The Risks of Franchise Contract Liquidated Damage Clauses

The Risks of Franchise Contract Liquidated Damage Clauses

By Jeff Wilder

Written for: Lodging Magazine

Dated: 7.31.98

Over the course of thirty (30) years in hotel brokerage and management, I’ve rarely encountered a more potentially punishing and equity eroding aspect of hotel ownership than the Liquidated Damage clause found in most franchise contracts. These clauses are an integral part of the contract’s boilerplate language and a franchisee’s attempt to negotiate it are mightily resisted.

The liquidated damage clause is nothing less than a gun to the franchisee’s head and should fully be understood in exactly that light. If one elects to leave a chain’s system, or is terminated prior to the natural end of the contract’s term, there’s a real danger of being sued for hundreds of thousands (if not millions) of dollars in liquidated damages. And, if you don’t protect yourself up front, the franchiser has the right to subject you to a costly litigation or high settlement expense in furtherance of its own economic goals. So, not to bargain hard for a low cost future exit to a potentially unwanted affiliation may be very harmful to the franchisee’s interest.

I find remarkably little written about this important topic in the national hospitality press. So, we must all be appreciative of Lodging Magazine’s willingness to publish an article on a subject most franchisers would prefer to be left un-discusssed. I hope that its publication induces national chain executives to respond and that Lodging elects to print those replies in a future issue.

What are Liquidated Damages ?

When two (2) parties enter into a contract that is terminated before the conclusion of its term, one side may lose an income benefit and deserve to be compensated by the other party. In the case of a franchise contract, the franchiser often writes a ten (10) to twenty (20) year agreement and receives a stream of fee income in return for providing national advertising, reservation traffic and other benefits to the franchisee. There is usually a clause allowing for early termination by the franchisee upon payment of a lump sum of money; this is called the Liquidated Damages Clause. The payment is usually based on (a) a fixed dollar amount per hotel room or (b) a multiple of the annualized gross fees paid, often totaling two (2) to three (3) year of "all in" franchise costs. It typically amounts to roundly 8% of annual room sales.

Of the national chains, only Best Western has no liquidated damage clause in its affiliation contract. Their philosophy is simple and refreshing--if its system doesn’t do a good job for your hotel, or you can do better with another brand, then you’re free to leave at no cost. Would that every chain were as confident in the value of their system to the individual hotel owner.

When Does the Issue Arise?

The matter of liquidated damages arises when either side breaks the franchise agreement. Interestingly, it’s not commonly understood that the franchiser can even sue for damages when it cancels a hotel’s franchise contract if, in its opinion, the subject hotel does not meet its current standards. In other words, "You’re not up to our vision of the brand, so you’re out. And, since we’re losing your hotel’s stream of franchise income, we’re suing you for damages, to boot. What gall ! But, it’s entirely legal unless you protect yourself from such an eventuality.

The boilerplate of franchise contracts is usually so one-sided that the franchisee may be trapped in an unwanted affiliation relationship even if the franchiser company changes hands, changes policies, adds competitive units that adversely impact the franchisee, allows its own standards to slip, and the like.

Usually the Liquidated Damage clause comes into play when:

the hotel is not performing well under one brand and the owner seeks an alternate affiliation to enhance income
the hotel is sold to a buyer wishing to re-flag the property under another brand
the hotel fails current quality standards of the franchiser, who then elects to impose early termination of the contract
the franchiser makes an "impact" decision that adversely affects an existing franchisee’s hotel who, as a result, then decides to leave the system

What is the Cost

In determining the amount a franchisee may be obligated to pay a franchiser in liquidated damages, let’s work with a realistic example.

Take a 100 unit hotel grossing $ 1.4 Million in Room Sales. The property is probably worth roundly $ 3.5 Million and is likely to be mortgaged at about 70% of its value, or about

$ 2.5 Million. So, the hotel equity is $ 1.0 Million. All-in franchise costs will run roundly 8% of room sales, and include basic franchise fees, marketing fees, reservation system expenses, and the like. In this example, the annual franchise cost is $ 110,000. Most liquidated damage formulas use a three (3) year multiple for calculation of damages. In this example, the cost is roundly $ 330,000. That represents fully one third (1/3^rd) of the property owner’s entire equity in the hotel !

The ability to change flags and maximize property equity value is especially vivid at the point of sale. I recently spoke to a top REIT executive who was just required to pay over $ 1M in liquidated damages to cancel an existing hotel affiliation on a hotel he’d purchased. Of course, years earlier, the old chain had little compunction flagging this hotel despite the fact that they already had a franchisee representative serving the same market. (When it flagged this hotel it didn’t pay a nickel to the already existing affiliate.)

Are Liquidated Damages Justifiable?

Franchisers say their brand systems need stability and, therefore, a high "penalty" payment is required as a hammer to prevent its sign from coming down in a marketplace merry-go-round. They say it is expensive to locate alternate hotel affiliations in various marketplaces and need to be compensated for the upset. Of course, as mentioned earlier, one of the largest chains in America (Best Western) gets by perfectly well, thank you, with a policy that allows members to drop out with no payment whatsoever. One wonders how this chain can accommodate change while most other chains find it necessary to impose very high costs on their departing franchisees.

Further, one might properly ask why pass-through expenses (such as marketing costs and per unit reservation charges) that nearly double the basic franchise fee are included in the calculation of liquidated damages. After all, the franchising community regularly trumpets these costs as non-profit centers, so how could their loss cause any damage when there is no profit in it, in the first place ? And, finally, why are damages not based on the franchiser’s Net Profit from the contract, rather than on its Gross Franchise Fees. Most businesses earn a

15-25 % profit, so it seems more equitable to base liquidated damages on Net than Gross.

Do Franchisers Sue to Collect ?

You bet they do! While franchisers sometime negotiate settlements at reduced levels, the fact of the matter is that the chain’s legal department usually works hand in glove with the company’s business side to maximize how much they can collect. Naturally, business considerations do come into play and it is clear that some franchisees are treated differently for varying reasons. For instance, if you have a number of flags with one franchiser you are more likely to get special treatment than if you only have one flag. While that informal policy doesn’t seem very fair, the franchiser uses the liquidated damage clause as a blunt edged hammer to improve its own business goals and leverage its benefit from each situation..

Regarding litigation over liquidated damages, he franchiser usually has deeper pockets than the franchisee and it relies on this imbalance, and the signed franchise contract, to win the day. It threatens litigation as a means of imposing a settlement and will usually not think twice about "turning the matter over to Legal" if it isn’t able to get an acceptable resolution.

What’s To Do About Liquidated Damage Clauses ?

Take Mrs. Reagan’s advice regarding drug use—"Just Say No."

Decide that you are not going to risk your capital with a franchise company that subjects you to a burdensome liquidated damage payment in the event the marriage doesn’t work out. I’ve just gone through such a circumstance with one of the old time major chains and promised myself I’d never put myself in such a circumstance again. If the franchiser resists negotiating a modest franchise contract cancellation payment up front, my suggestion is that you go elsewhere for a franchise, build the potential cancellation cost into your overall acquisition cost, or even take a pass on the hotel purchase. After all, it is almost indisputable that these clauses adversely impact the value of your hotel.

Our firm just brokered the sale of a 200 unit independent hotel, at a major East Coast airport, to an investor group who then hired us to manage the property. Prior to closing, four (4) franchise representatives called to ask if we’d affiliate the hotel with their company’s brand. Each was asked their company’s position on liquidated damages; each followed the "company line" of little negotiation room on the clause. That made our decision very easy. I will not put our clients in a compromising and weak negotiating position with a franchise company that, after all, isn’t putting ten (10) cents at risk with the investors. We’ll simply continue operating the hotel as an independent and remain in complete control of our own destiny.

Of course, if you are willing to continue taking the risk of putting a chain’s equity ahead of your own, go on doing deals as you have in the past. That means signing franchise contracts with relatively high liquidated damage clauses. For my part, I have come to the belief that "the emperor has no clothes" on that score.

Jeff Wilder is president of Wilder Group LLC, a nationally known hotel brokerage located in Great Neck, New York. He has been involved in over 350 hotel brokerage transactions in his 30 year lodging industry career, supervises the management of numerous hotels, is on the Executive Committee of New York University’s Hotel and Tourism School, is past president of HMBA: America’s Hotel Broker, has over 150 nationally published articles to his credit, and is co-founder of Innvest, a popular lodging internet site located @ www.innvest.com