THINKING ALOUD (BusinessLaw) BUSINESS MODEL: Franchising
“It’s (the franchise) bigger than big. It’s bigger than we thought it would be”— Bob Iger CEO Disney (on the success of The Force Awakens)
Franchise and Distribution Agreements:
Similarities and Differences explained
Writer: Chén Róng
A distributor's relationship with manufacturers shares some common features with franchisees. Some specific franchise laws may have provisions that directly relate to distributorship contracts. Under such franchise acts, a distributor comes within the definition of a franchisee in which the laws act to prevent contracts from unfair termination by their principals. For such inclusions, the distributor's business may be substantially associated with that of his principal, even if the distributor handles other product lines. Specifically, the distributor circulates catalogues and promotional materials containing the principal's logo; and the distributor's premises-sign carries the name of the principal. Even if the principal did not prescribe a marketing plan to the distributor as required in the franchise act, evidence of sufficient control over the distributor is generally sufficient to meet this requirement.
Aside from franchise specific laws, the franchise concept is fundamentally different from a distributorship model. The contrast between the two models can be markedly different in some ways.
Unlike a franchisee, a distributor is an independent entity. The distributor is in fact an independent selling agent who has a contract to sell the products of a manufacturer. But the distributor's operations are not under the direct managerial control of the manufacturer. His only influence over the distributor is probably the common methods for display and inventory management; and commonality in producing national advertising and symbolism for products represented.
The distributor operates the business under a name not related to the manufacturer he represents. The distributorship functions as a re-seller of products it buys from different manufacturers. Nevertheless, it does not conduct business on behalf of manufacturers, unlike a franchisee who pays an initial fee and on-going royalties for rights to operate a business under trademark name of a franchisor.
The distributor does display the principal's trade name in signage and in sales situations. But unlike a franchisee, established distributors carry both complementing and competing products of different manufacturers. Traditionally, distributors do not pay an up-front fee to manufacturers for the right to sell their products, although they may be contractually required to buy a specified minimum of stocks. Distributors are generally happy with this arrangement because of control over markets that they developed.
In major equipment business, substantial capital is deployed carrying and holding stocks of merchandise, including inventory parts. By purchasing goods at wholesale prices on their own account, distributors invariably offload the working capital burden of manufacturers. On their part, manufacturers generally provide marketing programs and conduct technical training in support of distributors. The hands of a franchisee are tight as he is restricting to products as presented to him by the franchisor. Insofar as a distributor is concerned, he may buy products from one manufacturer and have these items consolidated with products of another to add value to the end product.
Some people may find the Coca Cola franchise is little confusing because of its strong distributorship undertone. The franchise model is more than a hundred years old and seemingly obsolete for today's requirements. The model was created when Coca Cola was selling and distributing products it manufactured. The company's growth was based on bottling and distribution franchises with exclusive distributors who were contractually franchisees. These Coke bottlers or franchisees had exclusive rights to handle sales and distribution within their territories, all the way down to building close relationships with grocers. As Coke tries to boost new non-carbonated drinks and products of other manufacturers, the fragmented bottling network is a relic not suited to today's Coke -- both a manufacturer and a distributor of a growing beverage portfolio. There is an urgent need for control and more stringent control of the distribution network. Straight-to-warehouse delivery of the sports drink Powerade to Wal-Mart Stores was a move away from the century old practice of engaging Coke bottlers as distributors. There are already cracks in the century old model. Nevertheless, there is no indication that the contracts with Coke's franchisees will be re-modelled and re-named any time soon. Until further notice, the business model remains a Coca Cola Franchise.
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BUSINESS MODEL: Franchising
Writer: Chén Róng
An entrepreneur looking to start a business from scratch is highly risky. If his business is in footwear, it comes with inventory liability. In a recession, his inventory of shoes goes up. Accounts Payable increases. A franchised business does not have this problem, although it is not risk free. If the company that owns the franchise goes bankrupt, a franchisee can lose all his investment capital. It can be an expensive experience that might take a business person many years to regain his finances.
Franchising is a quasi-entrepreneurial enterprise in that the franchisee gets administrative and logistical support. He really needs to have a passion for managing a process to succeed. Franchisors impose obligations on franchisees to use their business methods and meet their operational standards. The purpose of these requirements is to protect the reputation of the franchise--if the business operates inefficiently, provides poor customer service or fails to maintain proper cleanliness standards, the economic value of the entire franchise could suffer.
To a franchise seeking entrepreneur, his reward comes with choosing the right franchise as there are franchises available for just about any kind of business. There are fewer risks with established franchisors like McDonald's. However, the financial requirements for setting up costs are the biggest barrier; the equipment and pre-opening costs can be as much as US$2 million each for most of its restaurants, excluding real estate. A franchisee will need to sell many, many hamburgers to recoup such a heavy initial investment.
It may be true; a McDonald's franchise is not within the reach of every entrepreneur aspiring to become a successful franchisee, not just the financial aspect but also the stringent suitability tests imposed by the company. Nevertheless, the writer considers the McDonald business model as one every aspiring franchisee in the food and beverage business should use as a reference point for his/her negotiation and due diligence work. Other franchise models may also find the McDonald's franchise a good reference. That is the personal opinion of the writer although others may have their choices.
McDonald's is a socially responsible company as all franchisors should be. The real world rarely works that way. McDonald's has consistently reduced the amount of salt, fat and sugar on its menu without significantly changing the taste that customers prefer. In truth, customers may be bending backwards to satisfy their cravings for the Big Mac cheese burger. Kids are also getting use to the idea that meals now come with non-carbonated drinks. It takes a role model like McDonald's to convince people eat healthily; and other players in the industry will follow.
McDonald's has not only improved its menu but invested across its business, such as staff training, kitchen technology and point of sale equipment over the past years. Since the company increases the number of outlets, higher sales revenue came as a benefit to its franchisees. One key driver has been the re0imaging of its restaurants with new colour scheme, fixtures and seats, hence giving their customers a welcome change for a more comfortable environment for hanging out. Investing in staff training, the company puts newer employees on its apprenticeship scheme in multi-skilled hospitality which typically takes a year to complete. The company also introduced a vocational qualification for teenagers who complete an 80-hour work experience programme. Other employees enrolled in other job enhancement programmes such as GCSE Maths and English-related qualifications.
McDonald is a public listed company owned by a number of corporate and retail shareholders. People keen on a McDonald's franchise may be happy to know that franchised restaurants are contracted out to individuals and not partnerships; and participation by investors is out. Franchisees must personally operate their restaurants and involved themselves in the day to day operation of the restaurants.
On the question of ownership, one significant observation from the writer is: private equity funds have recently been actively acquiring franchising rights especially in the food and beverage business. Unless an experienced shareholder retains a substantial stake in the business, a private equity fund may not have the strategic interests to build it into a global and innovative company. The manager of the fund may have short-term interests in making a quick profit at the expense of long-term planning. This is something a prospective franchisee will have to deliberate over as changing of franchising rights means the need to build relationships all over again. It is equally important to know if franchising terms included in anticipation of such ownership change in the near future and, hence, giving the franchisor a right to amend terms of the agreement because of changed circumstances.
With few established and socially responsible and trusted franchisors around, rules and regulations imposed by a country are the only safety nets that can save the day for all less endowed franchisees. Franchising can be made less risky if governments concerned overhaul franchising laws to safeguard the interests of local entrepreneurs. Franchisors ought to disclose past and present lawsuits (if any) brought against their franchisees including disclosure of signed confidentiality agreements with franchisees and preventing them from revealing their (franchisors) serious faux pas. These are just some of the things a government can and should implement to increase job opportunities for its people, if franchising is considered a business model.
Some countries may have extensive franchising laws in place (USA), others may have none (New Zealand). Where a franchise model seems to comply with all local laws, there may be other regulations in place that may restrict the smooth running of the franchise business. Are there restrictions on foreign trade, import and export controls, investment and currency restrictions? Are corporate and intellectual property laws compatible in both countries?
Both franchisor and franchisee must ensure they comply with local laws on direct franchising. National laws may require the franchisor to establish either a branch office or a subsidiary company. It may also be necessary to form a joint venture with a local partner to hold the master franchise to grant franchises in particular countries. Both parties must ensure that holder of the master franchise will have rights to the trade name and proprietary marks, business format, manuals on loan, staff training and other assistance. The master franchisee should be allowed to keep all initial franchise fees and royalties from the unit franchisees and remits an agreed portion of each to the franchisor.
The writer has in mind challenges that franchisees may face with different national laws.
- Local laws may be substantially different, or do not exist at all, for the protection of trade secrets because trademark laws on actual use as against intent to use are not the same. There may be a need for user agreements and sub-licensing rights to be registered.
- Investment Law may require the participation of a local partner as a pre-requisite for a valid master franchising contract. The master franchise need be held under a joint venture company with the franchisee as a partner. In that case, there may be regulations on minimum capital requirement or rules on local investment participation.
- Competition Law is another important piece of legislation that may franchising arrangements. Terms and conditions in a franchise contract may be rendered unenforceable or illegal by local competition legislation. Covenants on limiting competition or non-compete clauses are obvious ones. Other legal provisions may include customer and territorial restrictions; limitation of purchases from franchisor or master franchisee and their affiliates as such terms may contravene local competition laws.
- Taxation issues can be a major road block. Is there a tax treaty between the countries of the franchisor and franchisee? Related matters for consideration are whether the franchisee is responsible for withholding taxes in connection with franchise fees, royalties and other payments. And are such payments amortizable or deductible by the franchisee for tax purposes? Beside income tax, are there other types of taxes - value-added (VAT), import and export dues or tariffs and excise duties - to be considered? Besides engaging the services of a franchise lawyer, a franchisee may also need a tax consultant with the necessary knowledge from the start of negotiation. Sorry, the writer is also not a tax consultant. As a generalist, the writer can put his finger at places where things can go wrong with an international franchise.
- Other pieces of legislation may include acts of good faith in general consumer laws such as Fair Trading Act. It may contain regulatory provisions for unfair contract terms and unconscionable conduct.
A franchise contract carries with it advantages and disadvantages, and everyone getting into a franchise contract must understand the pros and cons of this business model before he signs the agreement. Think twice before scrimping on fees of consultants. Acting as your own franchise lawyer or tax consultant is financial suicide.
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Hubpages do not support words written in the Chinese Language. Readers can get a free online English-Chinese translation from GOOGLE TRANSLATE OR TRANSLATED.net
I have also included ChénRóng’s Little English-Chinese Dictionary for a more precise translation of select English phrases from the article.
FRANCHISING: Interests in Conflict
Writer: Chén Róng
When people think of franchising, the first thing that comes to mind is, inevitably associated with names like McDonald’s and Burger King. But there is much more than fast-food in the industry as many of franchises are demographics related.
In a cosmopolitan city like Singapore cultural barriers play a part in more than fast food; as the population gets older, younger people do not want to leave their elderly parents alone at home and unattended to. Franchising elderly-care services is now a necessity. Many elderly parents live in hospices -- retirement homes or sort for some -- in nearby State of Johor (Malaysia) where land and labour costs are much lower. The city-state's success in knowledge-based franchises such as in education may see the country exporting similar skills to franchising of elderly-care services. Such services are prevalent in Japan where franchising helps the elderly live independently by running errands, cooking meals and providing companionship. Worldwide franchises are thriving and crossing borders. The permutations seem infinite with the exception of fast-food chains because of cultural differences.
Conflict – operating units
Whatever the intended business -- retail sales, automotive dealerships, gasoline service stations, etc., people getting into a franchising arrangement should be aware of the contractual part of the business. One major aspect is the high probability of interests in conflict between franchisor and franchisee. For any franchise operation to thrive, there is a need to have an optimum number of operating units or outlets; and substantial sales within each franchise to give it the marketing power it needs. A franchisor is keen to have as many outlets in a particular locale to optimise his customer-base, but if units are placed too near to each other, franchisees may feel the heat of competition from their counterparts. There lie the different interests in conflict between the parties -- franchisor and franchisee, and between franchisees themselves, although a larger scale operation with more outlets or units is essential for optimising marketing power that benefits all concerned. Franchise contracts should stipulate that franchises are not to be sold less than a certain distance away from one another, unless local legislation is in place to control such sale.
Conflict – franchising fees
Another source of conflict of interests is where franchise fees are not tied strictly to sales, but to revenue (for instance) which includes other incomes, if any.
There is always that tug-of-war between the franchisor wanting to get more fees out of the business and the franchisee who tries to retain as much operating profit as possible. McDonald's business model seems equitable and an imitable reference system for other potential franchisees. The corporation only makes money from its franchisees’ food sales, which avoids the potential interests in conflict that exist in other food franchising operations where fees are not strictly tied to sales. Besides, their franchisees are independent, full-time franchisees - and not passive investors who sit on real estate for short to medium-term capital gains (conflicting interests) -- ensuring the success of the franchising model. McDonald's is also keen on seeing the success of its reward programme which sells more restaurants to its strongest-performing franchisees. An expressed or implied term of this nature in the franchising contract may be something a franchisee should look out for.
Conflict – the internet
Franchisors are also using the internet to communicate with their franchisees and through websites seek new franchising arrangements. But the internet is both bane and boon, creating unintended challenges for all. Some franchisees, by creating their own websites, try to attract new business hence setting off cyber-turf wars with their counterparts, and its parent company over who owns the customers and profits.
To avoid such conflicts, it should be the responsibility of a good franchisor to set up a single national website and contractually restrain its franchisees from setting up of own websites to attract new business. A single national website should identify ways to cross-market between franchisees and franchisor to align their cooperative interests to increasing sales in the system.
Food for Thought
Many people are turning to owning a franchise, perhaps because full-time jobs are more difficult to come by. Others might think that a franchising arrangement empowers them in that it allows them to control their own destiny. Whatever may be the reason, it is important to carefully consider the contract when becoming a franchisee. A contract governs the legal relationship between parties, and a franchisee should ensure there are provisions for future actions, if the relationship does not work out or interests in conflict have entered into the equation. There may be events - unexpected tugs-of-war - owing to the nature of its business model, and not mentioned by the author.
A franchise contract is like a marriage between two persons in love. Everything appears romantic, but sometimes a couple simply ignore potential conflicts, hoping that marriage itself will solve all problems when loving people make adjustments to meet daily challenges in life. Things rarely work out that way, although the writer does not advocate walking out of a potential marriage of minds at the first sign of conflict. Staying being aware of the conflict and try find a solution to resolving it is not the same as ignoring it, and hope for the best outcome.
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Writer: Chén Róng
Successful franchising stories are aplenty, and these are narratives often lauded by trade magazines. The writer has in mind for discussion is the less-talk- about ones -- the franchising scams. These are experiences that people feel too ashamed to talk about openly because these are considered taboos in some culture; or victims who are too broken-hearted even to mention them. But such stories will be more prevalent when good jobs are hard to come by and even micro businesses are considering trying their hands at franchising to expand into related activities as competition keeps tearing down profit margins.
Franchising scams exist in part due to a weak regulatory environment in some countries. However, people who get scammed are usually those who do not do their home-work, or in commercial parlance -- business due diligence. People who want to get into franchising as a business model has to bear in mind that only their own discerning selves could protect themselves from falling victim to a well-crafted scam. Nevertheless, there are always tell-tale signs a prospective franchiser can discern even in a well-laid scheme, if he exercises care and diligence.
Now, exercising due diligence is not just discussing your business plan with your best friends and associates. Chances are, they may just say all things nice, sensing your keen interest in getting into a particular business. The right person to talk matters over is a franchise lawyer. The writer is not a franchise lawyer and he will not pretend to be one. He will certainly consult a franchise lawyer when crossing that bridge, and he will not just consult any lawyer friend.
But before the writer even spends time and money engaging the services of a lawyer, there are things that his training and corporate experience would cause him to ponder like every prospective franchisee basically should. A business that has no proven track-record of success cannot possibly franchise itself legitimately. An offer of an attractively low franchise capital raises a doubt instead of an attractive proposition.
Another obvious question is: why does the franchisor so easily trusts someone with his brand and business model -- a person who has little or no experience with related-business activities of the intended franchise. If you are that someone, and the franchisor seems only interested that you are able to raise the initial capital and pay him his initial asking fee, the writer thinks the scheme is likely a red herring.
While expanding through wholly owned operations will cost a franchisor a lot more capital than franchising, the hard and soft cost - both at the start of the franchise and on a continuing basis - can be significant. The selection process for suitable franchisees has to be stringent and elaborate. This process is like a couple going through a courtship period, both parties will have every possibility to call off further engagement if one or both think a happy marriage is not to be. If a franchisor pushes hard to conclude the contract instead of offering a reasonable period for mutual engagement, chances are, the business proposal is a sham franchise.
The result of a study by a renowned Australian university showed that nine per cent of franchisees did not understand the terms of their franchise agreement. They also had vague ideas on other related disclosure documents and their requirements, but they still went ahead and purchased the franchise.
The disclosure document should show:
- Relevant business experience of the franchisor,
- details of current and past franchisees
- Franchisee’s costs to start the business and other fees payable under the franchise.
- A genuine franchisor will also provide details of certain legal proceedings against him or his director(s) instead of assuming an attitude of buyer beware in his dealing with prospective franchisees.
- Financial statements including a declaration that on reasonable grounds, the franchisor believes he is able to pay its debts; and
- Financial Reports for the past two financial years, supported by an independent audit.
The documentation should include details on what actions the parties must undertake at the end of the franchise contract. It should mention whether or not the franchisee has an option to renew or sell the business, and whether there are further obligations that may be imposed on the franchisee. If the franchisor has a history of selling an existing franchise back to his franchisee, in ways similar to McDonald's, a prospective franchisee may be hitting the bull eye, if he passes the stringent test imposed on him. In Singapore, retailer Fairprice offers entrepreneurs the opportunity to take over Cheers-brand convenience stores, and run them as their own franchised business. These are fully stocked stores that have been profitably in operation for at least a year. The risk is minimal but not every Tom, Dick and Harry can qualify to run these tried and tested outfits.
Once again, the writer's opinion is: seek legal counsel. Prospective franchisees should do your own basic due diligence and hire a professional to look over all franchise documentation, rules, regulations and so on. This is to ensure that the business opportunity offered is properly and legally crafted a fit for you as a business model. Insofar as the franchisee is concerned, the franchise contract is legally binding. He commits good money in terms of front-end fees, and expects that the franchisor does honour his contractual obligations. But unfortunately, when the rooster comes home to roost, the franchisee cannot depend on the signed contract. To recover bad money for reason that the contract is a sham, it would only mean, he has to incur additional financial costs which is not recoverable an expense.
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A franchise has its roots in the culture of the place where the franchisor crafts his goods or services. The franchisee is serving a version of what the franchisor has grown up on as a way of life.
The writer makes no warranty of any kind with respect to the subject matter included herein or the completeness or accuracy of this article which is merely an expression of his own opinion. The writer is not responsible for any actions (or lack thereof) taken as a result of relying on or in any way using information contained in this article and in no event shall be liable for any damages resulting from reliance on or use of this information. Without limiting the above the writer shall have no responsibility for any act or omission on his part. Readers should take specific advice from qualified professionals when dealing with specific situations.
Licensing & Franchising Contracts:
Writer: Chén Róng
Owners of small businesses or micro enterprises prevalent in many Asian cities are, at some point, faced with the need to put in more capital and grow, or continue with what they do best and stay small. The financial risks and effort required to grow a small business often prompts many owners to choose the path of inaction. In Singapore and Hong Kong, many small retailers and eateries eventually folded their businesses because of high rentals and competition from established fast food restaurants and chain stores. Others, holding onto their same business model, were seen re-locating to suburbs but only to delay their own eventual demise. Inaction was, therefore, not a good option for them.
Walking along one short pedestrian-street in a Singapore suburb, the writer was able to count more than ten stores all selling hand-phones and these businesses were all owned by young people. These young entrepreneurs probably convinced their parent-financiers that running a small business is more lucrative than working on a nine-to-five job; and the young man is his own boss! Excuse the writer for this remark: while entrepreneurship is a good thing, taking a seemingly easy way out of life is not. A boss probably has to work much harder than an ordinary worker. Perception rarely meets reality. Unless these young self-starters grow their business through licensing or franchising, some may have to close their shops for good. Such may include buying used phones from consumers and reselling them to others, and helping buyers make arrangements with local wireless services to get the phones connected -- all done in an organised and trusted international franchise brand. These consumers are better off buying from a licensee/ franchisee (who can arrange for service) than getting one on-line because there is no guarantee a phone works. This is just the writer having a conversation with himself and thinking it aloud. It takes a creative owner to think carefully if licensing or franchising is a suitable way to expand his business.
Indeed licensing and franchising are two ways through which business owners can quickly grow their enterprises and, at the same time, relegating much of the costs and commercial risks to a third party partner. But there are dissimilar legal implications, and business owners should be mindful of the different requirements and challenges they may face. One observation worth noting is: some franchises include licensing arrangements as well.
When a state government grants a company a license to supply a product or service, the intention is to ensure price-competitiveness. Licensing enables a system of stable, flexible supplies on a tranche-by-tranche basis to take advantage of opportunities arising from changing market conditions. With the same business strategy in mind, private businesses often grant other companies licenses to give them permission to use their intellectual property. In space-constraint Singapore, for instance, small to medium-sized enterprises account for major source of technological adoption and advancements owing to the intensified competitive pressure and necessity for entering global markets and, indirectly adding hundreds of millions to the nation’s gross domestic product.
A license is a contract. One party, the licensor, gives another permission to use its patents, trademarks, copyrights, designs or even trade secrets, although less so. The company, as the licensee, pays the licensor a flat fee, perhaps a royalty or a combination of the two modes. However, the contract does not transfer ownership of the intellectual property. Through licensing, small business owners can expand their commercial reach and grow their activities without having to invest in new premises or distribution networks. The risk of business failure is cut down.
A franchise is a contract. Franchising grows a business in manner similar to licensing but a little more so. It permits the franchisee the use of both intellectual property and operating system provided by the franchise. Hence, in addition to using the franchisor’s trademarks, the franchisee uses his principal's distribution systems, and its sales and marketing campaigns to sell the products and/or services. In return, the franchisee pays an upfront fee plus royalties, and a monthly or annual fee is not unusual. Franchising enables a small business to grow much faster than one without a similar partnership. But unlike a licensing deal, franchising will call for more set-up and investment. Nevertheless, it is a less expensive method than one expanding the business through a new outlet in a different location. For these reasons, drafting a licensing agreement is less demanding and it can be drawn up within a shorter period than a franchising contract. The selection process for a suitable franchisee is also more thorough and lengthy because all parties concerned need march in tune to a standardized internal operation, marketing and distribution system that has been painstakingly put in place.
A franchisor, therefore, maintain strict control over how a franchisee operates; and dictates as to how its intellectual property is used and how products or services delivered to customers. A franchisor usually retains the right to setting of prices. As a trade-off, the franchisor offers support in training staff, site selection and marketing. Such requirements must be reduced to writing, hence making its drafting more fastidious than one involving a licensing agreement.
In a licensing deal, the licensor has little control over the licensee and the way he runs his business. Generally speaking, a licensee can use the licensed property in whichever way he chooses. Over the lifetime of the agreement, which is also not as long as a franchising contract, licensees operate almost independently as licensor provides little, if any, support to the licensee.
What surprises most people are: licensees are often seen competing directly with one another so it does not come as a surprise if the guy next door holds the same licensing arrangement. In other words, with a small geographic region, there may be two or more companies licensed to use the same piece of intellectual property. Whereas every franchisee is usually given an exclusive area, in a designated territory, within which he operates. Some territories can be as small but a good franchisor will usually provide site-selection assistance provision in the contract to limit direct competition between franchisees.
One other problem with licensing is: some companies choose massive licensing over franchising to local dealers - especially in retail - in a fast and inexpensive effort to leverage better distribution channels. Unfortunately, this strategy led to failure for many when their distribution channels went out of control. Fake goods selling parallel to branded ones are inconsistent messages sent to the buying public. It is hard to regain customers trust when they have spent thousands of their own currencies on counterfeits from licensed retailers. Both licensors and licensees will suffer as a result. Careful consideration is needed when choosing between the two alternatives.
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