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Are you being disenfranchised?
Simon Allison looks at how the individual clauses within an a franchise agreement can ultimately leave owners unable to escape their contract.
Unlike the US hotel market, where it’s a dominant form of hotel branding arrangement, the franchise agreement is still a relatively under-used form of contract in Europe. Only a handful of HOFTEL’s hotels, for example, are operated under franchises, as against a far larger number that are leased or run under management contracts.
There are, of course, a raft of advantages in signing up to a franchise. It provides a brand, distribution mechanisms and often collateral benefits (training, pre-sourced financing packages etc) while still giving the owner or management company freedom to operate the property on a day-to-day basis. But there are some drawbacks too.
Perhaps as a consequence of their rarity, many of the arguments that rage around franchise agreements in the USA are not often found in European publications. HOFTEL thought it was worth outlining some of the key issues that owners of franchised hotels may face:
Brand Standards and Amenity Creep
As issue that faces franchisees across the world (and owner of managed properties too) is that of amenity creep – the process whereby a brand, over time, sets newer and higher standards for all its properties. This can involve IT roll-outs (eg. wireless in all rooms), new soft goods (eg. a Heavenly Bed), security measures, training initiatives, hygiene levels and, of course, participation in sales and marketing initiatives. While these new projects may help to distinguish the brand and might, in the long run, enhance profit for the franchisee, some of them also involve significant short-term expenditure. If a franchisee can’t afford them, they may face the risk of being thrown out of the system and having to pay liquidated damages (of which more later). The best franchisors have members associations, such as the IAHI (the body of Intercontinental Group owners) to which they put such improvements for approval before rolling them out.
Liquidated Damages
Perhaps the most controversial aspect of franchising at the moment is the clause in nearly all such contracts which forces the hotel owner to pay liquidated damages for virtually all circumstances of termination (apart from the franchisor’s default). This can range from two years’ fees to the entire liquidated damages for the remaining life of the contract. This may not sound so imbalanced until it’s realised that there are very few grounds which would constitute a breach by the franchisor but, according to some US observers, as many as 30 that represent a franchisee breach. What adds insult to injury for many franchisees is the prospect of losing the franchise because they don’t have the money to fund upgrades decided on by the franchisor and then having to pay a hefty penalty to the brand-owner for the privilege of being expelled! Since owners will often (and sometimes rightly) put the blame for their financial straits on the brand that’s failing to deliver the promised profits (which is why they’re unable to fund the upgrade), readers can understand why this issue is the one that seems to dominate articles about franchisee-franchisor relations. From a brand-owner’s perspective, the penalty is a means of preventing owners from “brand-hopping” at will, which is fair enough too – but you’d think that a hotel which had just been ejected from the system for poor standards would hardly be a threat!
Non-compete clauses
Following on from the previous issue, some franchise contracts also insert non-compete clauses preventing a former franchisee from adopting a rival brand after the contract ends. Given the need of midmarket hotels for widespread distribution, this can spell a death knell for a property which loses a franchise.
Franchisors may also seek, at the outset of the contract, to prevent the owner from operating other hotels under competing brands which may become a serious restriction over time.
Impact issues
In complete contrast to this, most franchisors also resist strenuously any limitations on competition (i.e. radius restrictions) placed on them by franchisees. A sensible franchisee will seek to prevent the franchisor from licensing hotels of the same, or competing, brands within a certain predefined area for a reasonable length of time. Franchisors will sometimes agree to 5 years, but of course that’s not very long in the context of a 20-year contract. In other cases, they may agree to carry out an “impact study” (to assess the damage that branding a hotel in the restricted area might do to the original one) but even leading hotel consultants regard these as being “educated guesses”. As a result, owners are well advised to stand their ground on this issue. As Peggy Berg, ISHC, President of the Highland Group, writes (in Hotel Investments: Issues & Perspectives, Third Edition 2003, AH&LA, Edited by Lori E. Raleigh & Rachel J. Roginsky):
“Impact occurs when a new hotel in the chain takes business away from an existing hotel. It’s a troubling topic, because every $100,000 in lost revenue to the franchisee means a loss of only $10,000 to the franchisor (royalties and reservation and marketing fees total approximately 10 percent of room revenues). Meanwhile, the new hotel may represent $100,000 to $1 million annually in new revenues to the franchisor. The franchisor stands to earn a substantial net benefit from impacting the franchisee."
A variation of the impact issue occurs when the franchisor’s group acquires or is bought by another branded hotel group. The owner can suddenly find that other local hotels are using the same reservations system and marketing platform as it is. A sensible owner will negotiate a right to terminate (without liquidated damages) in these circumstances.
Purchasing schemes
Readers may recall that there was a rash of cases, about five years ago, between owners of US hotels and the management/branded groups concerning purchasing discounts. The issue has largely faded into the background in a booming market but it may come back into vogue during the next downturn. Essentially, the arguments were about whether the branded chains, which have massive purchasing power (and often compel franchisees to buy from their suppliers) were passing on the discounts they had negotiated to their owners. In many cases they were not and quite a few owners sued them for failing to act – as they saw it – in their fiduciary capacity. Unfortunately for the owners, most of the management and franchise contracts didn’t say anything about fiduciary duties and the big brands won back on appeal most of the ground they had lost. Indeed, many responded by writing a mark-up on group purchases into new management and franchise contracts. I suppose that’s an improvement – at least owners now know what they’re getting into and transparency is half the battle.
Performance criteria
Unlike management contracts, a lot of franchise agreements don’t have performance-based termination clauses by which the owner can end the franchise or, if they exist, they are very weak eg. occupancy below 50% for several years. This is something which a franchising company will always be loath to agree – but if they want the site badly enough, possibly they might.
Taken singly, none of these issues may look that significant. Taken together, they amount to an owner having to sign up to a long-term agreement from which they cannot easily escape, where the counterparty has few obligations to perform and few restrictions that prevent it from competing head-on with its client (which the owner, after all, is). There’s nothing wrong with franchising a hotel per se – which is why the concept is still growing rapidly – but it’s pretty clear that a well-structured agreement will put the owner in a vastly better position than signing up to whatever is sent. As with all forms of hotel real estate, being a savvy owner makes all the difference.