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HOW TO BUY A HOTEL Handbook: Franchise issues in hotel purchase and sale transactions

 Buying a hotel -- the Hotel Purchase Agreement documentation and process.

Brand franchise issues in hotel purchase and sale transactions
by
Robert E. Braun and Catherine DeBono Holmes | Hotel Lawyers

 Key issues in hotel purchase agreements for buyers and sellers of branded hotels operating under franchise agreements.

 Buying or selling a hotel operating under a brand name requires special attention. Typically, the existing franchise agreement will be assumed, terminated or modified in some way, and the new branding arrangements will usually have a significant impact on the value and profitability of the hotel. The JMBM Global Hospitality Group® has represented buyers and sellers of hotels with all the major hotel brands, and has developed practical solutions 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 a lot of money, avoid major disruptions of hotel operations upon the sale and increase the value of the property itself.

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

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

 Some hotel buyers and sellers believe that the hotel brand can be sold along with the hotel. That is not true. Virtually all franchise agreements currently used by the major brands provide that the seller's existing franchise agreement terminates when the hotel is sold. The buyer will need to enter into a new franchise agreement if the buyer wants to retain the brand. This leads to two key concerns.

First, unless a franchisee (the seller) has negotiated otherwise with the franchisor, the sale of the hotel will cause the termination of the franchise agreement, obligating the seller to pay a significant termination fee. While most franchisors will waive the termination fee when an approved buyer enters into a new franchise agreement, the transaction documents, conditions and timeline must deal with this reality.

Second, the new franchisee (the buyer) 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.

 The hotel purchase and sale agreement should address these concerns. For example, the seller 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. The parties' respective obligations to effectuate the transition should also be spelled out.

 
The hotel purchase agreement must allow enough time to complete the new franchise approval and execution as part of the transaction process.

 Hotel franchisors have an application process, which requires 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 perhaps negotiate a few modifications. 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 a signed (new) franchise agreement before closing the sale of the hotel.

 For the buyer: How to deal with "PIP" requirements of the franchisor.

 Almost every hotel franchisor will require a new franchisee to undertake a property improvement program or "PIP" 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 in 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
• 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 http://www.hotellawyer.com/.

 For the seller: How to deal with liquidated damages.

 Most hotel franchise agreements require an owner/seller to pay a termination fee or liquidated damages on termination of a franchise. Often this amount will be a multiple of the average annual franchise fee earned by the franchisor over the prior years. The franchisor may also charge 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 satisfactory 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.

Unless there is a specific condition in the contract, even if the buyer is obligated by the purchase agreement to execute a franchise agreement after the closing (and does so), the franchisor has no obligation to waive termination fees. And of course, if the buyer does not enter into a franchise agreement after the closing, the franchisor can demand that the seller pay all of the termination fees and charges. Often times, such termination fees and related charges are secured by the personal guaranty of the owner/seller, which means that the franchisor can sue 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 old 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 and logo will need to be removed from the hotel and replaced.

 In addition, a change of hotel brand will likely also mean a change of reservation systems. This may necessitate 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 buyer needs to start marketing the property a soon as possible 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 the hotel 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. For future flexibility, it is also wise to negotiate for the ability to change hotel managers without the franchisor unreasonably withholding its consent.

 
Robert E. Braun is a senior member of the Global Hospitality Group® at JMBM. Mr. Braun advises hospitality clients with respect to management agreements, franchise agreements and spa agreements. He also advises on business formation, financing, mergers and acquisitions, venture capital financing and joint ventures, telecommunications, software, Internet, e-commerce, data processing and outsourcing agreements for the hospitality industry. Contact him at (310) 785-5331 or rbraun@jmbm.com.

 Catherine Holmes is a transaction and finance partner with JMBM's Global Hospitality Group® and Chinese Investment Group™ and specializes in resort and hotel purchase and sale transactions, resort and urban mixed-use financing and development including EB-5 financing and public and private securities offerings, hotel management and franchise agreements, and hospitality asset workouts. Contact Catherine at 310.201.3553 or cholmes@jmbm.com.