The Right Way to Manage a Management Agreement

March 2009

Owners of hotels and motels often determine that their limited time and resources mandate employing a third-party manager to maximize a property’s profitability. This is particularly true when a family-owned business decides to expand its ownership of one or two properties to cover several different income-producing sites. Management agreements come in all shapes and sizes, but the issues that you as an owner need to focus on remain constant. This article will analyze those issues and discuss the pros and cons of negotiating a third-party management arrangement.

SERVICES

What services do you want a management company to perform for you? That is the single most important question to ask yourself when negotiating with a management company. While an owner may feel that he wants a manager to handle the entire hotel operation, often when the words on the page are negotiated, the owner comes to realize that he wants to give up a limited amount of control, but not complete control, over his investment. If an owner desires to maintain some control while delegating to the management company the obligation to oversee operations, an appropriate management agreement might provide for the management company to assume the following responsibilities:

  • selection, promotion and supervision of executive staff (including a general manager) and service employees
  • establishment of prices and rate schedules for guest rooms, meeting rooms, banquet facilities, etc.
  • negotiation of basic leasing and concession arrangements, including equipment leases and service leases, subject possibly to the owner’s approval if these contracts exceed a certain amount
  • procurement and maintenance of licenses and permits required to operate the hotel, and the compliance of the hotel with applicable laws, statutes and ordinances
  • submission to the owner, on at least an annual basis, of a budget for the day-to-day operations of the hotel and capital expenditures
  • maintenance of adequate supplies, inventory and equipment at the hotel
  • proper advertisement and promotion of the hotel
  • compliance with the terms of the hotel’s franchise agreement
  • maintenance of an appropriate accounting system
  • maintenance of the hotel in good operating condition, including making all necessary capital improvements
  • maintenance of adequate books and records concerning the operation of the hotel
  • maintenance of appropriate insurance coverage
  • oversight of construction services required by the owner or franchisor

Obviously, the owner may wish to control the management company’s ability to make decisions regarding some or all of the matters described above. What type of control should an owner have and what is reasonable for an owner to expect, to maintain a certain level of influence with the management company, while giving it the type of independence the management company may feel is required to perform its job properly?

BUDGETS AND APPROVAL RIGHTS

The most basic element of control that an owner will have is the right to approve the budget for the operation of the hotel. The owner should maintain strict control over the budget process, and expenditures should be made to conform with the budget, once it is approved by the owner. If for some reason the owner and the management company cannot agree upon a budget within a reasonable period of time after its submission (which should be made on an annual basis, at a minimum), then the parties should agree to part ways and terminate the agreement. The management company will often attempt to negotiate some form of liquidated damages in the event of a termination following the failure to agree upon a budget. The owner may resist this, possibly feeling the management company could arbitrarily propose a substantially higher budget than is necessary, knowing that the owner will not approve it. In this case, the management company will end up being terminated and entitled to liquidated damages as a result. In the end, the parties have to agree to work in good faith towards a mutually acceptable budget, and trust that each will act prudently during the budget process.

The owner should require his approval if the management company wants to deviate significantly from the budget. The budget should contain all of the categories of expenses that will be incurred in running and maintaining the hotel, and provide the management company with some flexibility in terms of making expenditures within these categories. For example, if the budget calls for $75,000 in equipment leases, the management company may be given discretion on how to spend that $75,000, but the owner’s approval should be required if more than this aggregate sum is spent on leasing.

The owner also may obtain control over the management company’s activities by requiring approval of certain specific actions, or approval of certain contracts or engagements that exceed a predetermined scope. For example, the owner may require the right to approve capital expenditures in excess of a given amount, or contracts if the amount to be spent pursuant to the contract exceeds a given amount per year. The owner may decide to require his approval of a marketing campaign or some other specific aspect of operations that the owner feels justifies his input. A certain level of control is certainly justified in light of the fact that the owner will be funding performance by the management company of its obligations under the contract.

The budget process is a key element to focus upon in negotiating a management agreement. Assuming that an owner and management company can agree upon the scope of the management company’s services and a methodology for determining how to fund the management company’s performance of those services, how should the parties measure whether the management company is fulfilling its obligations?

BENCHMARKS FOR PERFORMANCE

There are many ways to measure a management company’s performance of its obligations under a management agreement. Many contracts simply say that the management company needs to operate the hotel in accordance with a franchisor’s requirements and in the manner that is customary for the operation of similarly situated hotels and hotel brands. However, you can be more specific in determining whether a management company has met its obligations.

A management agreement often contains a specific set of criteria that determine whether the management company will be permitted to continue to manage a hotel. The criteria might include the following:

  1. increasing occupancy levels
  2. increasing gross revenue
  3. increasing net income
  4. increasing quality evaluation scores on the periodic testing of the hotel facility conducted by the franchisor

MANAGEMENT FEES

Most management agreements provide for either a fixed fee as base compensation, or a base management fee that is determined by reference to gross revenues or gross operating profit of the hotel. There also may be a separate fixed fee for certain services provided by the management company, such as accounting services, payroll services and marketing services. The management contract also may include a fee for construction management services in the event that there is a major renovation being planned for the hotel or a significant property improvement plan that needs to be implemented for a franchisor.

When negotiating compensation for a management company, an owner should be mindful of the need to incentivize the management company to improve profitability at the hotel. Providing the management company with too much of a fixed fee, or a fee based on gross revenues, ignores the ultimate profitability of the hotel as a barometer for measuring the management company’s performance. If a management company’s fee is tied to profitability, then the company will have an incentive to increase revenue while at the same time controlling expenses. Keep in mind that expenses of the hotel are going to be paid by the owner; the only incentive for the management company to keep those expenses down, apart from professional responsibility to the owner, is a compensation formula that rewards the management company for improving the owner’s profits and cash flow.

TERMINATION OF THE CONTRACT

Management contracts generally have a term of years that defines the period during which the parties are bound to their agreement. Most contracts also provide that the owner can terminate the contract “for cause,” such as the management company’s default in its failure to perform under the contract (generally after notice and an opportunity to cure the default have been given to the management company), the company’s misappropriation of funds or commission of another crime or offense and, perhaps, the failure of the property to produce projected revenue, profit or occupancy level. Likewise, the contract will generally provide for the management company’s right to terminate “for cause,” such as the owner’s failure to pay the management company or fund expenses which the owner has agreed to fund pursuant to a budget approved by the owner.

The more interesting questions arise in contracts where one or either of the parties can terminate the contract “without cause.” Such provisions are almost always accompanied by so-called “liquidated damages” clauses that provide for a payment to be made to the management company in the event of termination. If the management company has fulfilled its obligations under the contract, but is being terminated prior to the expiration of the contract, it is reasonable for the company to receive some compensation. The important thing is to negotiate this figure up front and, preferably, provide for it to be a fixed amount that the owner can budget for in the event the owner decides to reassert control over the day-to-day operation of the hotel prior to expiration of the contract. The management company likely will ask for a termination payment that is based upon the remaining period of the contract at the time it is terminated and the average monthly payment made to the management company prior to termination. A typical provision would multiply the remaining months of the contract by a percentage of the average monthly fee earned by the management company prior to termination.

SUMMARY

A management contract, like a franchise agreement, is at the core of the myriad of agreements that an owner negotiates in connection with the ownership and operation of a hotel. These documents should be negotiated carefully and with the advice of an attorney, who can highlight issues and help achieve the owner’s objectives. Management agreements can generally be negotiated more easily than franchise agreements. Owners should take this opportunity to make the best deal possible to protect their investment.