By Daniel R. Weede
Selecting a hotel brand and a hotel manager are two of the most critical choices hotel owners can make, yet many don’t fully understand the key material issues or don’t attempt to negotiate their franchise and management agreements. This article addresses essential and frequently negotiated issues in these agreements.
Hotel franchise agreements
To maximize RevPAR (and obtain capital investors and financing), owners usually approach a major hotel brand to “flag” their hotel with an appropriate hotel brand. The right flag can increase hotel occupancy and the room rate significantly, and add upwards of 20%–40% to a hotel’s value when compared to “unflagged” or weaker brand options. The document that formalizes your rights and obligations is the hotel license agreement or franchise agreement. There are dozens of material terms in the franchise agreement; however, the vast majority of these terms are non-negotiable. The key to negotiating successfully with a brand is understanding which terms are open to negotiations in certain situations.
While very few of the legal terms in the franchise agreement are open to negotiation, if raised while negotiating the term sheet prior to committee approval by the brand, there are several business terms that owners have some ability to negotiate. Owners have more leverage on economic terms if they are developing the hotel instead of buying a stabilized asset. The terms that are considered business terms and are potentially subject to negotiation are:
- Key money (in development deals)
- Areas of protection (in development deals)
- Royalty fee “ramp ups” (in development deals)
- Special termination rights for failing to obtain financing (in development deals)
- Deleting the brand’s rights of first refusal
- Brand preapproval of the management company or the ownership structure
- Construction commencement date and opening date (in development deals)
- Brand preapproval of the guarantor
- Caps on guarantor liability
The ability to obtain concessions from the brand is largely dependent on an owners’ leverage (i.e., is the owner developing a new hotel, or agreeing to perform a major renovation? Does the owner own several other hotels within the brand family?) and knowledge of the issues. An experienced hospitality attorney or hotel consultant can help guide owners through negotiations.
Hotel management agreements
A hotel management agreement establishes the basic relationship between an owner and its agent/operator of a hotel property. Because a hotel manager oversees the hotel’s day-to-day operations including employee relations, reservations, marketing and maintenance, it’s critical to negotiate owner and manager rights and obligations in connection with a manager’s duties.
In most cases, the initial draft of a management agreement is provided by a prospective hotel manager to a hotel owner. It typically provides managers with a long-term right to operate the hotel with owners’ involvement largely limited to the annual budget approval process. However, unlike franchise agreements, when negotiating a management agreement, owners have more leverage in the deal. Savvy owners can frequently require that a manager agree to major revisions to its standard form of management agreement.
Key material terms in a management agreement:
- Term: The length of the term is often the most critical of all business issues. Initial terms are typically much shorter in third-party management agreements. Shorter terms allow owners to quickly move on to another manager if that manager is not responsive to the owner’s concerns or if the hotel is underperforming. Shorter terms mean lower legal fees as lawyers will need to spend less time negotiating performance tests, operating standards, etc. Ideally, the hotel owner will want to negotiate for as short a term as possible (2-10 years for non-branded managers and 10-20 years with branded managers).
- Fees: These include base fees (often 2%-4% of gross revenues); incentive fees (often 10%-20% of income after debt service); fee caps; and subordination of fees to the mortgage. An incentive fee structure based on gross revenue alone can create a conflict of interest between managers and owners, and can incentivize managers to maximize gross revenues, regardless of whether it increases NOI.
- Alignment of interests/operator incentives: There are many ways parties can do this including shared investment, key money, NOI or GOP guarantees, or guarantees against negative operating cash flow.
- Limitations of operator authority: Savvy owners will also want to place specific limits on managers’ ability to execute material or long-term contracts, incur liabilities, engage in collective bargaining or purchase goods from affiliates.
- Termination: (i) For cause; (ii) on sale; (iii) failure of performance standard; (iv) for convenience (buyout clause); (v) by owner for inability to get financing or open; (vi) bankruptcy.
- Damages: Does the manager have any damage rights beyond specific and limited liquidated damages? Does the manager have specific performance rights?
- Operating standard: Agency law should govern all management agreements and managers should have fiduciary duties to the owner; managers should be required to use commercially reasonable efforts to maximize NOI.
- Budgets: (i) Content; (ii) timing; (iii) owner’s approval rights over the operating budget and capital budget. Owner wants to control costs, managers want sufficient discretion to incur expenses necessary to operate the hotel i/a/w brand standards. A fair compromise allows owners to review, approve and require changes to the budget prepared by managers, without unreasonably restricting managers’ ability to operate and maintain the hotel per the brands operating standards.
- Reports/inspections: (i) Periodic reports, annual reports, flash reports; (ii) audited financial reports; (iii) right of owner to inspect and audit both financials and operations.
- Employment matters: (i) Who is the employer; (ii) union matters; (iii) WARN Act obligations upon sale/termination; (iv) owner approval of GM and executive staff; (v) manager rights to negotiate severance and union agreements. Typically, owners will want the hotel’s employees to be the manager’s employees. Owners should preserve the right to hire, or have a replacement management company hire, all hotel employees upon the expiration/termination of the HMA and the right to review and approve employee compensation (out of the hotel’s revenues).
- Licenses and permits: (i) Who is responsible to obtain and maintain them; (ii) what are the consequences of failing to maintain a permit; (iii) unique liquor license issues (if the manager holds, what obligations does it have to cooperate on sale, or upon foreclosure?).
- Lender protections/SNDA: (i) Obligations to sign one with both current and future lenders; (ii) are the fees subordinated (incentive vs. base fees); (iii) subordinate to debt service (not just the interest portion of debt service). To make the hotel more attractive to potential lenders, the management agreement should contain certain provisions protective of the lender such as allowing lender to collect its debt service before the manager collects its fees when a default has occurred under the loan, allowing the lender to terminate the management agreement upon the lender’s foreclosure on the hotel, an obligation to provide notice to the lender if the agreement is breached, and allowing the lender to cure such breach on behalf of owner after owner has failed to cure the breach during the original cure period.
- Indemnification: Owners typically agree to a broad indemnification of manager except as a manager’s (and sometimes the GM’s) gross negligence.
- Guest data: (i) Who owns it; (ii) liability for breaches; (iii) assurances that managers comply with industry best practices.
- Self-dealing/group services: Group services should include only those services that can be provided more efficiently for the entire group of hotels maintained by the management company instead of on a hotel-by-hotel basis. Such services typically include reservation, accounting, payroll and marketing and advertising services.
Daniel R. Weede is a shareholder in the Carlton Fields law firm’s Atlanta office. He has extensive experience in representing hotel brands, owners, investors, developers, lenders and managers in all aspects of hotel ownership, management and financing. He is the cofounder and past president of the Atlanta Hospitality Alliance, an approximately 300-member Atlanta-based hospitality industry networking and professional development group that meets quarterly to discuss hospitality industry trends and developments.
This is a contributed piece to Hotel Business, authored by an industry professional. The thoughts expressed are the perspective of the bylined individual.