Buying a Hotel? Don’t Forget the FranchiseJuly 2009
When a buyer agrees to acquire an existing hotel that is franchised, one of the first things to examine is the franchise agreement and how that agreement will affect the acquisition of the hotel. Buyers often assume that the terms of the franchise arrangement will not significantly impact their acquisition and that they simply will succeed to the rights of the buyer to use the franchise name, reservation system, etc. Of course, this is not the case, and the franchisor-franchisee relationship that the buyer is about to engage in brings with it many issues that must be analyzed and addressed.
The terms “franchise” and “license” and words derived from these terms are used interchangeably in this article to mean the right of the then-current owner of a hotel property to a franchisor’s name, reservation system, marketing plan, training programs and similar benefits.
GETTING YOUR APPROVAL
Franchise agreements do not “run with the land.” Each prospective hotel buyer must be approved by the franchisor, and granted a license to use the franchisor’s name and other franchise attributes, before the buyer becomes entitled to these benefits.
If a buyer has already been licensed by the franchisor at other properties, the buyer should be familiar to the franchisor. Assuming that the buyer has a good record of compliance with his franchise agreements at other locations, and has a sound financial background, the franchisor will likely agree to continue the franchise at the facility that the buyer is seeking to acquire. If the buyer has never received a franchise at another location from the franchisor, the franchisor will certainly require significant background information on the franchisee’s principals, experience, financial capacity and other matters that are relevant to the operation of a successful facility that utilizes the franchise name.
Whether the franchisee is new to the franchisor’s system or has had significant experience as a franchisee for the franchisor at other locations, the appeal of the prospective franchisee/buyer is not the only thing that will be looked at carefully by the franchisor in deciding whether to approve a “transfer” of the franchise to the new hotel owner.
IMPROVEMENTS TO THE PROPERTY
One of the issues that frequently arises upon the so-called “transfer” of a franchise to a new owner is the status of the property’s compliance with the franchisor’s requirements concerning the improvements at the property. A buyer should insist upon reviewing the most recent property improvement plan or similar checklist for compliance with the franchisor’s improvement requirements prior to entering into an agreement to buy a hotel from a seller. The buyer will then be able to analyze whether the seller has fulfilled his improvement obligations, and assess what needs to be done in order to obtain a franchise for the buyer.
Although the franchisor may be motivated to continue the franchise at the hotel site in the event it has been a successful operation, he has no obligation to permit the franchise to be continued at the property through the new buyer, and will often impose significant new improvement obligations upon the buyer as a condition of issuing the franchise. If the property improvement plan mandated by the franchisor has generally been complied with by the seller/franchisee, the buyer will have a sound basis for negotiating a new plan as a condition of the buyer’s approval. If the property improvement requirements have not been fulfilled, a prudent buyer should require the seller to complete the requirements of the franchisor as a condition of the sale of the hotel to the buyer or, if there is not adequate time before closing for this purpose, to escrow the cost of completing these improvements at the closing.
Termination fees are another major issue to consider when acquiring a hotel and attempting to continue to operate a franchise at the acquired property. Many franchise agreements impose fees, often phrased as “liquidated damages,” if the seller’s license to use the franchise is terminated prior to its scheduled expiration. Since the license is personal to the franchisee, each time a property is sold, the seller’s license will terminate and a new license must be issued to the prospective buyer. Fees for termination of the franchise are generally based upon a set amount per room, or a fixed amount per month or per year for the period between termination of the seller’s franchise and what would have been the expiration of the franchise term. The termination fees may be waived by agreement of the seller and franchisor if the buyer is approved as a new franchisee.
A prudent seller will often include a clause in the purchase and sale agreement with the buyer that makes the transaction contingent upon the approval of the buyer as a franchisee and corresponding waiver of all termination fees. An alternative to the seller might be the buyer’s obligation to pay these termination fees in the event that the buyer is not approved as a franchisee or does not desire to continue having the property bear the name of the seller’s franchisor. The buyer will have to assess the seller’s proposal and deal with the issue of termination fees in the context of the agreement of sale.
FEES FROM THE NEW FRANCHISEE
The flip side of termination fees payable by the existing franchisee is the payment of initial charges and recurring fees, such as royalties, reservation system fees and similar amounts, by the new franchisee. These charges may be negotiable. It may not be necessary for the new franchisee to pay the same amounts that were payable by the seller. It may also not be necessary to pay termination fees if adequate upfront charges are paid by the new franchisee. The buyer should factor into account the fees that will be payable by the buyer as a new licensee when negotiating the financial terms of his agreement of sale with the seller.
THE FRANCHISOR-LENDER RELATIONSHIP
As mentioned throughout this article, a franchise is personal to the entity that signs the franchise agreement and does not run with the land. The mortgage lender that funds the buyer’s acquisition of a property will almost certainly be concerned about the termination of the franchise in the event that the lender forecloses its mortgage and takes possession of the property or seeks to sell it to a third party. The absence of a franchise is likely to significantly reduce the value of the lender’s collateral. Accordingly, the lender and the franchisor need to negotiate an acceptable arrangement that provides the lender with sufficient comfort to move forward and make a mortgage loan to the buyer. This is often referred to as a “comfort letter” from the franchisor.
The arrangement between the lender and franchisor generally focuses on several key issues that are critical to the lender. The lender will certainly seek to obtain notice from the franchisor of any default by the franchisee under the franchise agreement, and an opportunity to cure that default on behalf of the franchisee. The lender will also seek the right to obtain a new license from the franchisor in the event that the lender acquires the property, under certain specified terms and conditions. These conditions might include the payment of a fee to the franchisor, the requirement that all defaults of the franchisee be cured prior to the issuance of the new license, and compliance with the franchisor’s policies and procedures concerning the issuance of a license. These issues must be worked out in advance by the lender and franchisor if the buyer is to obtain a mortgage loan and proceed with its plans to acquire the property.
There are many other concerns that arise in the context of a franchise agreement that will be discussed on this website. The matters addressed in this publication are indicative of the global view that one must take when negotiating a franchise agreement, negotiating an agreement of sale and obtaining a mortgage loan to finance an acquisition. A franchise is a critical component of any hotel operation, and the franchise agreement and its ramifications should be analyzed carefully, with an attorney, before a hotel is acquired.