What To Consider Before Signing a Franchise Agreement

franchise fees

Jim Butler, Chairman, Global Hospitality Group, Jeffer Mangels Butler & Mitchell LLP (JMBM) in Los Angeles, says would-be franchisees should not be too quick to sign on the dotted line. Even before they contact an experienced hospitality lawyer like him, they need to weigh the costs against the benefits of taking on what may be an expensive 20-year commitment.

Butler’s team has been working in the hotel space for nearly 30 years, managing more than 1,000 franchise agreements and 1,000 management agreements in that time. However, Butler says that when it comes to franchise negotiations, there have been some changes in recent years.

He first notes that there are many excellent reasons to go the branded hotel route. Perhaps first among them is a sense of security that comes with an identified brand, something that resonates with investors, lenders, and guests. “It’s difficult to obtain investors or financing without a brand, although it is done occasionally. For them, it’s like insurance and predictability. It provides a reservation system and adherence to regulations and the specific standards that define the brand.”

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However, Butler stresses that buyers seeking a little security of their own should make sure they fully understand what they could be getting into, to determine whether the benefits of any franchise are worth the cost.

In the franchise agreement, he explains, costs can go far beyond the franchise fee, which is typically 5 percent to 6 percent of gross rooms revenue. “To that, you need to add reservation fees, brand marketing fees, IT fees, and loyalty program charges. In fact, at up to 6 percent to 7 percent of revenue derived from program members, the cost of loyalty program participation can equal or exceed the franchise fee,” he adds.

Beyond the expense, there are also risks and obligations. It is standard for a franchise agreement to obligate the franchisee to lock into the brand for the full 10 to 20 year term without performance or other termination rights. “Without a specific contractual right of termination—or ‘window’ allowing for termination—the owner is contractually bound to remain in that system, using that brand, maintaining its standards, and paying franchise fees,” he says. And as the property ages, the cost of complying with standards increases greatly. Yet the brand’s agreement not to compete with the hotel in a given territory is limited, both in scope and for a specific number of years—typically far less than the 10 or 20 year term—may not provide the amount of protection expected. “You need to know that the ‘protection’ afforded by a non-compete stipulation extends only to specific brands or sub-brands of the franchise, so they need to understand how full the francishor’s reservation system is with all product that may compete whatever the brand or sub-brand,” he warns.

Butler also notes that all brands are not created equal, and would advise even a buyer who is pre-sold on a particular brand to at least consider the alternatives. “Depending on the brand and how badly they want you, you may get concessions you wouldn’t get otherwise—e.g., great owner approval rights, a bigger and longer non-compete, windows of time for free termination, and waiver or reduction of certain fees.”

For these reasons, he says, the first step is a thorough analysis. “Get advice from people who really know the business and can help you evaluate what different brands can bring to you for your hotel in a given location, and find out what’s happening to their reservation system. You need to figure which brand will be best, not only by looking at the power of the brand but also the saturation of the market by that brand’s reservation system and the associated costs.”

Also before you start negotiating, Butler says, “You should also get legal advice from people who have been through this to help identify terms in a franchise agreement that can make a big difference in the economics and satisfaction you’ll get with the brand.”

Butler says there are relatively few provisions in the franchise agreement that can be modified. “You need to know which terms may be up for negotiation and not waste your time, credibility, or legal budget on those, but still make sure you’ve gotten the best deal possible.”