Owners and management companies can compromise when negotiating early termination rights.
The term length of a hotel management agreement is critically important to the hotel management company and the hotel owner. Hotel management agreements for branded upper-upscale and luxury hotels often have terms of 20, 30 or even 50-plus years. Management companies require these terms to ensure a fee stream for a guaranteed number of years to warrant their initial investment in a hotel, as well as to justify any radius restriction in the agreement that prohibits them from opening other branded hotels within an agreed distance from the hotel.
On the other hand, hotel owners generally prefer shorter terms that offer more flexibility. In the downturn, owners learned it was often more difficult to sell a hotel subject to a long-term management agreement than a hotel that offered the new owner the opportunity to determine the brand and management.
Unaffiliated hotels are attractive to a wider universe of buyers, such as owner-operators and owners with deep brand and management affiliations of their own. They also offer new owners the opportunity to seek financial incentives, such as key money from management companies in exchange for brand and management rights.
A compromise struck by owners and management companies with increasing frequency is negotiation of early termination rights for the owner’s benefit. These types of hotel management agreements typically do not permit early termination by owners, except in connection with a default or performance test failure. In exchange for accepting a long-term agreement, an owner may negotiate for a right to terminate the agreement early in additional specified—and heavily negotiated—situations.
The most common example is a termination upon sale right. This right permits the owner to terminate the management agreement before the end of its stated term in connection with a sale of the hotel, in exchange for payment of a termination fee. While this sounds straightforward, there are a number of variables to consider when negotiating a termination upon sale provision:
- Trigger date: A hotel management company typically will not give a termination upon sale right in the early years of the management agreement, because it needs to flag the hotel and earn its fees for some minimum period of time to justify its investment in the hotel. Often, the termination right may not be triggered until after the end of the seventh or even 10th year of the operating term.
- Termination fee: Next to the trigger date, the termination fee is the most heavily negotiated element. Generally, the termination fee is a multiple of trailing 12 or annualized 24 months’ management fees (base plus incentive), with the multiple reducing each year. For example, a termination fee may be 5x for a termination in year 10, 4x in years 11-13, 3x in years 14-16, 2x in years 17-20 and 1x for the rest of the term.
- Sale: What constitutes a “sale” for purposes of triggering this termination right? Management companies want to ensure only bona fide sales to third parties trigger the termination right and generally require a 100% change of ownership. Owners might try to include sales of 50% or more of the ownership interests in the hotel, so the termination right may be exercised in connection with the creation of a joint venture or the admission of a new partner.
- Key money: Management companies may contribute “key money” to owners in connection with the development of new hotels. The key money generally amortizes over the stated term of the management agreement, with the owner not required to repay the funds to the management company unless there is an early termination of the hotel management agreement. When determining whether to exercise a termination upon sale right, the owner must consider the amount of key money that must be repaid to the management company, which might be a sizable amount.
Franchise conversion right
In a variation on the termination upon sale right, an owner and management company might agree to a franchise conversion right. Some management companies, such as Starwood Hotels & Resorts Worldwide, Hilton Worldwide and Marriott International, offer franchises of some of their brands. The franchise conversion right permits an owner to convert its management agreement to a franchise agreement, generally in connection with a sale of the hotel. A franchise conversion right keeps the flag on the hotel while allowing the owner to install its own on-the-ground management team.
In addition to the issues relating generally to termination upon sale rights, the parties must negotiate a number of conditions to exercise the franchise termination right:
- Franchise agreement: The management company requires that the purchaser of the hotel accept its standard franchise agreement for the brand, while the owner wants its purchaser to have room to negotiate the standard form. The parties can compromise by agreeing that the management company will “reasonably” consider changes to the standard franchise agreement, or pre-negotiating certain key terms (such as a radius restriction) that will be included in the franchise agreement. The term of the franchise agreement will generally equal the remaining term of the management agreement.
- Key money: The management company wants any unamortized key money to be repaid upon a franchise conversion, while the owner wants the key money to continue amortizing during the term of the franchise agreement.
- Approval of purchaser and new manager: The management company wants approval rights over the purchaser, as it would have if it were entering into a new franchise agreement. The owner often presses the management company to pre-approve any new owner that satisfies the transfer provisions of the management agreement. In addition, the management company needs the right to approve the proposed new third-party operator of the hotel.
- Fees and expenses: The purchaser will be required to pay all fees and expenses relating to the conversion to a franchise agreement.
It is unlikely that the stated terms of hotel management agreements will shorten in the near future. Early termination rights, such as a termination on sale or franchise conversion, afford owners more flexibility in connection with exit options while providing management companies assurance of a certain contract term and compensation for the early termination.
Teresa K. Goebel is a partner in the San Francisco office of Goodwin Procter LLP. She focuses her practice on the representation of hotel operators and investors in a variety of matters relating to the acquisition, development, financing, management and sale of hotel, resort and fractional ownership properties around the world.
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