In the face of seemingly innumerable challenges triggered by the COVID-19 pandemic, constituents in the hospitality space continue to grapple with how to recover and to find opportunities for growth and investment. For some operators, the joint venture is an attractive model for hotel acquisitions, allowing for portfolio diversification, easier expansion into new markets, and creative risk management, as well as opening the doors to more favorable financing options. The factors involved in formulating a successful hotel joint venture, though, are numerous and complex. To maximize the benefits of the joint venture structure, it is imperative that parties proactively approach the negotiation and consummation of the venture so as to plan for, and minimize, any issues that may arise.
Structuring the Joint Venture
Joint ventures offer significant flexibility and can be tailored to the specific circumstances of the transaction and to the needs of the parties. Important decisions should be negotiated early and in writing. Following initial internal approvals and then early-stage discussions (typically directly between potential co-venturers), a term sheet should be considered as a next step to set expectations and guide the parties towards completion of the underlying transaction.
The Term Sheet
The term sheet is an early-stage document that outlines major elements of the proposed venture, most notably the deal structure and business model. While generally nonbinding (subject to inclusion of certain binding provisions, in particular with respect to confidentiality and exclusivity), term sheets offer venturers the opportunity to summarize the key objectives of the proposed venture in the early stages.
Term sheets inevitably vary by transaction, but typically cover (at a minimum) the following areas:
- An identification of parties (investors, operators, sponsors) to the venture;
- The proposed project for which the venture is to be formed;
- The venturers’ equity percentages (whether 50/50 or something else), together with the amount of equity that each venturer will contribute to the acquisition or project, additional equity that may be required on an ongoing basis, and distribution waterfalls;
- Liquidity provisions (including buy-sell and right of first refusal matters);
- Investor funding conditions; and
- Management of the venture, including control events and removal mechanisms.
The Joint Venture Agreement
Venturers will commonly create a new entity for the joint venture to aggregate equity and to facilitate any additional entities that will own or lease the underlying project. The venture’s governing documents (including, most pertinently, the limited liability company agreement or limited partnership agreement (the “JVA”)) fill in the gaps of the term sheet, delineating how management, transfers, and succession planning will be handled, and setting forth with specificity timelines and exit mechanisms. The JVA should also grapple with the relationship of the venture vis-à-vis any affiliates of a venturer, in the areas of operator control and key employee requirements, operator removal provisions, and events of default. Properly drafted (and as the primary binding agreement of the venturers), the JVA can reduce the opportunity for conflict and embolden parties towards a trust-based relationship.
Related Transaction Documents
For sophisticated transactions like hotel acquisitions, other pertinent documents may be necessary to paper the deal.
Cost Sharing Agreement
A cost sharing agreement (a “CSA”) governs how venturers will share due diligence and other expenses incurred in connection with the hotel acquisition, including contract deposits, application fees, and third-party reports. The CSA typically covers the period from when a hotel acquisition purchase contract is entered into until the closing or earlier termination of the acquisition contract. The CSA should (i) contain “true up” language for the acquisition closing in favor of a party that has fronted a majority (or all) of the acquisition pursuit costs, (ii) address what happens if funds allocated to pursuit costs remain after the acquisition closes (whether returned to the venturers, contributed to the venture as capital contributions, or used in some other fashion), and (iii) detail the reimbursement of funds if the parties determine not to proceed with the underlying transaction.
If the hotel being acquired or constructed will be operated under a franchise brand or “flag,” the franchisor will require that the venture (or its affiliate) enter into a franchise agreement. The franchise agreement will govern franchisor and franchisee obligations and cover varied areas including franchisee operational responsibilities, hotel improvements (including property improvement plans (“PIPs”)), franchisor proprietary rights, franchise fees, transfers, and termination. Franchise agreements are uniformly franchisor-friendly and notoriously difficult to negotiate with any discernible substance, but franchisors are open to negotiation in discrete areas, including with respect to franchise and royalty fees (fee ramps), ownership transfers, and the scope of PIPs and other capital improvements.
Hotel Management Agreement
The hotel management agreement (the “HMA”) is an agreement under which a hotel management company agrees to operate a hotel on behalf and for the benefit of the hotel owner. The HMA is typically for a defined term beginning on or around the closing of the underlying transaction and will set forth the management company’s day-to-day management responsibilities (and limitations on authority), management fees (including, in some instances, incentive fees), working capital levels, and so on. The bargaining strength of the parties and the experience of the management company and its affiliation (if any) with a venture party will dictate whether the HMA is a balanced or one-sided arrangement.
The goal of the joint venture is to build a sustainable, ongoing relationship between parties; thoughtful planning and negotiation from the outset – including the establishment of a robust set of venture governing documents – and continuous communication surrounding expectations and desired outcomes are key to successful hotel, and indeed all, joint ventures.
This article is intended for general informational purposes only and should not be considered legal advice or counsel, nor does it create an attorney-client relationship.
Cameron Betterley is an attorney practicing in the Corporate, Real Estate, and Finance Practice groups. He provides representation to hotel owners and operators in negotiating and structuring hotel joint ventures, acquisitions, sales, developments, and financings. Cameron can be reached at email@example.com or (585) 672-5500.