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TGIFF! It’s Franchise Friday. Read on for key considerations when buying and selling a franchise or branded hotel.
Key Considerations When Purchasing or Selling a Hotel Subject to a Franchise Agreement
In evaluating a hotel purchase and sale transaction, it is important to consider whether a hotel carries a franchise or brand. Part of what is being purchased may be the right to use the name of the hotel, and all the benefits and obligations associated with third-party hotel management or franchising. A franchise agreement provides the hotel owner/franchisee with a license to use the intellectual property associated with the brand and the brand system, in exchange for an application fee, license fees, marketing fees, and reservations fees. The grant of the license is for a specific hotel and location. A franchise agreement is personal to the hotel owner/franchisee and cannot be assigned or transferred without the franchisor’s prior consent. Sellers must assess whether the hotel management agreement or franchise agreement includes a right of first offer, right of first refusal, or some other purchase option or termination right that benefits the manager or franchisor. These issues determine what is necessary to complete the transaction, in addition to the negotiations between the seller and purchaser with respect to the purchase and sale agreement. Preparation for sale may need to include renegotiation of third-party contracts to remove obstacles to sale. No sale process should be undertaken without a thorough evaluation of the third-party issues likely to arise.
Under a franchise agreement, the hotel owner/franchisee (or a pre-approved third party manager) manages the hotel in conformity with terms and conditions set forth in the franchise agreement and the brand system and standards, including standards as to intellectual property use, marketing programs, reservations systems, food and beverage operations, and physical property attributes. The franchise agreement also sets forth the hotel name approved by franchisor.
Franchisor’s Right to Consent to or Terminate a Franchise Agreement Upon Hotel Sale
Under a typical franchise agreement, the restrictions on transfers are quite burdensome for franchisees. Because the franchise agreement is personal to the hotel owner/franchisee, any sale or other transfer of the hotel is prohibited without franchisor’s prior consent. If the hotel owner/franchisee sells the hotel without franchisor’s prior consent, typically the franchisor will have the right to terminate the franchise agreement immediately and collect liquidated damages from the hotel owner/franchisee.
If the franchisor consents to the hotel sale, the consent usually triggers franchisor’s right to require the purchaser to (i) apply for a franchise with the franchisor and pay the application fee, (ii) agree to complete a new property improvement plan (PIP) at the hotel, and (iii) execute franchisor’s then current franchise agreement. Franchise applicants must meet certain standards as to financial wherewithal and hotel operating experience. Typically, the franchisor will not consent to the sale of a hotel to a competitor of the franchisor. If the hotel owner/franchisee proposes to sell the hotel to a competitor of the franchisor, typically, the franchisor has a right of first refusal to purchase the hotel at the same price offered to the competitor or terminate the franchise agreement. The franchisor might exercise its right to purchase the hotel if the hotel is of strategic importance to the brand.
During the due diligence period, counsel for the purchaser should carefully review the terms and conditions of any existing franchise agreement. Hotel owner/franchisee usually requires as a condition to closing under the purchase and sale agreement that the franchise agreement either be terminated or assigned to the purchaser. When the purchaser assumes the franchise agreement, typical provisions in the assumption agreement include a waiver of liquidated damages against the hotel owner/franchisee and payment of all accrued franchise fees up to the closing date.
If the franchise agreement is terminated upon sale, in addition to the hotel owner/franchisee paying any required liquidated damages, the purchaser will need to (i) cease operating the hotel as part of franchisor’s system, (ii) cease using and remove from the hotel franchisor’s intellectual property, (iii) turn over to the franchisor all confidential information, (iv) make physical alterations as may be necessary to distinguish the hotel from its former appearance as part of the franchisor’s system, and (v) maintain a sign at the front desk indicating that the hotel is no longer operated as part of franchisor’s system. De-branding a hotel is an arduous process that can involve a loss in continuity in the hotel’s website, telephone numbers and brand markings. Purchaser can help prevent business losses during the transition period by pre-planning marketing activities and coming up with systems to replace those previously handled pursuant to the franchisor’s procedures.
Key Considerations When Purchasing or Selling a Hotel Subject to a Management Agreement
When a hotel is operated under a brand, a brand manager typically has the primary responsibility for day-to-day operations of the hotel. A management agreement between the brand and a hotel owner can have multiple values to the brand, including as a source of increased revenue and as a means of fulfilling a geographic or strategic need within the brand system. As a result, brand managers will seek management agreements with long terms and strong brand manager rights to protect against terminating the management agreement.
A management agreement is the key document governing the relationship between a hotel owner and a brand manager. The management agreement covers every aspect of the operation of the hotel (e.g., employees, marketing, reservations, maintenance, capital improvements, accounting, books and records and taxes). During the due diligence period, counsel for the purchaser should review carefully the terms and conditions of any existing management agreement.
Brand Manager’s Right to Consent to a Sale of a Hotel
Generally, a management agreement gives the brand manager the right to approve a purchaser of the hotel. Some management agreements may also give the brand manager a right of first refusal, a right of first negotiation or a right of first offer to acquire the hotel. A brand manager would want such a right if the hotel is of strategic importance to the brand. These provisions also preserve the seller’s ability to sell the hotel at a satisfactory price. In addition to these rights, most management agreements allow brand managers to prohibit sales to undercapitalized purchasers, felons, and brand manager’s competitors. If brand manager does consent to an assignment of the management agreement to a purchaser, brand manager will often use that opportunity to require purchaser to complete a PIP and pay any delinquent amounts due from hotel owner under the management agreement.
Hotel Owner’s Right to Terminate Management Agreement Upon a Sale of a Hotel
While brand managers value long-term management agreements, hotel owners normally want the right to terminate a management agreement upon sale of the hotel. To address both parties’ positions, many management agreements contain a lockout period during which the management agreement cannot be terminated on sale. After the lockout period ends, a hotel sale is permitted subject to the purchaser meeting certain criteria, including not being the brand manager’s competitor, and the seller paying a termination fee. Usually the termination fee is an amount equal to a multiple of the prior years’ management fees (base fees and incentive fees).
The following actions are routinely required upon a termination of a management agreement:
Other Issues to Consider with a Hotel Sale Transaction Involving a Franchise or Branded Hotel
Counsel for the purchaser must be aware that franchisors and brand managers often use the transfer of a franchise agreement or management agreement upon a hotel sale as an opportunity to require the purchaser to upgrade the hotel pursuant to a PIP. This opportunity arises because there are usually loan proceeds available to complete upgrades that the FF&E reserve is not sufficient to cover. Under a franchise agreement, the franchisor’s consent to a sale of the hotel will be conditioned upon the purchaser entering into the franchisor’s then current franchise agreement that provides for the upgrade of the hotel to address any needed renovations to bring the hotel into compliance with franchisor’s brand standards.
The purchaser should review any PIP carefully to determine (i) whether it complies with brand standards and the law, (ii) its impact on the hotel’s building and operations, and (iii) the purchaser’s return on investment. During weaker economic periods, brands will offer hotel owners some latitude in maintaining brand standards. As a result, a hotel acquisition that occurs as a weak economy begins to improve may involve a larger PIP than normal due to deferred maintenance. If the purchaser is unable to make the required investment, the brand may consider extending the time period in which the PIP must be completed or changing the hotel brand to a less expensive, lower tiered brand within the brand’s portfolio. However, if the purchase involves a municipal ground lease, the municipality may require the hotel to come into compliance with brand standards. Counsel for the purchaser should advise the purchaser to review and negotiate the PIP prior to entering into the purchase and sale agreement. If that will not occur, then the purchaser should make finalizing the PIP a condition precedent to the purchaser’s obligation to close under the purchase and sale agreement.
For a branded hotel, the transfer of inventory upon a sale of the hotel can be complicated.as some of the consumable inventory (e.g., toiletries, towels, napkins) contains the brand logo. Franchise agreements and management agreements typically require that branded inventory that is not being transferred to the purchaser be destroyed or repurchased by the brand manager upon the sale of the hotel.
If the purchaser will be entering into a franchise agreement and obtaining acquisition financing, a comfort letter will be required by the acquisition lender. A comfort letter memorializes the relationship between the franchisor, franchisee, and lender.
Lexis Practice Advisor: For comprehensive coverage of a host of transactional law topics, including more practical guidance and forms related to hotel purchase and sales, visit Lexis Practice Advisor. Click this link for a free 7-day trial.