Brand Franchise Issues in Hotel Purchase and Sale Transactions - Investment Law Blog

Buying or selling a hotel operating under a brand name requires special attention – the existing franchise agreement will be assumed, terminated or modified in some way, which will have a significant and lasting impact on the value of the hotel. The JMBM Global Hospitality Group® has represented buyers and sellers of all of the major, and many minor, branded hotels and have developed practical solutions for our clients to achieve a smooth transition of the franchise from the seller to the buyer, or to change the franchise if that suits the buyer’s goals. Knowing when and how to work with the franchisor as part of the transaction can save both parties tens of thousands of dollars, avoid major disruption of hotel operations upon the ownership transfer and increase the ongoing value of the property itself.

In this article, we some of our experience in dealing with the key hotel franchise issues that need to be addressed during the negotiation and transition process.

The first thing you need to know: the franchise does not follow the property – it terminates when the hotel is sold.

Some buyers and sellers of a hotel believe that the hotel brand can be sold along with the hotel; that is not true. The existing franchise agreement terminates when a hotel is sold and the buyer has to enter into a new franchise agreement if the buyer wants to retain the brand. Franchises are personal agreements between the franchisor and the franchisee, and virtually all franchise agreements include restrictions on the ability of a franchisee to transfer the franchise. This leads to two key concerns. First, unless a franchisee has negotiated otherwise with the franchisor, the sale of the hotel may cause the termination of the franchise agreement, making the seller obligated to pay a significant termination fee. While most franchisors will waive the termination fee on an approved sale, this fact has to be addressed. Second, a franchisee must make independent arrangements with the franchisor to continue to operate the hotel under the same brand (if it chooses to do so), starting on the day the transfer takes place.

Because of this, the hotel purchase and sale agreement must address the franchise agreement . For example, buyer might include provisions in the hotel purchase and sale agreement to require that the buyer receive approval from the franchisor and a new franchise agreement from the franchisor before the closing of the transfer. If the buyer intends to change the franchise, then the seller needs to take into account the termination fees that the franchisor will charge for termination of the franchise, and the seller may want to increase the purchase price or negotiate terms with the buyer that reflect the seller’s payment of any franchise termination fees.

Build in the time to complete the franchise approval and execution as part of the transaction process.

Hotel franchisors have an application process, and require detailed background and financial information from the prospective hotel buyer, before they will accept the buyer as a new franchisee. The seller will want to find out how long the franchisor will take to review the buyer’s franchise application. The buyer needs to be prepared to file a franchise application and submit the necessary background and financial information to the franchisor as early as possible. A franchisor can take several weeks to review a franchise application from a new franchisor. Less time may be required for a buyer who already operates other hotels under the same franchise, but the buyer will generally still need to submit a new application and obtain franchisor approval. The franchisor may also require the buyer to commit to upgrades of the hotel as a condition of approval (more about that below). The buyer will want to review the franchise agreement presented by the franchisor, and negotiate modifications to make it more acceptable to the buyer. The seller and buyer need to provide time in the transaction process for the buyer to go through the approval and negotiation process with the franchisor before the closing. Once the buyer and the franchisor have agreed to the terms of the new franchise agreement, it may take additional time for the buyer to receive the signed franchise agreement from the franchisor. It is prudent for both the seller and buyer to wait until after the buyer has signed a new franchise agreement before the closing of the sale of the hotel..

For the buyer – how to deal with “PIP” requirements of the franchisor.

Almost every hotel franchisor will require any new franchisee to make improvements to the property as a condition of receiving a new franchise agreement. If the hotel has not been upgraded for several years, which many hotels have not since the economic downturn began in 2008, the franchisor may require the buyer to make a substantial investment in property upgrades. If, on the other hand, the seller has recently made upgrades, the buyer may be able to reduce the required improvements, and/or to negotiate a longer time period after closing for the buyer to complete property improvements. The buyer will want to start the discussion process with the franchisor early in the purchase transaction, so that the buyer can determine the costs of the improvements being requested by the franchisor, and be prepared to discuss a timeline with the franchisor to manage the costs and operating disruptions that will be required for the upgrade. Inexperienced buyers will want to engage knowledgeable consultants to help review and evaluate the franchisor’s requested improvements, and suggest “value engineering” modifications to the franchisor’s property improvement plan to reduce the buyer’s cost.

For the buyer – how to negotiate with the franchisor for better terms of the franchise agreement.

Although many of the terms of a franchise agreement will not be negotiated by a franchisor, there are some provisions that are negotiable. Some of the most frequently negotiated provisions include:

A lower initial franchise fee rate, with a ramp-up in franchise fees over time;
The inclusion or expansion of a restricted area within which the franchisor will not issue new franchises for the hotel brand;
Flexibility in transfer provisions to reflect the terms of the buyer’s internal ownership or financial structure;
The elimination of a right of first refusal of the franchisor;
Elimination or reduction in termination fees for the future sale of the hotel by the buyer; and
Some required standard before the franchisor can require the buyer to make future renovations.

Another major issue for negotiation will be the guarantees that the franchisor requires from the buyer and its affiliates. Buyers should be aware that there are different forms of guaranty, and it is possible to negotiate a guaranty that will reduce the potential liability of the guarantor. For additional recommendations on Hotel Franchise Agreements, see our article, Hotel Franchise Agreements: The Five Biggest Mistakes an Owner can Make, at www.hotellawer.com

For the seller – how to deal with liquidated damages.

As noted above, virtually every hotel franchise agreement requires a seller to pay liquidated damages on termination of a franchise. Oftentimes, the fee will be a multiple of the average annual franchise fees earned by the franchisor over the prior years. The franchisor might assess the seller other fees, such as charges for the hotel signs that the franchisor leases to the seller for a fixed term. The seller will want to ask for a waiver of all liquidated damages, which the franchisor will often grant, as long as the buyer enters into a new franchise agreement with the franchisor. The seller should not allow a buyer to close on the hotel purchase before the seller has obtained a waiver from the franchisor and the buyer has obtained a new franchise agreement from the franchisor. Even if the buyer is obligated under the purchase agreement to enter a franchise agreement after the closing – there is no obligation of the franchisor to waive the termination fees, even if the buyer does eventually enter into a franchise agreement. Worse, if the buyer does not enter into a franchise agreement after the closing, the franchisor will demand the seller to pay off all of the termination fees and charges. Often times, these liabilities will have been secured by the personal guaranty of the owners of the sellers of the hotel, which means that the franchisor can bring claims against the owners directly for these amounts. Therefore, it is critical to the seller to obtain the waiver of termination charges by the franchisor before the closing.

For the buyer – how to coordinate a de-branding if the hotel is changing flags.

If the buyer intends to change the hotel flag, the process of removing the hold name and replacing it with the new name will require coordination and timing. This is typically done by the buyer immediately following the closing, in accordance with a pre-arranged schedule. The buyer will want to coordinate with the franchisor, because hotel brand signs are often leased, rather than owned, by the seller. In addition, all items with the old hotel brand name will need to be removed from the hotel and replaced, usually with similar items with the new hotel brand name. In addition, a change of hotel brand may also mean a change of reservation systems, which could also require replacement of existing technology at the hotel to accommodate the new reservation system and training of personnel who are not familiar with the new system. The buyer will want to be in a position to immediately turn on the new reservation system when the old one is turned off, to avoid a disruption in bookings. If the hotel does a significant amount of group business, the buyer will want to discuss existing group bookings with the franchisor, and if possible obtain a commitment from the franchisor to leave the existing group bookings in place without soliciting the groups to move to another hotel within the franchisor’s system.

At the same time, buyers should be aware that franchisors often steer bookings away from properties when those properties change brands; thus, the marketing of the new property needs to take place early in the process to avoid unreasonably low occupancy when the hotel opens under new ownership and brand.

For the buyer – obtaining approval of the independent hotel manager and the right to change hotel managers in the future.

The hotel buyer will often bring in an independent hotel management company to manage a hotel operated under a hotel brand franchise agreement. Since the hotel franchise agreement will include a provision that requires the franchisor’s approval of any third party manager of the hotel, the hotel buyer will need to confirm early in the transaction that the franchisor will approve the buyer’s choice of hotel manager. Many independent hotel managers are approved to operate a number of hotels under the franchisor’s brands, including many that are not owned by the buyer. In that case, the hotel manager may actually have a greater motivation to support its own good relations with the hotel brand than its relationship with the hotel owner. In order to avoid a situation where the hotel franchisor prevents the hotel buyer from changing hotel managers, the buyer should seek to negotiate with the franchisor some ability to change hotel managers without the franchisor unreasonably withholding its consent.

In the coming weeks, we plan to provide more practical information to hotel buyers and sellers on additional issues such as handling branded hotel management agreement issues in a purchase and sale, transitioning liquor licenses and operating permits, taxes and prorations, and environmental and ADA issues.

Catherine DeBono Holmes is the chair of JMBM’s Investment Capital Law Group, and has practiced law at JMBM for over 30 years. She specializes in EB-5 immigrant investment offerings and hotel and real estate transactions made by Chinese investors in the U.S. Within the Investment Capital Law Group, Cathy focuses on business formations for entrepreneurs, private securities offerings, structuring and offering of private investment funds, and business and regulatory matters for investment bankers, investment advisers, securities broker-dealers and real estate/mortgage brokers. Contact Cathy at CHolmes@jmbm.com or 310.201.3553.