Franchising in the Hotel Industry

Differing in Purpose

This chapter discusses some of the decision points and issues that arise in the relationship between franchisee and franchisor. Franchising is a changing and growing industry and this chapter also looks at the emerging future of hotel franchise relationships. The best-known names in the hotel industry, Holiday Inn, Hampton Inn, Courtyard by Marriott, Sheraton, Ramada, etc., are not directly in the lodging business. They are franchising companies. Names such as JHM Enterprises, White Lodging, Starwood, Sunburst Hospitality and many others that are seldom recognized by hotel guests, are actually hotel companies. This is the nature of franchising, and it creates an opportunistic relationship between hotel companies and their franchisors.

Franchisee	Franchisor
Hotel owners are in the business of leasing hotel rooms. For the use ofa room, they charge a room rate. Their related businesses may beentertainment, dining or other services offered to guests.	Hotel franchising companies are in the business of leasing a brand nameto operating hotels. For the use of that brand name, they charge apercentage of revenues. Each franchising company also operates related businesses, such as reservation systems and purchasing services, which they provide to their franchisees for a fee.
In the hotel business, a company’s revenues and profits depend on thefrequency with which they rent rooms (occupancy) and the rate at whichthose rooms are rented (average rate).	In the franchising business, a company’s revenues and profits dependon distribution, or the number of hotels, which carry its brands.
The hotel company’s most visible assets are the real estate it ownsand operates. So, one of its missions is to build real estate value.	A franchising company’s most visible assets are the brand names itowns. So, one of its missions is to build brand recognition.
Travelers (guests) are the customers of hotel owners.	Hotel owners are the customers of hotel franchisors.

 

Although they differ in purpose, and often have conflicting goals, hotel franchisees and franchisors have a symbiotic relationship. They need each other to survive. Obviously, a franchisor has no source of revenues without the hotel owners who are its clients. Conversely, a hotel owner has a strong need for the franchisor because we live in an extremely brand-conscious society.  A small business like a hotel simply does not have the money to sustain brand awareness on its own. Participation in a franchise provides brand.

 

Franchise Desirability

Franchises differ in many ways. Some franchises offer more services than others. For instance, Holiday Inn has a large skilled and well-equipped support staff for its franchisees to use. In comparison, Red Carpet provides comparatively little in terms of training, staff and technology. Some franchises represent upscale hotels while others represent mid-market or economy product. For instance, Hilton Garden Inn has only high quality new hotels in its system while Ramada represents a wide range of product. Some franchises have a very large brand loyal customer base, generate a large proportion of their franchisees room sales, and their franchisees consistently out-perform the market. Courtyard by Marriott is currently the best example of this. Other brands are recognizable, but have lower market penetration, on average. Howard Johnson is an example of this.

People tend to select a franchise by process of elimination. First they identify the franchises that may be available for a given location, eliminating those brands that are already represented in the neighborhood. Then they narrow the field to those franchises that would consider their project. For instance, Marriott brands, Hilton Garden Inn and Comfort Suite franchises are generally only available for new construction hotels; they are unlikely to accept a conversion from another brand. Days Inn, Clarion and Four Points license new construction hotels, but also accept conversions from other brands. Then, from among the potential brands, the prospective franchisee selects a first choice. Making that selection may be a delightful process, if you have a great site in a market where the best franchisors would like to gain representation. In that situation, you can select among desirable alternatives by comparing productivity of each franchise, and the deal each franchisor will offer. On the other hand, if you are in a location where the most desirable franchises are already represented, or if you have a product that is less than desirable, selecting a franchise may mean choosing between less desirable options.  A host of factors contribute to a franchise’s desirability, but the strongest are those listed below.

Franchise Desirability
Distribution	Brands with a strategically located collection of stores generate morebusiness because they have stronger recognition among potential guests.For instance, Hampton Inns brand strength increased as its distribution became national. However, distribution does not have to be national to be effective. A well-placed regional chain can be very effective. Days Inn was extremely strong on Interstate 95, before it had national distribution, because it was well distributed on that corridor.
Consistent Product	Brands that have consistent product typically have a higher proportionof loyal customers who travel within that chain. The fundamental reasonfor selecting a product by brand is the guests’ belief that the brand removes the risk of making a bad selection. A chain of hotels that is very different from one property to the next puts each guest at risk of making a poor choice every time they select that brand. As soon as the guest lands in a poor quality property, or hears about someone staying in an unsatisfactory hotel in the chain, their loyalty is shaken. A consistent chain has more repeat business, which is the least expensive way to attract guests. To attract the same proportion of guests through their chain affiliation, an inconsistent chain would have to spend much more on marketing. As a result, inconsistent chains typically generate less business for their franchisees.
Marketing	Marketing programs offered by franchisors are paid for by franchisees.They differ in terms of the amount of money directed to marketing, thesophistication of marketing programs, quality of advertising, distribution among various media and market segments, and direct yield to the franchisee. While each brand markets to a wide range of market segments, most focus on market segments appropriate for their hotels. For instance, national convention sales efforts would not be appropriate for Econolodge any more than promotions for truckers would be appropriate for Hyatt. Marriott’s marketing for Courtyards is most targeted within the corporate segment. For full service Marriotts, the company targets groups more directly. Hilton’s marketing is known for its effectiveness with groups and executives. Days Inn was historically strong in the Senior Citizen market, but their success has drawn direct competition for these customers in recent years. The best brand for a location has marketing appropriate for the kinds of customers who will be attracted to that specific hotel. Marketing programs differ in other ways as well. Choice’s marketing has been oriented toward television, and has promoted a multi-brand system over individual brands. Cendant brands, which are also clustered within one company, are promoted individually. They focus on different media, depending on the marketing goals of the particular brand.
Reservation Systems	Reservation systems are extremely expensive to install and operate.They are also technology-intensive. Chains with senior executives who arecomfortable with technology and believe in its application tend to have better systems. Franchisors who are willing to forego short-term profits to invest in the future of their chains tend to have better systems. Holiday Inn has a reservation system called Holidex that has been upgraded and updated as technology changes, and is one of the strongest in the hotel industry. Radisson, which has travel agencies as sister companies, was one of the first to make its reservation system directly accessible to travel agents, a major breakthrough. Radisson was comfortable investing in technology, at least in part, because its executives had seen the impact in their other businesses.
Corporate Culture	The culture in each franchise company is remarkably different from itscompetitors. Prospective franchisees evaluate these cultures throughvisits to the corporate headquarters, interaction with franchise salespeople, discussions with other hotel owners and other means. Attitude becomes oddly important in the selection of a brand. People say that they become Marriott franchisees because of the company’s culture. They feel that Marriott is committed to the success of its franchisees. Yet, the actual terms of a Marriott franchise agreement mean that the culture could be changed at any time. US Franchise Systems markets its intent to treat franchisees fairly, and uses this attitude to offset its relative newness and still small distribution. However, corporate culture is a transient thing. It changes when brands are sold, top executives replaced, private companies are taken public (or vice versa), and when the market changes. Culture in Howard Johnson changed significantly several times as the brand changed owners. Holiday Inn changed when the company moved from Memphis to Atlanta, and so on. The culture of a franchisor is important to its franchisees. It determines how pleasant, or unpleasant, conducting business will be. Starting a franchise relationship in a culture you like is important. However, that culture is highly likely to change before the end of the franchise agreement. Only the actual franchise agreement (contract) commits the franchisor and franchisee to a standard of behavior.
Image	A franchise that is desirable on one hotel, may not be effective onanother. For example, an owner-operator built a small high-quality limitedservice hotel in north Atlanta. He selected a franchise that had excellent distribution and a well-known brand name. However, the brand was targeted toward economy travelers, and the hotel was designed for mid-market guests. Corporate customers were deterred by the brand while economy travelers were deterred by the room rates at the hotel. Among other decision criteria, it is important to select a brand that attracts the appropriate customers for the specific hotel. Hoteliers will sometimes settle for an inappropriate brand, if better-suited brands are not available. The developer assumes that the desired clientele will use the hotel anyway, following a little extra marketing effort. It rarely works, because this society is very aware of image. Guests do not just select on the basis of product, they select the brand that suits their image. The hotel industry has trained its customers well and it is extremely risky to move into a marketplace with the wrong brand for the hotel and location.

 

Brands with strong marketing, strong reservation systems, strong image, good distribution and consistent product are the brands that deliver above market performance. They are today’s most desirable brands.

Pricing a Brand

Like any other business relationship, participation with a franchise comes at a price. The price of a franchise is not intended to be “fair” to the franchisee, any more than the profits on a hotel are intended to be “fair” to guests. Franchise price is as high as the franchisor can command, without losing too many franchisees. Similarly, room rates are as high as a hotel owner can command, without losing too many guests. The price of a franchise has a number of components. It isn’t a simple dollar amount, because it is a price paid over a long period of time. In addition, it encompasses a menu of services and benefits.

The basic fees associated with a franchise are:

Royalties– A royalty is the fee charged for the use of a brand name. In the hotel industry, royalties are typically in the range of 3 to 5 percent of room revenues. They vary depending on the value of the brand and some peculiarities of the market. In general, a strong brand commands a higher royalty and commands that royalty in full over the life of the agreement. A weak brand may have a lower royalty, and may negotiate discounts during some part of the term of the agreement. Pricing of royalties reflects more than the simple desirability of a brand. Franchisors consider the speed at which they wish to sell franchises, the cost of the services they provide, the amount of competition from other franchisors for hotels at their product level, and other factors. Since royalties are calculated as a percentage of room sales, the royalty earned per room rented is much higher on a hotel like a Hyatt, with rates well over $150, than on a hotel like a Red Roof Inn, which may have rates under $50.

Costs of Entry– Franchisees pay application and initiation fees at the time they join the franchise system. In addition, among other items, costs of entry include:

• signage
• logo’d items
• architectural details required by the brand (like Holiday InnExpress’s clock tower)
• brand specific computer systems
• charges for operating manuals
• charges for training (both sending management to training and paying for franchisor trainers and openers to come to the hotel)

Reservation System Charges– Franchisees pay for the operation of the chain reservation system. Typically, the reservation system is charged back to the franchisee community “at cost”, meaning that the franchisor does not book a profit on the system. Reservation system charges generally include a percentage of room sales. There may also be charges per reservation, charges for reservation equipment, and various fees for usage. Travel agent commissions and Global Distribution System charges are also billed through the reservation system. The charges for delivering guests to hotels add up when they include franchise fee (5 percent), reservation and marketing fee (3.5 percent), Global Distribution System charge ($3 to $4 per reservation), travel agent commission (10 percent), etc. For a hotel with a $50 rate, these charges may total over 35 percent of revenue. For a hotel with a $200 average rate they may exceed $40 for a room night. Most hotel reservation systems allocate the costs of the reservation service as a percent of room revenues. This method encourages franchisees to use the reservation system as much as possible because their costs do not increase for heavier usage. The benefit to the franchise company is that the franchise system controls a larger proportion of the total volume of sales at its hotels. Guests also receive the most seamless service because franchisees are likely to make more of their rates and group programs available through the reservation system. The alternative system allocates a larger share of the cost of the reservation system to the hotels that use it most heavily by charging a fee per reservation booked, in addition to a base fee. Under this system, some hotels keep special programs, like group bookings, off the national reservation system and require group guests to book directly with the hotel. In general, taking full advantage of the reservation system is beneficial to hotels.

Marketing Assessments– Franchisees pay for the national marketing programs of their brand. These programs are officially not-for-profit to the franchisor. There is a suspicion in the franchisee community that franchisors use marketing and reservation system money to offset other costs of company operations. For this reason, many franchise systems have a committee of franchisees with some authority to review the expenditures of the marketing and reservation funds. There is generally a base marketing assessment that is a percentage of sales. In addition, there are charges for:

• special programs
• listings with some travel consortia
• rooms rented to guests through select promotions (for instance Holiday Inn hotels pay a fee for each room rented to a Priority Club guest)
• participation in regional marketing programs (marketing collectives of hotels within a chain are now prevalent, for instance, Days Inns in Florida have a franchise-sponsored collective that identifies specific marketing programs and funds those programs in addition to their national franchise marketing assessment)

Various Charges– Incidental other charges are a common part of  the franchise relationship. Some costs associated with a franchise would be incurred by an independent hotel as well, and may be less expensive for a franchisee. Management education is a good example. Without programs provided by a franchisor, it is difficult for a hotel operator to find training programs that are cost effective and specifically designed for a given type of property. Various charges include:

• fees for attending national conventions, regional meetings and required training sessions
• mandatory fees for franchisee councils
• computer support arranged through the franchise company for franchise-specific software and hardware
• miscellaneous fines for non-compliance
• required upgrades of computer systems and other technology (like adding a satellite dish to communicate with the chain, or purchasing a specific computer for staff training)
• required chain standard items (adding irons and ironing boards to all guest rooms, for instance, or adding continental breakfast to allhotels, or creating “senior citizen” rooms to support a national marketing effort)
• signage changes (Holiday Inn changed its “Great Sign” to its current signage standard some years ago, Best Western, Howard Johnson, Hilton and Choice brands, among others, have also changed their signage)
• complying with changing facilities standards
• purchasing insurance to protect the franchisor against a possible loss of revenue in case of a problem with the hotel

Sticking Points

Most of the time, most franchisees and franchisors get along. Most of the time, both parties make money and both parties are reasonably happy. But, not always. These are the common sticking points.

Impact (Called Encroachment in Other Industries)

Impact is probably the most contentious issue between franchisees and franchisors, in all industries. 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, reservation and marketing fees total approximately 10 percent of room revenues). Meanwhile the new hotel may represent a $100,000 to a million dollars annually in new revenues to the franchisor. The franchisor stands to earn a substantial net benefit from impacting the franchisee.

Franchisee	Franchisor
The franchisee’s approach to impact is relatively simple, the Systemshould grow, but NOT IN MY BACKYARD.	The value of the brand is based on its distribution. If the brand doesn’thave enough representation in a city, than none of the brand’s hotelswill perform. Further, if the system doesn’t have enough hotels, it will not have the funds for effective marketing.
Every dollar lost to impact represents lower profits, and lower assetvalue.	Franchisees have ulterior motives for claiming impact. They may want toprotect a hotel that is vulnerable due to a lack of renovation. They mayown a hotel of another brand near the new location, and want to protect that hotel from competition, etc.
Impact, to a franchisee, is cumulative. For example, the sister hotel15 miles west may only have taken one occupancy point, and the sisterhotel 20 miles south may only have taken one occupancy point, and the sister hotel 10 miles southeast may only have taken two, but add one more and the total loss may be over 6 percent of revenues and may change a profit to a loss.	The brand has to be represented in these sub-markets if it is to besuccessful. If we don’t develop the location, and make our roomsavailable to our customers, someone else will get those customers.
If my franchisor denies this application, because of impact, this newcompetitor may never be built.	If we don’t license this hotel, someone else will and they may takeeven more of your business.
As long as I am constantly threatened with impact, I cannot trust myfranchisor to treat me fairly in business. I am concerned aboutretribution if I object. I am concerned about new competition from my franchisor because my marketing information is stored in the franchisor’s computer.	We intend to be fair to our franchisees in the matter of impact, theyjust have to trust us…

 

Impact is particularly threatening when the franchisor is also the owner and operator of the new hotel. In these situations, the franchisee generally is concerned that his hotel will take second place in the reservation system, and in marketing programs. Concern about conflicts of interest in terms of data use and concern about retribution also become more prevalent in these circumstances. In general, there is no protection from impact for the franchisee within the franchise agreement. To the contrary, most franchise agreements specifically reserve the right for franchisors to add units at any location. Instead, some hotel franchisors provide “Impact Policies” specifying the level of protection they offer. Unlike franchise agreements, impact policies can be changed at any time. Impact policies offer one of two forms of protection.

Area of Protection – is a protected territory around the franchisee hotel in which the franchisor agrees not to license new properties. The trouble with areas of protection is that markets change. Over the course of a 20 year franchise agreement, the bounds of a reasonable territory might grow or shrink by ten miles in any direction. Recognizing this problem, franchisors confine areas of protection to small sub-markets. The adjoining sub-market then becomes fair game for a competing hotel in the same franchise, and that new hotel may be on the border of the existing area of protection.

Impact Study – is an estimate of the revenues the existing franchisee will lose if the additional hotel is licensed. Franchisors with impact study policies generally have a hurdle such as 3 percent of occupancy or 5 percent of room sales. If the estimate is higher than the hurdle, the new franchise is denied. The measure of impact is generally defined as the amount of franchise-generated business that would be lost and could not be replaced, if a hotel of the same brand is opened, rather than a hotel of a comparable brand. Three percent seems like a hurdle that would be readily exceeded, but the definition is so narrow that the hurdle is hard to reach. Particularly since the studies do not always measure the difference in impact if no new hotel is developed, which would be likely to be much higher. Further, under these policies, the franchisee may have to defend a hotel by purchasing an impact study every six months, if the franchisor is aggressive about adding distribution in a market.

So far, a satisfactory formula for compensating a franchisee for revenues lost due to impact has not been established. Franchisors and franchisees continue to propose new compromises.

Termination

Franchise agreements are contracts with a specified term, generally twenty years in the hotel industry. A franchisee who chooses to leave the system is, by contract, commonly liable for the present value of estimated future franchisee fees through the end of the contract term, unless otherwise specified. For a full service hotel, liquidated damages can run into the millions of dollars (for instance liquidated damages could be the present value of 8.5 percent of gross room revenues for ten or more years). They can exceed the market value of the hotel itself. A twenty year agreement with extensions is fine, when the franchisee keeps up the standards of the hotel and the franchisor continues to perform. However, not all relationships are so smooth. A few of the issues that arise concerning termination are listed below.

Franchisee

Franchisor

If the buyer of my hotel wants to change the brand, but I have to sellencumbered by the franchise, the franchise reduces the value of my hotelMy franchise is reducing my revenues because it holds my rate down; I need to terminate because I need a different brand Reinvestment required by the brand is too high for me to earn a return in this location, I need to leave the system My franchise is no longer appropriate for my business, I need to terminate The franchisor can replace the franchise fees from this hotel with a new hotel in less than a year; no damage is suffered if this hotel leaves the system, liquidated damages should be minimal

The heaviest cost to the franchisor, and the biggest benefit to thefranchisee, is early in the term when the hotel uses the franchise toestablish a customer base and set up operations, termination should not be possible once the franchisee has been availed of this benefit 20 year franchise agreements provide a stable investment platform, and are preferred by lenders Liquidated damages for most hotels aren’t that much money. If the franchisee can get a higher rate with another franchise, they should pay the liquidated damages out of their increased revenues, and leave the system The franchisor incurs a long term loss if a planned stream of franchise fees from a hotel is taken away

 

The current movement is toward a more conciliatory approach to franchise termination among many hotel franchisors. The three common approaches are:

• to specify an amount of liquidated damages, in the franchisee agreement, that appears less onerous for the franchisee
• to permit a franchisee to exit if the hotel’s performance is below a hurdle level
• to offer periodic “windows” or points at which both the franchisee and the franchisor have the option to terminate the agreement

Traditional agreements only allow the franchisor to terminate the agreement in the event of a default by the franchisee. This is to remove the temptation to kick a franchisee out as soon as a larger and potentially more lucrative hotel becomes available to the franchisor. If a franchisor wants to get rid of a franchisee and can’t persuade them to leave, they look for a default, exit window, or renewal window.

Preferred Vendors

Franchise companies used to have purchasing departments which franchisees were required to use. The purchasing departments were largely disbanded, under pressure from franchisees. In their place, hotel companies set specifications that franchisees are required to meet when they purchase goods and services directly from vendors. Franchisors also provide a list of preferred vendors which offer special pricing to their franchisees. Most vendors in these programs provide a negotiated price, which may or may not be better than the price the franchisee can get outside the program. However, the negotiated price sets a benchmark, which is beneficial. In the case of logo’s items, the franchisee is more likely to be required to purchase from an approved vendor. In these instances, franchisees are more likely to be concerned that the prices are inflated by licensing charges.

In some cases, those preferred vendors pay a fee for preferred status, and may contribute to the cost of producing promotional materials which the franchisor distributes to franchisees. In addition, some franchisors command a rebate from the vendor for all sales to their franchisees. In other industries, preferred vendor programs are extremely restrictive. Franchisee discontent in these industries is garnering a response in the hotel industry, particularly since Preferred Vendor programs are getting more restrictive in the hotel industry. In addition, the amount of profit reported by the public hotel companies from these programs is considerable and is getting the attention of franchisees.

Franchisee	Franchisor
I can get better prices from my vendors than from the franchisepreferred vendor programs and I want to be able to select my goods andvendors	Consistent quality in the system suffers when franchisees shop for thelowest price; they simply don’t get the same quality. We requirefranchisees to use the preferred vendor program because it is the only way to control quality in the system
If my franchisor is getting a rebate on sales to me, I should at leastget a share of the rebate returned to me	The franchisee gets low prices through our program, even with therebate, we do not owe franchisees any share of our preferred vendor fees

 

Venue

In the case of a dispute, litigation between a franchisor and franchisee is almost always in the home state of the franchisor. This has been a deterrent to franchisees considering litigation.

Franchisee	Franchisor
Litigation should be in the jurisdiction where the hotel is located,otherwise the franchisee can’t afford to bring an issue forward	Litigation should be in the jurisdiction convenient for the franchisor– it’s just a matter of whose attorneys have to travel

 

Transfer, Sale and Renewal

When ownership of a hotel is transferred, when a hotel is sold, or when a license is renewed, the franchisor has the opportunity to reconsider whether to continue with the franchisee and hotel. Accordingly, at each of these junctures, many franchisors inspect the hotel and provide a “product improvement plan” that must be completed for the hotel to remain in the system. The franchisor also has the opportunity to evaluate the franchisee. The franchisor may accept the buyer of a hotel, or refuse to let that buyer into the franchise system. There is generally a fee associated with this process, and that fee can be significant.

Franchisee	Franchisor
Transfer fees should be minimal, they make re- structuring or changingownership within a family unreasonably expensive	Transfer fees are a cost of doing business
The brand is part of the value of my hotel asset. I should be able tosell that franchise agreement along with the hotel, as long as there isremaining term	The brand is our asset. We do not have to license it to anyone we haven’taccepted as a franchisee, or to allow anyone we wouldn’t want in ourfranchise “family”; while we reserve the right to decline a prospective franchisee, it is uncommon
I should not have to do a major renovation to renew my franchise orsell my hotel, the product has been adequate for this brand up until now	Renewal is our one chance in the term of the agreement to get rid of abad franchisee or a bad hotel, if we do not require all renewals to comeup to the standard of our newest hotels, then the entire quality of the system will decline

 

Sale of a Franchisor

When a franchise company is sold, the hotel franchise agreements are part and parcel of the sale. The franchisee does not have the right to approve or disapprove the buyer of the franchise company. Nor can the franchisee set minimum standards for the new franchisor, beyond those specified in the franchise agreement. This is a significant issue because buyers of hotel franchise companies have been known to change those companies radically, often having a major impact on their franchisees.

Franchisee	Franchisor
The franchisor has the right to accept or decline a buyer of mybusiness, I should have similar rights with regard to the buyer of thefranchise company If they don’t perform after a period of time, I should be able to leave the system. After all, the buyer of the franchise company has a much larger impact on my business than the buyer of my hotel has on the franchise company	The value of the franchise company depends on the present value of thefuture income stream from its franchisees. If the franchisees can leave onsale, the franchise company has much less value As current owner of the franchise company, we can make changes as radical as any buyer, and the franchisee has no recourse. They should have no recourse if a buyer makes those changes

 

Information

We are entering the era of the database and the information in databases is increasingly being sold to third party users. Hotels collect information including the names, employers, telephone numbers, drivers license numbers (in some states), payment habits, credit card numbers, auto tag numbers, frequent flyer numbers, and addresses of their customers (among other information about those customers such as smoking preferences, length of trip and other patterns of travel). More and more of that information is being stored in computers owned by franchise companies. Data about the hotel itself is also increasingly stored in the franchise company’s computer including occupancy, rate structure, group customers, contract accounts and their lead contacts, revenue, and considerable information about the franchisee. What happens when the data is sold?

• Should the franchisor be allowed to sell customer data?
• Should the franchisee be allowed to sell guest data?
• Should the data be available for sale to competitors of that hotel within the same brand in the local market? (ie. should a list of loyalcustomers from one hotel be sold to a new hotel of the same brand openinga mile away?)
• Should a list of brand loyal guests be sold to another hotel in another market? (Say a hotel in a resort area like Myrtle Beach wants to market to chain loyal guests who have residential zip codes in Greenville and Charlotte.)
• Should the data be available for sale to hotels of other brands owned by the same company?
• Should personal information provided by guests be sold by the hotel company to other companies, like credit card companies, for instance?
• Should a franchisor be allowed to sell information about group and contract accounts at a franchisee hotel?
• Should the personal information provided by the franchisee to the franchisor as part of the application process be confidential?
• If the information is sold, who should get the money?

Personal Liability

Franchise agreements are generally between one corporation (the franchisor) and another corporation or partnership (the franchisee). However, most franchise agreements require a personal guarantee from the franchisee.

Franchisee	Franchisor
This is a corporation. Its franchisor should not have recourse to mepersonally if the corporation and its franchisor have a dispute aboutfees. The owners of the franchise company don’t provide personal guarantees, they provide corporate guarantees. The personal guarantee puts me unreasonably at risk in the event of a problem	Many franchisees are very small companies, and they have littlecollateral beyond a personal guarantee. They personally guarantee theirreal estate loans, they can personally guarantee their franchise fees

 

Brand Exclusivity

In other industries, it is common for franchise agreements to restrict franchisees from owning stores of competing brands. This is not commonly enforced in the hotel industry, but remains a feature of some franchise agreements.

Franchisee

Franchisor

I own a hotel in my community and the market is ready for anotherhotel. My total revenues will be higher if I have two hotels withdifferent brands and price points than if I expand my existing hotel. Good business dictates building a hotel of another brand

Our hotel operations are unique and better than other companies. We donot allow franchisees to operate hotels of other brands because they woulduse our procedures to benefit another company Our brand is very strong and relatively expensive. We do not allow franchisees to operate hotels of other brands because they would fill the other hotel with our customers just to pay lower franchise fees Our goal is to build a system of multi-unit franchisees who are totally committed to our product. If our franchisees want to build additional hotels, we want them to build only our brands

 

CapEx and Standards in a Changing Marketplace

Some of the most difficult situations in a franchisee-franchisor relationship arise over the issue of CapEx, or capital expenditures. Franchise companies that have not required sufficient capital investment for their franchised hotels to offer a competitive product have lost brand value – and their hotels have lost customers and market share. Yet, it can be very difficult for franchisees to justify re-investment in some hotel businesses. None-the-less, the brands that will remain strong are those that require their franchisees to re-invest. However, a franchisor makes money from a hotel even when that hotel loses money. Except for franchisee complaints, nothing restricts a franchisor from requiring the franchisee to invest money in renovations. If the renovation requirements are frivolous, or are designed to upgrade the entire system, the franchisee may not see a return for many years, if ever.

Working Relationships

Whatever the legal aspects of a franchisee-franchisor relationship, franchising is proliferating. Franchising works in today’s market. It provides a means for an individual to own and operate a business in a complicated world. It makes it possible for lenders to mitigate their risk when they lend to inexperienced operators. It provides national brand marketing for businesses owned by individuals. Franchising is growing because it is a very good idea. Good working relationships between franchisee and franchisor make the best franchise systems effective. Those relationships are based on the concept that an improvement in the franchisee’s business is good for the franchisor, and the matching concept that an improvement in the franchisor’s brand is good for the franchisee. The actual interaction in these relationships takes place in several ways.

Franchise Services

Franchisors have a staff of professionals dedicated to the betterment and operation of the hotels within a brand. Those franchise service professionals:

• Inspect hotels, develop product improvement plans, and generally make sure that the quality of the product in the system is up to standard
• Provide marketing support through direct corporate and group sales, telemarketing, representation at trade shows, design services, marketing planning, representation to travel consortia, providing listings in directories and networks, developing packages and special promotions, advertising, etc.
• Operate the reservation systems
• Advise operators on their marketing and operations
• Develop training programs for hotel staff (both in conferences and training materials to be used at hotels)
• Bring additional hotels into the system (identify locations that would be desirable for brand distribution and sell franchises)

Hotel franchisors have shown a real interest in maintaining a positive relationship with their franchise communities. In general, the franchisor staff that deals with franchisees is accommodating and works to provide services to their franchisees.

Franchisee Advisory Boards

Most chains have advisory organizations comprised of franchisees. The structure of the franchisee organizations, and their mandate, is significantly different from one system to another. Choice and Cendant are examples; each system has its own version of an advisory group.

In Choice Hotels, the organization is called the “IOC” and is purely advisory; the Choice Board of Directors has veto power over the IOC. The IOC has regional boards as well as a national committee, which encompasses sub committees for education, technology, awards, audit and other functions. All of Choice’s brands are represented through committees in the IOC. There are corporate (franchisor) representatives on the IOC voting committee.

Cendant has a separate franchisee group for each of its brands. For instance, “Rina” is Ramada’s organization. It includes representatives of the franchisor, and is restricted against actions that would be detrimental to the franchisor (for instance, it cannot reduce franchise fees). However, it is available as a means of communication and discussion between franchisee and franchisor.

For franchisees, active participation in the franchise advisory committee of a chain is an effective way for franchisees to keep up to date with the system. It is also important as a way of protecting franchisee interests within each system.

For franchisors, the advisory committee is a means of communicating with the franchisee community, and a way to gather information about the concerns of their franchisees. Since franchisees tend to be small businesses and vulnerable in comparison to their franchisors, many will not express their concerns or business needs to the franchise company. The advisory committee becomes a conduit for this information. Advisory committees can also provide valuable input for marketing direction and product planning. The franchisor’s corporate staff benefits from feedback about practical ways to implement or modify their strategies.

Benefiting from the Franchise

Although they spend a remarkable amount of money on their franchise, many franchisees do not use the services of their franchisor effectively. It’s relatively easy to buy a franchise. Learning the ins and outs of the franchise organization, identifying the programs that will be most beneficial to a specific hotel, and identifying the person within the franchise company who can provide a service, takes effort. The franchisees that benefit most from a system maintain good contacts within the franchisor organization and are knowledgeable about each of the various programs offered.

Understanding the reservation system is probably the most complicated task. Each hotel company has a unique system. Even companies that use a similar software platform develop their own approach to reservation generation. It is worth sitting in a room at the reservation center, watching a reservation screen, and listening to the reservationists work. Key items to understand are:

Approach to pricing– some chains sell by discounting and others sell on standardized value (eg. consistent pricing). For instance, if you have a Comfort Inn, your pricing should be high enough to permit discounting to a high proportion of guests. If you have a Hampton Inn, you can expect relatively little discounting, and price accordingly. Chains change their approach to pricing periodically in order to optimize rate. When a reservation system changes its approach to pricing, it becomes harder to guests to find the lowest available rate, at least temporarily. Hilton has been particularly successful at managing the pricing structure used by the reservation system. Days Inn moved from top-down selling (quoting high rates first, and then bargaining down with the customer) to best available rate selling (the customer could count on getting the lowest possible rate on the first try). Later, they moved back to quoting higher rates first. When the chain’s approach to pricing changes, the hotels in the system also have to change, so management has to be aware of pricing strategy and be prepared to react.

Guest loyalty programs– many chains now have specific guest loyalty programs. If your hotel participates in a guest program, it is important to understand the way it functions so you can position your hotel effectively. The most effective guest loyalty programs have been Holiday Inn’s Priority Club and Marriott’s Honored Guest. A hotel can derive less than 10 percent or more than 50 percent of its business through loyalty programs, depending on the brand, and the skill of the operator at managing the program.

Reservationist screens– the reservationist’s computer monitor is the franchisee’s primary means of explaining a hotel to this sales person. Accordingly, it is important to understand the reservation screens and make sure that the appropriate information is displayed for your hotel. In some systems this can only be changed with difficulty. In others, it can be modified from the hotel’s computer.

Specials– chains offer special promotions such as summer sales. Some may benefit your hotel, others may not. For instance, if the summer promotion is based on a deep discount and your hotel will be full anyway, you may not chose to participate. On the other hand, if your hotel could use the business, you need to understand the special well enough to present your hotel effectively.

One way versus two-way communication– in some reservation systems, the hotel operator designates a certain number of rooms of each type as “available” and reservationists sell from that inventory. Reservation communication is one way, eg. the reservation system sends reservations to the hotel. In this type of system, inventory has to be monitored. In markets like Orlando, where there may be several hotels in a chain competing for the same guest, good managers are on the reservation computer constantly, adjusting inventory and pricing to control the flow of bookings. In chains with two-way communication, the reservation system is on-line with the front desk computer and is constantly updated as to the availability of rooms of each type. In this type of system, a manager who wants to keep rooms available for regular customers and walk-in guests has to monitor activity and hold rooms as needed. Increasingly, two-way reservation systems are tied to property management systems and hotel history data files. At Holiday Inn, for instance, the system advises management about inventory and pricing based on fill patterns from prior years and future bookings. That system is also designed to optimize by length of stay and fill patterns across the week. (For instance, if a hotel fills on Saturday nights, but not Friday, the System will show a preference for Saturday bookings that include a Friday or Sunday).

Franchisors can market hotels more effectively when they have detailed up-to-the-minute information. In any given system, the hotel may be asked to submit information over the computer, via the internet, over the fax, and by mail. Deciphering the forms, and meeting deadlines for the information, is an unending task. However, if it isn’t done, the franchise system won’t work effectively for the hotel.

As a franchisee, the best surprise is truly no surprise. If you are ever surprised by the existence of a specific marketing program, it will probably be too late to participate. If you are ever surprised by a chain requirement to add amenities or make physical plant changes, it will cause havoc with your capital budget for the year. The way to avoid surprises is to maintain communication with the franchisor, to attend franchise meetings, and to talk to other franchisees in the system. If you handle a franchisor well, you should avoid most surprises.

Troubled Relationships

If all franchisee-franchisor relationships were smooth all the time, the participants wouldn’t be human and their hotels wouldn’t be in a dynamic economy. Within every system there are franchisees who are having a difficult time with their franchisor. Throughout the course of a 20 year agreement, most of these working relationships will endure some easy and some difficult times. Issues like termination, liquidated damages, and litigation can be brought on by a host of factors. Some of these include:

There are franchisees who have a policy of operating hotels at the minimum allowable quality standard. Those hotels, particularly as they age, become a problem for the franchisor.

When a franchisee isn’t making money, either because of local market conditions, the economy, financing terms, or the productivity of the brand, it is difficult to pay the franchisor. This is particularly true when the franchisor is collecting significant fees while the franchisee is funding operating losses.

Some hotel locations become obsolete (or were inappropriate for development in the first place). Since the franchise sales process tends to encourage development, franchisees tend to blame their franchisor for poor performance.

Over the life of a franchise agreement, a hotel may change owners or it may be operated by several generations of hoteliers. It may also be operated by one individual who has a stronger interest in the operation at some times than others. In any case, the operation is likely to change from time to time. Although a fundamental part of franchising, that is a difficult situation for a franchisor, who’s goal is to provide a consistent product.

Franchisors, some more than others, pursue new locations. Once a brand has broad distribution, many new locations will have some impact on existing licensees.

Over the life of a hotel company, corporate direction may change. The brand may be positioned in the mid market, re-positioned in the economy market, and then re-positioned again. The corporation may chose to focus its energies on other brands. The brand may be sold to a company with different goals and objectives. Each shift is difficult for the franchisee, who may end up owning a hotel for which there is little marketing support, or which is not consistent with the other product in the brand.

With more franchisor control in the relationship, a strong franchisor can control the first four issues better. With more franchisee-friendly relationships, the franchisee can mitigate the risk of the last two issues better.

Regulation

In a franchisor-franchisee relationship, a large company (the franchisor) negotiates with a small company (the franchisee) in most instances. As could be expected in a situation where a comparatively powerful and sophisticated organization negotiates with a smaller entity, the agreement is tipped in favor of the larger company. One-sided agreements have been a problem with franchising, and have earned franchising a poor reputation in some industries. Franchising appears in a wide variety of industries, from Coca Cola bottling to interior decorating to ice cream.

Franchise relationships, from fast food to retail to lodging, tend to be fairer in industries where franchisees are large enough and wealthy enough to negotiate effectively. They also tend to be fairer in industries where there is competition among franchisors who use favorable terms in a franchise agreement as a competitive sales tool. The hotel industry has both these characteristics. The price of entry into the hotel industry is high because of the cost of the real estate, so hotel companies often have both capital and ownership by sophisticated entrepreneurs. In addition, unlike many other industries, hotel owners are likely to own properties in several different franchise systems. Further, hotel franchising has been competitive for many years, and effective franchise sales organizations have used franchisee-friendly terms in their agreements to sell franchises. That does not mean that hotel franchise agreements equally balance the interests of the franchisee and franchisor. However, some (not all) hotel franchisors are among the better companies in the franchising industry.

Franchise agreements in other industries can be more onerous in a number of ways. For example, one is called “Post Term Non Competition”. Under this clause in a franchise agreement, a franchisee is prohibited from operating a competing business under another brand, if the franchise location is terminated or not renewed. In contrast, in the hotel industry, a franchisee may change to a new brand immediately on termination.

Legislation

Over time, legislation has made franchising somewhat fairer. The movement is slow, and has been affected by the effective political organization of franchisors. Legislative activity is likely to increase in times of recession, when franchisees suffer economically and take their concerns to their political representatives. In good times, when people are making money, there is less legislative activity. There was more legislation proposed in the recession of the early 1990’s and proposed legislation diminished in the last several years when business has been good in so many industries. Activity is likely to increase again in the next several years and a significant franchisee-oriented bill was introduced at the end of the 1998 session of the US Congress (HR 4841, the Small Business Franchise Act of 1998). It may be heard in the 106^th Congress.

Oddly, not all legislation proposed to control franchisors is beneficial to hotel franchisees. Most franchises are sold in industries which have a localized market. A Subway restaurant, or a Mailboxes, etc. store, draw their customers from the immediate vicinity. Hotels draw customers from other cities, states, and countries. Hotel franchisors will defend against virtually all regulation of franchising. For franchisees, it is important to stay knowledgeable about legislation proposed on the local and national level. Some can be damaging and some will warrant enthusiastic support.

UFOC (Uniform Franchise Offering Circular)

There is government regulation of franchising in all industries, including the hotel industry. However, that regulation is limited. The government does not dictate minimum terms that would make a franchise agreement fair to both franchisee and franchisor. Rather, it requires disclosure of all the conditions of a franchise agreement. You cannot expect a franchise agreement to be fair or equitable. However, you can expect it to specify the conditions of the franchise. If you read one carefully, or if you pay your lawyer to explain the terms in gory detail, you may never become a franchisee. Recognizing this problem, and still wishing to own a hotel, many franchisees simply close their eyes and sign. They shouldn’t.

The government, through the Federal Trade Commission (FTC) provides ground rules for the promotion and sale of a franchise. Prominent among these is the requirement that a franchise company disclose the conditions of its arrangement with its franchisees. The disclosure is manifested in a document called the Uniform Franchise Offering Circular or UFOC. Every franchisor has to have a UFOC (reviewed on the state level in some states, but not on the federal level) prior to beginning franchise sales and that UFOC is part of the information provided to every franchisee. The UFOC is a legal document prepared to meet the disclosure requirements mandated by the Federal government. That means it is thick and somewhat complex to read. The UFOC is written to protect franchisees, so they appreciate what they are getting into. It can be difficult to evaluate the downside risk of provisions of the franchise agreement.

UFOCs and franchise agreements are written by franchisor’s lawyers and, not surprisingly, they are one-sided. They are also negotiable to a limited degree. Franchisors have to be reasonably consistent in their dealings with franchisees, for both legal and market-driven reasons. Companies that are large franchisees and powerful within the franchisor’s system tend to have the best negotiating situation. Franchisors are in business; they do not negotiate if they don’t have to. There is little negotiating room in markets where a franchisor has more than one company competing for the brand, for instance.

Several documents in addition to UFOC’s and franchise agreements govern the operation of a franchised hotel. Since the franchise agreement is in place for 20 years, standards that change with the marketplace need to be presented outside the agreement. These include the following documents, among others.

• Impact Policy
• Operating Policies and Procedures
• Product Specifications
• Reservation System Manuals and Procedures

Although they are not incorporated within the UFOC, except by reference, they have a major effect on the operation and cost of a hotel. To the extent possible, they should be reviewed by a prospective franchisee prior to entering into a franchise contract.

Lobbies

Recognizing the imbalance in franchise agreements, politicians have advanced a variety of legislation that relates to franchising, including the legislation that requires UFOC’s. Franchisors have a lobbying association called the IFA (International Franchise Association) that traditionally represents them on these issues. The IFA now accepts franchisees as members, but still has a franchisor orientation. Franchisees have representation by an association called the AAFD (American Association of Franchisees and Dealers), among others. The AAFD advocates a platform of Fair Franchising across all industries and provides a definition of fair franchising. An organization called the AFA (American Franchise Association) is also vocal on the franchisee side. Since franchisors are a wealthier group with more clearly defined common interests, the IFA tends to be better funded as a lobby.

In the hotel industry, the AHMA (American Hotel and Motel Association) has traditionally stood for franchisees, since its members are exclusively individual hotels. However, the AHMA has decided to accept donations from franchisor employees to AHMPAC, its Political Action fund. It may be more difficult for the AHMA to lobby for franchisee-friendly legislation under these conditions. AAHOA (Asian American Hotel Owners Association) has been a strong voice for fair franchising. AAHOA advocates a 12 point platform and has had some success negotiating from this basis.

AAHOA’s 12 Points
1	Performance	A hotel brand should perform at a minimum percentage of occupancy orthe franchisee can exit the agreement without liquidated damages
2	Impact	A fair formula should be established to protect a franchisee’s assets

 

3	Buyout/Voluntary Termination	Liquidated damages should be negotiated based on a reasonable time (forthe franchisor) to replace the (revenues from the) property
4	Vendor Exclusivity	Franchisees should be free to buy from any vendor
5	Dispute Resolution	An independent and fair process should be established for arbitrationand mediation of disputes
6	Venue	In the event of a dispute, the proceedings should take place in thecountry and state where the property is located
7	Transferability	Minimize transfer fees
8	Database Information	Should not be used for crossbrand selling by the franchisor; franchiseeshould share proprietary rights to the database
9	Sale of Franchise Company	If a franchisor wants to sell the brand to another entity, and the newowner wants to change system requirements, the franchisee should have theoption of leaving the system, or remaining and making the requested changes
10	Disclosure	There must be greater franchisor accountability for marketing andreservation funds
11	Quality Assurance Inspection	Franchisors should permit an independent quality inspection in theevent of a dispute
12	Franchise Sales Ethics/Practices	Franchisors should mandate good faith and fair dealing practices amongtheir sales agents

Source: Asian American Hotel Owners Association

 

The FTC and the NFC

Recently, a group of franchisors formed the NFC (National Franchise Council). The companies forming the NFC are among the best and strongest franchisors in a variety of industries. Hotel companies including Holiday Inn and Cendant are participants and leaders in the organization. The NFC is proposing an alternative franchise rule enforcement program in which the FTC (Federal Trade Commission) could refer a franchisor that committed a minor or technical violation of the Federal disclosure rule to the NFC for re-training on franchise sales disclosure law. The NFC expects this to result in greater compliance with the Federal disclosure law and benefit franchisees. This would be a significant change because it would be the first time the FTC entered into partnership with private interests in franchising to increase rule compliance. Additionally, any franchisee that claims to have been damaged by the franchisor’s violation of the Federal disclosure law could mediate that dispute under the auspices of the “National Franchise Mediation Program” which is administered by the independent New York City-based CPR Institute for Dispute Resolution. The mediation program is subscribed to by many of the strongest hotel franchisors and provides an impartial organization to address conflicts between individual franchisees and their franchisors. The test of whether or not this is a fair approach for both franchisors and franchisees will be if franchisees have enough trust in the system to bring alleged disclosure abuses to mediation.

Litigation

Franchising is generally governed by contract law. The franchise agreement is a contract and it defines clearly the responsibilities and rights of both franchisor and franchisee. Since contract terms favor the franchisor, franchisees often find that they can complain but they have little legal justification under the terms of the contract. The great majority of disagreements between hotel franchisors and franchisees are negotiated to conclusion before litigation is invoked. Some are addressed through the formal mediation process. Even after lawyers are involved, most disagreements are settled before they go to trial. However, two recent cases have particular application to issues in the hotel industry:

In Broussard v. Meineke Discount Muffler Shops, Incorp. franchisees brought a class action suit against Meineke for breach of fiduciary duty in the management of Meineke’s Weekly Advertising Contribution account, among other things. The court found that a franchise relationship (absent extraordinary circumstances) does not give rise to fiduciary duties. This is significant to hotel companies because franchisors spend such a large amount of hotel operators’ money through reservation and marketing contribution accounts. The franchisee generally relies on the franchisor to act in the best interests of their hotels when spending the money. There is no longer any reason to make this assumption.

In Linquist & Craig Hotels & Resorts, Inc., v. Holiday Inns Franchising, Inc.a franchisee brought a case against Holiday Inn for impact. This is the latest in a long series of cases in lodging and other industries concerning a franchisor’s right to engage in business activity at any other location. The court again did not protect franchisees against impact, as long as the franchise agreement contains the appropriate language permitting the franchisor to add units.

These cases speak to two of the sorest spots in the franchisee-franchisor relationship. In both cases, the courts supported the franchisor’s position. This tips the balance of power in the relationship further toward the franchisor, until franchisees find the strength to alter the standard terms of their contracts with their franchisors. Where the franchisor has appropriate terminology in the contract, other cases have supported:

• a franchisor’s right to collect liquidated damages for termination of a franchise agreement
• a franchisor’s right to require reinvestment in a property
• preferred vendor rebates

Franchise law has evolved considerably over the past thirty years, and franchise agreements are increasingly sophisticated. In fact, the American Bar Association has a section devoted exclusively to franchising. Many of its members are corporate – they work for franchisors, not franchisees – and they have honed franchise contracts for franchisors. The underlying premise to enforcement of franchise agreements is that the franchisee has a choice. Any franchisor will tell you, if you don’t want to live by the terms of the agreement, you don’t have to buy a franchise.

Future Trends

Franchising is an industry in flux. It is a growth industry. It gets more sophisticated every year in its operation. It gets more effective every year in its ability to promote and support national brands. It is high profile and closely watched by legislators. Both franchisors and franchisees expect some changes over the next several years.

Legally, the franchisor has been gaining strength in the franchisor-franchisee relationship. This is unlikely to change through law suits in the next few years. However, the concept of “fair franchising” has been promoted aggressively for several years now. Slowly, franchise agreements may move toward “fairer franchising” under pressure from the franchisee community.

The strongest brands are forging tighter relationships with their franchisees. Franchisors that have a consistent and desirable product are taking a more active role in the actual operation of member hotels. They are binding franchisees closer through increasingly strong and centralized marketing, reservations and property management systems. They are also taking a stronger stance on renovations and product quality. Over the next several years, franchisees in these systems will become more like investors in a hotel, with jurisdiction over the choice of general manager.

The weaker brands are getting still weaker. Some consolidation of brands is likely in order to improve distribution and critical mass for marketing, as well as profitability for the franchisor.

Many new brands have been introduced in the past five years. A few will be sustainable and the others will be absorbed into stronger chains. It has gotten more expensive to launch a new brand. But, regional chains continue to form and a few will become successful franchisors.

Companies that own hotels are more interested in franchising than they have been in the past twenty years. Hilton Hotels, for instance, is franchising more aggressively now. Patriot American and Starwood are companies that own and operate hotels. Each also owns brands. They could become the strongest franchisors of the next decade.

Several companies that are in the business of owning and operating hotels have enough properties to establish their own brand and have immediate critical mass, if they pull their hotels out of their franchised brands. That has the potential to change the balance of power in the franchisee-franchisor relationship.

The brands that want to continue to command a market premium over the next decade will have to become tougher about CapEx. They will also have to cut hotels from their systems when the hotel product does not conform. The strongest brands in 1999 and 2000 will all be 10 to 15 years old. The oldest 10 to 20 percent of these hotels will require major capital investment, if the brand is to keep up with guest expectations.

The political pendulum in the United States has been swinging in the direction of supporting big business for several years, and this has been beneficial to franchisors. Eventually, the pendulum is likely to swing the other way and franchisees will benefit.