adherence to brand standards relating to the physical components of the hotel as the primary means of evaluating a hotel’s compliance with FLA terms relating to operational matters and the brand standards.

Term Length

Franchisors not only rely on the FLA to help ensure adherence to brand standards, but also as a means of (a) capturing market share for the brand in a particular market and (b) creating predictable revenue streams for the brand’s parent company. To do this, most franchise agreements have long terms ranging from 10 to 30 years and in most instances, the term length is not negotiable. Further, the FLA will not (other than in some very rare instances) include any termination rights in favor of the franchisee. An early termination of an FLA by the franchisee is treated as a breach of the agreement. In most FLAs the remedy for such a breach is a termination fee that is characterized as liquidated damages. These liquidated damages are purposely high to discourage early termination and are usually based on a multiple (e.g., 2 to 5 years) of trailing 12-month fees paid by the franchisee to the franchisor.

Assignability of Franchise Agreement

Franchisors are also particularly concerned about the identity, experience and financial resources of the franchisee. As such, FLAs are not typically assignable by the franchisee. Except as described below, franchisors will not allow for an open-ended right to assign the FLA to a successor that has not been vetted and approved by the franchisor and pre-assignment approvals of a “permitted transferee” are quite rare. This does not mean a hotel investor must pay liquidated damages for early termination in order to sell the hotel. However, when selling a hotel, the outgoing franchisee (as the seller) should require the new owner to either (a) enter into a new franchise agreement with the brand (which will allow the outgoing franchise to terminate the original franchise agreement without the payment of any liquidated damages) or (b) agree to pay any liquidated damages as a result of the early termination of the FLA.

Application Fees and Franchise Fees

As part of the regulatory regimes governing franchise agreements, franchisors are required to treat franchisees and potential franchisees on a fair and equitable basis with respect to the fees payable by a franchisee. Among the fees a potential franchisee will encounter in the process will be a meaningful upfront application fee (as an example, Marriott can charge $85,000 or more for a franchise agreement application depending on the size of the hotel). The fee structure under the FLA will vary based on brand and product type, but usually includes a franchise or license fee (in the range of 3% to 6% of gross room sales), food and beverage fees (2% to 5% of gross food and beverage sales), marketing fees (1% to 3% of gross room sales), reservation fees (usually a set dollar amount for each room booked through the franchisor’s distribution channels) and guest rewards program fees. The fees specified in each brand’s franchisor disclosure document are not typically negotiable, except in limited circumstances.

So Where Should an Owner Focus?

While the aforementioned restrictions suggest that there is not much left to negotiate in the FLA, there are still a number of opportunities for hotel investors to increase the value of their franchise agreement. To do so in an efficient and effective manner, franchisees should focus their negotiations on the components laid out below when negotiating a franchise agreement. For any negotiated component of an FLA, franchisees should also consider negotiating the right of future franchisees to have the benefit of the negotiated terms, especially where the negotiated term has an economic impact. 

Property Improvement Plans and Key Money

One of the most crucial components of acquiring a hotel and entering into a franchise agreement is the property improvement plan or PIP. If an existing hotel does not conform to the brand requirements then-applicable to a branded hotel, there could be considerable – and costly – renovations, new furnishings and equipment required as part of a new FLA. In the purchase and sale context, buyers of hotels need adequate time to obtain and price the cost of the PIP. As part of the FLA negotiation, the new franchisee is advised to negotiate with the brand around the scope of the PIP as well as the timing for completing the PIP. The brand may exempt or delay the implementation of certain components of the PIP based on how recently other renovations have been completed, the nature of the hotel itself (i.e., location, age or product type, especially for soft-brands) or other factors that support the exemption.

New franchisees may also want to approach the brand about contributing toward the cost of the PIP or other renovations in the form of an amortizing loan that is often referred to as “key money.” Key money provided by the franchisor is amortized over the term of the FLA and the franchisee does not have any obligation to repay the key money unless the FLA is terminated early. Given that the sale of the property usually results in the termination of the FLA, the franchisee will also want to negotiate with the brand to allow for the “assumption” of the key money obligation by a successor franchisee.

Fee Ramps

While the fee structure is generally not negotiable, in certain instances, especially for new hotels, hotel conversions (i.e., when the hotel converts to a new brand) or a major renovation, brands may consider a temporary reduction in franchise license fees and food and beverage or marketing fees as the hotel stabilizes. These reductions are usually phased out over 2 to 4 years before reaching the proscribed fee levels in the franchisor’s disclosure document. In addition to a ramp-up of the franchise fees, franchisors may also consider a reduction in the renovation or FF&E reserve requirements following a substantial renovation or investment by a franchisee, such that the reserve requirements are lower in the initial years following the renovation. 

Permitted Transfers

Though franchisors do not generally permit the assignment of a franchise agreement to a new franchisee, franchisees are able to negotiate certain assignment rights relating to the ownership structure of the franchisee, provided that the identity of such new franchisee (or the entity or persons that would control the franchisee) are disclosed and known up front. This allows franchisees to negotiate with the franchisor for permissible assignment of the FLA to partners in a joint venture that may occur by reason of buy-sell arrangements in a joint venture agreement. By failing to negotiate certain permitted transfers as part of the FLA, investors may be required to apply for a new franchise agreement as the result of the exercise of certain rights set forth in a fund, partnership or joint venture agreement, which could trigger not only the payment of another application fee, but potentially a new 10- to 30-year term, increased franchise fees and a new PIP.

Competition

While an implied covenant of good faith and fair dealing may prohibit a franchisor from licensing a competitor hotel in close proximity to an existing franchise, owners should consider negotiating restrictions that limit direct competition in the hotel’s market. This area of protection (AOP) prohibits the brand from issuing another franchise agreement of the same brand to another hotel within a certain geographic area. The temporal scope of such prohibition can range from a few years to the entire term of the FLA. It is important to note that most AOPs are limited to a single brand and do not cover other brands controlled by the franchisor’s parent (i.e., an AOP for a Courtyard by Marriott would prohibit other Courtyard hotels in the proscribed area, but a Spring Hill Suites or Residence Inn would not be prohibited).

Unique Features

While the FLA is presented as a one size fits all agreement, it is important for new franchisees to surface unique aspects of a given property or transaction early in the FLA discussions. To the extent the property has intellectual property interests (especially with respect to the hotel’s name) or independent food and beverage outlets or other components that should be outside of the purview of the franchise agreement (such as spas, golf courses, retail, office or residential components), franchisees are advised to seek modifications to the franchise agreement so that it is tailored to cover these unique components. Such components should be identified to the brand as early as possible.

These provisions reflect some of the best opportunities for franchisees to enhance the value of their franchise agreement. Furthermore, by focusing on the more negotiable provisions and not attempting to negotiate the tightly controlled provisions of the FLA, franchisees will have a much smoother and more efficient negotiation of their FLA.