Due Diligence – Do Your Homework Before You Buy

April 2009

Congratulations! You just signed an agreement of sale to buy a hotel. You think you paid a good price based on the financial statements that the broker provided to you. You know you can finance the acquisition and you are already planning on how you might be able to “flip” the project in a year or two and make a handsome profit. Optimism reigns supreme! But wait, your lawyer is telling you (or should be) that there is a lot of work to do before you get to the finish line - investigatory work must be done before you become irrevocably committed to buy the hotel. While this may dampen your enthusiasm, it is good advice to follow. This article outlines some of the essential steps you must take to ensure that you are getting what you pay for when you acquire a hotel.

THE AGREEMENT OF SALE

To protect your interest as a buyer, you must establish an interest in the property that you are acquiring before you spend significant amounts of time, energy and money performing a due diligence investigation. This requires you to sign an agreement that contains a reasonable due diligence period that will allow you to perform the investigations necessary while you have the seller’s commitment to sell the property to you. Many sellers ask for buyers to conduct their due diligence before a binding agreement is in place. This is a mistake from your perspective as a buyer, as the seller retains the right to sell the property to another buyer while you are spending money on your due diligence inquiry. Forty-five days is generally a reasonable period of inquiry to accommodate a buyer’s needs while not requiring the seller to keep the property “off the market” for an unreasonable length of time. You might even allow the seller to continue to market the property during the due diligence period, so that the seller can line up “backup” agreements in the event that you decide to terminate the contract during the inspection. The buyer should insist on having the right to terminate the agreement of sale during the due diligence period for any reason. If the seller resists this concept, then it is acceptable to outline the types of reasons that would permit the buyer to terminate the agreement.

Those reasons include the results of any of the elements of a normal due diligence inquiry as described below.

FINANCIAL DILIGENCE

When you decided to submit an offer to buy the property, the decision was no doubt based on an analysis of financial information that was submitted to you. What types of financial information were submitted to you? Did you receive tax returns of the seller? Did you receive audited financial statements, or were the financial statements that you received prepared by the owner himself with little or no backup to support them? You and your accountant need to use the due diligence period to thoroughly review what it is that you have and, perhaps more importantly, what it is that you don’t have at the inception of the due diligence period, and then proceed to obtain the information that is necessary to give you a complete financial picture of the property that you are acquiring. Ideally, you will obtain audited financial statements that relate only to the property, and not other property owned by the seller. In many cases, this is not available, but you can certainly have your own accountants review the financial statements that you have received and ask for the backup or “raw” data that led to those statements being prepared. You can also ask for the financial statements that were submitted by the owner to his lender and analyze the owner’s tax returns and compare them to the financial statements to see if they are consistent. You should involve your accountant in this process to make sure that the analysis is thorough and in accordance with generally accepted accounting principles. Most sellers are unwilling to provide detailed representations and warranties in an agreement concerning the financial information that they provide to you. If possible, you should require the owner, in the agreement of sale, to warrant that the financial information that he is providing to you is true and correct in all material respects and accurately presents the financial position and results of operation of the seller and the property as of the date of the financial statements for the periods that they cover. While this is helpful in providing you with a possible claim in the event that the owner’s financial information turns out to be inaccurate, it is no replacement for a thorough due diligence investigation of the owner’s financial situation.

PHYSICAL INSPECTIONS

You will need time after acquisition of the property to conduct a phase I environmental investigation of the site, and a thorough physical inspection of the condition of the property. In particular, you will need to focus on the property improvement plan, or “PIP,” that is likely to be imposed by the hotel’s franchisor as a condition to the transfer of the franchise and approval of your company as the new franchisee. Buyers need to work with franchise companies to develop the property improvement plan that will be required. Do not rely on an old, incomplete PIP and assume that the remaining work is all that you will have to do. You will need to make application to become a franchisee and deal directly with the franchise company to determine what is necessary.

You should also not rely on previous environmental reports that are provided to you by a seller when you acquire a property. Environmental conditions change, both on site and off site, over time. You need to conduct your own phase I environmental inspection to determine the condition of the property at the time that you are about to acquire it. If you rely on a report that is a year or two old, you will have no way of knowing if, for example, an adjacent property has become contaminated and whether there is a threatened release from that property on to yours. While it is tempting to save money and rely on an old report, it is not prudent to do so and, if you are involving a new financial institution as your lender in acquiring a property, you will almost certainly be required to perform a new environmental inspection as a condition to getting your financing.

EMPLOYEES

As part of your due diligence, you need to do a thorough inquiry of the work force that is engaged at the property. In most cases, you will agree to continue to employ many of the people who are working at the property at the time you acquire it. You should study the list of the employees, their job descriptions, wages and benefits, and analyze whether the property is overstaffed or understaffed. If you are allowed to do so by the owner, you should also interview the employees. At a minimum, you must interview the General Manager of the hotel and others who may be involved at a high level in the day-to-day operation of the business. If there is a labor contract in place, that contract must be analyzed carefully by you and your lawyer to determine whether you have successor liability. If there is a pension plan in place, you and your counsel must also analyze it, to determine how that plan will affect you after you acquire the business. You must also confirm that the owner has fulfilled all of his obligations with respect to withholding taxes and that he is current in his obligations to the employees. The employees are the lifeblood of your business, and you must pay attention to the many issues that revolve around the employee/employer relationship.

FRANCHISE/CONTRACTS

One of the most important contractual relationships that you will be engaging in as a new hotel owner is the contract between you and your franchisor. This is a contract that needs to be negotiated during the due diligence period. You will need to apply for your franchise as soon as possible following execution of the agreement of sale. The standard franchise agreement, including many of the economic and non-economic provisions, can be negotiated. In particular, you need to focus on the term of the franchise, liquidated damages in the event of termination of the franchise agreement, and the reasons for franchise termination by the franchisor. The due diligence period gives you an opportunity to negotiate a deal that you find acceptable for the long term, since the franchise relationship will be at the foundation of the success of your hotel operation.

While the franchise agreement is certainly important, there are other contracts involved in the operation of the hotel that you will have to evaluate. Leases for furniture, locks and other equipment will have to be evaluated to determine whether they are assignable, and whether you want to assume them. Contracts for services, such as extermination, trash removal and other routine maintenance operations, will have to be evaluated. To the extent that you want to assume a contract and it requires the consent of a lessor or vendor, you should attempt to obtain that consent during the due diligence period. You should also evaluate carefully the economic provisions of each contract, particularly those that relate to penalties for early termination (if you do not want to assume the contract) or provide for lump-sum payments in the case of the expiration of a lease for equipment.

PERMITS

The operation of a hotel requires a number of permits that relate to both the real estate and the business operation that is conducted on the real estate. The property will require occupancy permits, and there will be building permits required in connection with certain work mandated by the PIP. There are also likely to be permits issued with respect to the operation of the hotel as a business, particularly liquor licenses and other permits related to food and beverage operations. You need to investigate the status of these permits and whether any approvals are required in connection with the transfer of the property and the permits to you. An attorney can certainly be helpful in this regard, but your investigation needs to start with the General Manager and a thorough review of the books and records of the hotel.

LITIGATION

You should investigate the status of any pending claims that affect the property or its employees. In particular, you need to evaluate any employee claims concerning matters such as sexual harassment, age discrimination, etc. You should also evaluate whether there is adequate insurance in place to cover claims such as these or claims for personal injury or property damage. While you as a new owner may not be liable for those claims that pre-date your acquisition of the property, the ultimate resolution of these claims could affect aspects of the business (such as your relationship with employees) going forward.

TITLE

Your due diligence period should be used to examine legal title to the property that you are acquiring. Your attorney should engage a title insurance company to provide you with a title insurance commitment that discloses restrictions, easements, mortgages, and other liens and encumbrances that affect the property. Your lawyer must evaluate these exceptions to title and determine their impact upon the property. Do not simply accept the fact that the property has been operated for a period of time and that there is nothing of record that would impact its operation. A thorough review of the title insurance commitment, and the subsequent purchase of a title insurance policy, will provide you with the type of assurances that you need concerning the quality of title when you acquire the property.

While there may be other areas of concern that need to be addressed in a particular transaction, the foregoing outline should provide you with a basis for conducting the type of due diligence investigation that you and your investors should require before you acquire a new hotel. To quote an old phrase, “an ounce of prevention is worth a pound of cure.” Do not be hesitant to spend a reasonable amount of time and money in advance to seize appropriate opportunity or protect against a potential problem down the road. If you have an adequate due diligence period, and the ability to terminate a contract if adverse circumstances arise as a result of your investigation, you will know that you made a reasoned, and hopefully sound, investment decision when you acquire the hotel.