Scrutinize Franchises' Early-Cancellation Clauses

Scrutinize Franchises' Early-Cancellation Clauses

Reprinted from Advanstar
Hotel & Motel Management Magazine
June 25, 1990
By Jeff Wilder
Wilder Group, L.L.C.

One of the little secrets of the franchising business is that after the anxious hotelier signs up with a chain, he becomes liable for major early-cancellation penalties if he wants to get out of the franchise contract. The early-termination liabilities often run into many hundreds of thousands of dollars, and the cancellation clauses are quite enforceable.

New franchisees are usually so focused on negotiating for reduced upgrading requirements to come into the system that bargaining over termination "windows" gets short shrift. The usual franchisor policy on early cancellation by the licensee is to enforce payment of termination penalties to the hilt.

How are termination penalties assessed? Generally, if you sign a long-term lease agreement, the licensor will take the projected stream of income through the contract term and bargain for that level of payment, if the franchise terminates. Sometimes there are five-year "windows," so that the maximum payment by the franchisee is limited to five years of fees or less. The lump-sum payment is due upon cancellation.

Let's translate an early franchisee-induced termination penalty into hard dollars. You have a 150 unit hotel that grosses $1.5 million in room sales annually. The usual franchise fee, including all extras, is 8 percent. Therefore, your annual franchise fee costs approximately $120,000. If you have five years left on the contract, and you want to cancel, then the chain stands to lose $120,000 multiplied by five years - or $600,000 in fees.

Too Costly to Cancel

If the hotel is worth $4 million, you are obligated to pay about 15 percent of the total hotel value (and a significantly higher portion of the property's net equity after mortgages) to the franchisor. In other words, you're boxed into keeping that chain affiliation even if it's not really benefiting the property. The same principle applies to a buyer who wants to switch flags. The franchisor can cancel you, at no cost, but you can't cancel it.

Today, the major chains are in every bit as competitive a world as the hotel operator, so it was only a matter of time before the system cracked. Recently, the Howard Johnson chain began offering a two-year "get acquainted" period. The company calls it a "test drive." In other words, if you don't get an acceptable benefit from its system, you can go elsewhere with no penalty within two years.

Best Western Plus

For years, one of Best Western's unheralded advantages has been its year-to-year membership. There's no penalty in discontinuing the marriage since the contract term is one year. I'm surprised Best Western has never dramatized this advantage. It's quite a plus.

I believe that in today's hotly competitive climate, a potential franchisee can negotiate liberal cancellation payments. I'm confident that every chain will do its best to resist negotiating on its cancellation clause; however, tangible benefits of a particular affiliation to a specific property are initially conjectural. Therefore, it seems prudent to allow an out in the contract if the hoped for benefits don't appear. The out shouldn't require payment of an unreasonably stiff cancellation fee if the benefits simply aren't worth the annual fees, or if a purchaser wishes to switch horses upon acquisition.

Howard Johnson's test drive is an extraordinary policy. While it was probably borne of necessity, it really is quite equitable and smart. The company is standing behind its product and putting itself under constant pressure to produce results for the franchise.