HOUSTON — While hotel brand companies generally have the advantage when negotiating a franchise agreement, owners have more options than just signing on the dotted line.
Franchise companies are resistant to change that will affect consistency across their brands, which has led them to perpetuate the use of form franchise agreements, said Michael McGee, partner at Dentons Bingham Greenebaum, during a presentation at the Hospitality Law Conference.
“However, due partly to the competitive evolution of the market with a focus on fostering a strong, long-lasting relationship under the franchise agreement, franchisors have become more relaxed and more open to negotiating points and changes in between franchise agreements,” he said.
There are six key provisions that franchisees should negotiate in every agreement: geographic restrictions; term and renewal options; personal guarantees; third-party management companies and vendor and supplier exclusivity; and transferability.
Geographic restrictions
Most franchise agreements will reserve the right for the franchisor to grant similar licenses to others to operate a hotel, so the franchisee will typically counter with a geographic restriction clause, McGee said. The provision restricts the franchisor and its affiliates from operating competing hotels within a general geographic area or market.
The restriction needs to define what would be considered a competing hotel, such as whether a franchisee operating a Courtyard by Marriott could be down the street from another franchisee with a Fairfield Inn, he said.
“We want to make this definition of a competing hotel as broad as possible,” he said.
The next part would be defining a reasonable geographic area, McGee said. It’s usually market specific, but typically franchisees will seek a 4- to 6-mile radius around their hotel. In a more rural market, they’ll want at least 5 miles.
In turn, franchisors will seek to install a burn-off period in which the geographic restriction will expire after a certain period of time, he said.
“Maybe five years, maybe 10 years for the longer initial terms,” he said. “The geographic restriction provision should always last for the full term of the agreement.”
Term and renewal
The length of the initial term of the agreement is almost always wholly contingent on the industry experience of the franchisee, McGee said. Those with less experience may want a shorter term because there’s potentially less liability than an early termination. The franchisor may also be hesitant to grant a longer term because a less experienced franchisee will be seen as a greater risk.
In turn, those with more experience will typically want a longer term and have more renewal options, he said. They’ll also try to insert additional exit opportunities, such as an early termination window and potentially some for-cause termination rights.
In his experience, McGee said some franchisees will seek as short a term as five years with no renewal options and those who want 20 years with one 10-year renewal option.
“It’s also very common that franchisors are going to include certain requirements to exercise renewal options,” he said. “We always want to categorically remove any conditions for the exercise of renewal other than franchisees’ continued compliance with the terms of the franchise agreement.”
Franchisees will also want to avoid a requirement to execute a new franchise as part of renewing, McGee said. That’s become a more common requirement in the last five years.
“It’s added extra time and expense, but it also prevents franchisees form locking in those terms that were agreed to in the first place, and so it’s pretty much starting over,” he said. “If you can remove the requirements to execute a new franchise agreement, we suggest doing so.”
Termination
A franchisee’s attorney should closely review the termination provisions in the franchise agreement to ensure there are adequate exit opportunities for the franchisee and ensure the franchisor isn’t able to prematurely terminate the agreement, McGee said.
Pay particular attention to termination windows, periods of time after signing the franchise agreement when the franchisee can terminate the franchise agreement without any further liability or expense, he said.
“You need to be aware, though, of what we call ‘gotcha clauses,’" he said. “Gotcha clauses are provisions that franchisors will include in the franchise agreement which will prevent the franchisee from exercising their rights under this early termination."
One common clause covers whether the franchisee has ever in the course of the franchise agreement committed events of default regardless of whether they cured that event of default, he said. Another is whether the franchisee has ever received a low-quality satisfaction score from the franchisor. Both such cases would result in the franchisee losing future rights to exercise early termination.
When these windows become active depends on the franchisee’s experience, he said. A less experienced franchisee wanting to limit their potential liability in the event of an early termination will want an earlier window, so they try to place it around the fifth year of the agreement.
Franchisors will always reserve the right to terminate a franchise agreement in the event of default by the franchisee, McGee said. When listing what would call for this termination, the franchisee will always want to include materiality thresholds. They should not be in default under the agreement as long as they are in material compliance with the covenants and obligations. They also should have cure periods.
That means if a franchisee doesn’t remit payment for franchise fees on time, they shouldn’t be automatically in default, he said. The franchisor should provide notice and give 10 days to cure it.
When calculating liquidated damages from an early termination, which is typically a percentage of gross revenue over a period of time, franchisees should try to keep this window at no more than 12 months and capped at $100,000, he said. Recently brands have tried to have windows as long as 24 months. Liquidated damages should be the only basis for recovery and not allow the franchisor to see actual damages, and to have repayment amortized over a reasonable period.
Personal guarantees
Franchisors will often require principal owners or managers of a franchisee to personally guarantee the obligation of the franchisee, McGee said. The franchisee’s attorney should review this and consider adding caps to the maximum amount the guarantor can be liable for.
“We do not want to see a cap more than $100,000 for the guarantor,” he said.
The guarantor should never be required to cover punitive or consequential damage, he said. That often seems inherent, but those are typically excluded on the franchisee side.
Personal guarantees most often come up with less experienced franchisees, McGee said. He said his firm has had some success negotiating put a personal guarantee in place for the franchisee, but it needs to burn off after five years.
“Because in five years, we can prove to you we’ve run a successful hotel, we’ve run a successful franchise,” he said.
There’s also something called a “Bad Boy” guarantee, which is only enforceable against the personal guarantor if it’s due to an act of gross negligence or criminal misconduct.
Third-party management and vendor exclusivity
Almost every franchise agreement will initially require the franchisee to retain general control over the franchise, but often franchisees want to hire a third-party operator, McGee said. Franchisors, however, are usually hesitant to let the franchisee freely choose the operator.
“So, they’re either going to require the franchisee to retain the recommended general control, or they’re going to require the franchisor’s pre-approved set before they engage a third-party management company," he said.
Franchisees can ease the administrative burden by going ahead and including a list of pre-approved third-party management companies in the franchise agreement itself, he said.
In a similar way, franchise agreements often restrict the type of vendors and suppliers a franchisee can use, McGee said. It’s meant to ensure consistency across all the flags. Again, the franchisee can ease the administrative burden by asking the franchisor to include a pre-approved list of vendors and suppliers in the agreement.
“We also will demand that franchisor pass on any volume discounts to the franchisee, as well as reimburse the franchisee for any revenues or commissions they received by virtue of franchisor purchases from that vendor,” he said.
Transferability
Every franchise agreement will include some form of restriction on franchisees’ ability to transfer their rights and obligations onto other people, McGee said. Franchisors carefully screen and select their franchisees as it’s important for them to engage with a franchisee who can uphold their brand standard requirements.
“It is reasonable to assume there will be certain restrictions on transferability,” he said.
However, the agreement should have clauses that limit the franchisor from withholding their consent for a transfer in an unreasonable, capricious or arbitrary manner, he said. They should also always allow transfers to family members or affiliates of the franchisee. The language defining affiliate typically allows for an entity under common ownership or control with the existing franchisee.
The agreement should also allow for transfers to third parties that already have met the objective standards for granting a franchise, which is important when trying to transfer rights to a third-party entity already operating a franchise under the brand.
Franchisees should also seek a carve-out for spaces in their hotels, McGee said. If a hotel is going to have a gift shop or restaurant for which the franchisee grants a lease, that will be considered a transfer under the agreement, requiring pre-approved consent from the franchisor unless the agreement has a carve-out for those spaces.
Franchise agreements also consider it a transfer when there’s a change in control of the franchise, McGee said.
“This is often a very big point of contention, because we want to remove this idea of change in control from the definition of transfers and definition of assignments altogether,” he said.
At the very least, the franchisee will want to define the change of control as setting a bottom threshold at least 50%, meaning the agreement should not consider a change in control in assignment unless 50% of the equity investment in the franchisee is sold or transferred, he said. Franchisors have pushed for a 10% threshold.