Franchise community clamors for more equitable contracts

"Things are changing; a lot of C.E.O.s know that to continue to grow as a brand and an industry, we need to be more franchisee friendly. Hopefully, we will begin to leave the lawyers outside and enable employees to make the necessary decisions."

2001 Franchise Guide
May 21, 2001

Franchise community clamors for more equitable contracts
David Frabotta

There's no lack of debate about fair franchising. The topic warrants a panel or lecture at most industry events and conferences.

But the unprecedented attention given to franchise contracts has successfully opened the lines of communication and collaboration between franchisors and licensees, yielding more influence from the franchisee community and a slow progression to more equitable contracts, according to Jay Patel, C.E.O. of Lodging Hospitality Systems, which franchises Ashbury Suites & Inns.

"Franchising is a good concept if people can ethically and morally learn to work to implement the right system," said Patel, who wrote "Franchising: Is it Fair?" "My whole concept of the book was that trying to dictate terms to a franchise company is like Sadaam Hussein coming into the United States and asking us to change our policy. But if we educate people, then we can get a better understanding of how these agreements work."

Patel, who also is a franchisee of several other brands, said the advent of brand franchisee advisory boards in the past decade and organizations such as the American Franchise Organization and the
Asian American Hotel Owners Assn. boosted the negotiating power of individual franchisees.

But despite the new bargaining power afforded to potential licensees, there are a few sticking points that dominate the debate about more equitable contracts, mainly territory protection, termination clauses and liquidated damages.

Part of the problem lies in the presentation of the contract. Franchise salespeople often refer to an agreement as a business partnership, but it's not a legal partnership.

"Franchisors are using the term partnership euphemistically and not legally," said Shelley Spandorf, counsel with Sonnenschein Nath & Rosenthal. "A true partnership means that both parties share profits and losses."

But the spirit of partnership is beginning to manifest itself with sensitive issues, including balancing the franchisor's ability to grow with protecting an existing franchisee's territory.

US Franchise Systems offers unique territory protection for each individual contract that lasts for the life of the contract, according to Steve Romaniello, president and C.O.O. of USFS.

"You'll see a lot of the smaller companies that need to demonstrate performance will be more likely to have more franchisee friendly agreements in general," he said. "Larger companies are moving at a much slower pace in general."

Similarly, GuestHouse International Franchise Systems allows potential franchisees to negotiate an encroachment policy, a major competitive difference, according to Rob Wilson, president of GuestHouse.

"There needs to be a culture in the corporate environment that believes in the concept of true partnership," he said. "Because encroachment is so closely tied to shareholder value, its difficult to walk the walk."

Fred Pozin, G.M. and proprietor of the Ramada Inn Mandarin Hotel & Conference Center in Jacksonville, Fla., renewed his franchise contract with Ramada Franchise Systems, a Cendant Corp. brand, earlier this year. He said many properties have some bargaining power with initial fees, continuing fees and exit clauses. But territory restrictions are a bit less malleable.

"I didn't feel a lot of bend and stretch in encroachment or termination," Pozin said. "It's difficult to get exclusive areas. When it comes to out clauses, I think there are some negotiable areas, but it isn't as easy as some people make it out to be."

Should I stay or can I go?

Franchisees have an expectation that a brand will perform in terms of central reservation contribution, average daily rate and occupancy. Realizing that some brands might not work with certain assets in some markets, franchisors increasingly have developed exit clauses based on performance.

The difficulty in establishing exit clauses exists in large part because franchisors must maintain growth to secure shareholder value and to grow the system with value for all properties under its umbrella, according to Tom Bernardo, executive V.P. of franchise sales and development, Cendant Hotel Division.

"USFS started a very aggressive program when they launched Best Inns, and GuestHouse is very aggressive with short windows," Bernardo said. "But they are companies that are in major need of market share to generate revenue. It's a double-edged sword because if they don't have the marketing dollars and funding for their reservation system, then they are going to go out of business-and there will continue to be consolidation as a result [of generous exit clauses.]"

But exit clauses are giving franchisees more opportunity to exit a failed business venture. Choice Hotels International offers five-year windows in its franchise contracts, allowing licensees to exit the system without paying liquidated damages.

Performance-based exit clauses also are becoming more pervasive, especially with smaller brands. GuestHouse and USFS allow franchisees to exit the system without penalty if occupancy falls below a threshold for a specified period of time, and the growth success of some brands with more lenient exit policies has been prompting other franchisors to follow suit.

Cendant's Travelodge is guaranteeing a 15-percent increase in revenue for the second 12 months of operation as a Travelodge to new franchisees. If a property is not driving 15 percent more revenue in the second 12 months, it can leave the system without penalty with a 12-month notice. The program was launched in June 2000 and is slated to expire Dec. 31.

"I'm glad franchisors are starting to stick their neck out on those things because we think its good news," said Pozin, who sits on Ramada's franchisee advisory board. "If the brand has done everything they can to deliver services and you have done everything in your power to follow the programs, then you should be allowed to bail out."

Although exit clauses are becoming more widespread, franchisees often are required to pay liquidated damages if they breach a contract without an exit clause. "We charge liquidated damages to replace revenues that we anticipated in the market," Patel said. "But if that revenue has already been replaced with another property before I am done paying liquidated damages, then some of that revenue should come back to me."

But liquidated damages compensate the franchisor for any opportunities it might have turned down because of territory protections, ultimately protecting the viability and longevity of the brand, Bernardo said.

"Our experience is that it takes 24 months to sign another contract and ramp up another property in terms of occupancy to replace the revenue stream that we lost," he said.

Despite obvious differences in the perception of equitable contracts, it's a mainstay for discussion in the industry.

"Things are changing; a lot of C.E.O.s know that to continue to grow as a brand and an industry, we need to be more franchisee friendly," Patel said. "Hopefully, we will begin to leave the lawyers outside and enable employees to make the necessary decisions."

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Risks: American Franchise Association, AFA, Encroachment (too many outlets in area), Performance-based exit clauses, United States, 20010521 Franchise community

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