Franchising Inquiry Submission - Case Study Example

1. Franchisee Background The franchisee consists of five people who have pooled together their retirement proceeds to setup a business. The members of the group were former colleagues who have received as reasonable amount of pay after their company decided to relocate and an option for early retirement was made available. The members initially agreed to pool $1 million as starting capital each contributing $200,000. The fund was designed to explore business opportunities especially in Australia’s budding franchise industry. At present, there are several options available for the group to consider. But the group wanted to focus on food either establishing their own restaurant or acquiring a franchise of a reputable restaurant or fast food brand. 2. Executive Summary The group has decided to acquire a franchise of The Greasy Spoon, which is a well-known restaurant serving fried food. The Company was established in 2001 and has approximately 30 stores in Australia. All The Greasy Spoon stores are not Company owned and are available mostly in shopping malls. The stores are mostly located in Brisbane and Perth but the founders of The Greasy Spoon are planning to expand in New Zealand. The franchisee would propose setting up a Greasy Spoon franchise in Sydney. As for the location, the Queen Victoria Building appears to be an ideal place for the store. The five individuals comprising the group will also be in-charge of managing the store. The outright franchise fee for the store is $60,000 and the estimated start-up cost for the new franchise is $500,000. The owners of the franchise charge 15% royalty fees without marketing levy. Based on the 2008 Franchising Survey conducted by the Griffith University, food and accommodation services rank as second as the most preferred franchise in Australia. In terms of units, the aforementioned industry ranks as number one in number of units franchised. Overall, the franchising industry has improved by 15.4% as compared to the figures in the previous years. Business format franchises in 2007 amassed a total of $61 billion (Frazer, Weaven and Wright, 2009). 3. Terms of Reference The Ministry of Small Business and Economic Development seeks for some clarification regarding existing laws governing franchises. In Australia, there is no private group that oversees the welfare of franchisees and also ensures that clauses in franchise agreements are adhered to. But there have been rumors circulating that some franchisees are starting to gather to discuss the possibility of establishing a group catered to franchisees. 3.1. Guaranteed Annual Profits There is no substantial literature that supports the notion that the franchisor needs to provide revenues to franchisee at certain agreements. According to the Griffith University website, Go Sushi offers $100,000 guaranteed net profit for the first year to franchisees. This deal assumes that the franchisees to follow agreed system operations and reporting requirements. The offer is rare among franchisors but Go Sushi implies confidence that their franchisees will have success in selling their food. A study made by Griffith University highlighted a failed effort to promote the aforementioned deal. Kleins is a large clothing retail firm that introduced guaranteed profits to franchisees. When the deal was introduced in 2004, guarantees ranged from $60,000 to $100,000. From mid 2005 until 2006, guaranteed annual profit increased to $70,000 and some received $125,000 annual guarantees. But in May to August 2006, Kleins decided to reduce the guarantees to a range of $60,000 to $85,000. Until the Company decided to remove the guaranteed amount and instead promoted the tag “strong return of investments”. After Kleins franchising collapsed, more than 130 franchisees were affected. The conclusion of the study cautioned future franchisees to review these deals. Another important point made by the study is for franchisees to seek professional help before resorting to any franchise deals. In relation to the Greasy Spoon plan, the study strongly underlines the difference between guarantees for service and product franchises. Product franchises which included food and clothing have high operating costs. But the most critical costs are usually fixed making guaranteed income unviable. The Greasy Spoon franchise, however, will be wholly owned by the franchisee. Hence the profitability burden is solely dependent on the efforts of the franchisee. Moreover, the group decided to acquire the franchise based on the brand and quality of food served at the Greasy Spoon. 3.2. Pre-franchise Education The Australian government does not implement mandatory education to groups and individuals aspiring to own franchises. Aside from the usual permits and tax reporting schemes, the government has no clear plan as to educating franchisees. There are several reasons why the government should take a look at institutionalizing such requirement. First, owning a franchise does not really require a degree from a university. The survey of Griffith University stated that 58% of franchisees have no direct education on the business nature of their franchise. This implies that franchisees see success is not dependent on managerial experience in the industry. Another important aspect made by the survey is that about half of the franchisees have not completed post secondary education. The success of a franchise is achieved when all aspects are considered. Managing and market know-how are vital in day-to-day operations. Also, knowing franchise cycles and consumer behavior is critical in ensuring sustained success. Pre-franchise education goes beyond orientation but also allows franchisees to see the big picture. A pre-franchise program conducted by Griffin University provides a wide scope of learning to franchisees. There are other institutions in Australia that provide similar programs catered to various forms of franchises. The government needs to understand that franchises serve as the franchisees major investment. Much like stocks and back accounts, the government needs to protect the welfare of franchisees. Protection of investments starts with knowing the ins and outs of franchises and checking of current trends. Programs designed to educate franchisees are useful in ensuring the proper decision making processes are followed. Another reason why the government needs to require pre-franchise education is to sustain the growth in the industry. As mentioned previously, revenues from franchising in Australia is already north of $60 billion. Prospect franchisees are better encouraged when education programs exists or are required. The government has the capacity to make their own programs partnered with institutions such as Griffin University. This requirement shows sincerity on the part of the government to improve the industry. Also, this will promote due diligence which is important to improve the success of franchises. Government participation also provides an avenue for franchisors to provide their inputs. 3.3. Services Agreements When agreement is made between a franchisor and a franchisee, there are some clauses that need to be specified. The first aspect involves the nature of service or the specific product that the franchisee will serve to the market. The franchisor needs to provide a guide on how a particular product is prepared or processes needed to deliver a particular service. For instance with The Greasy Spoon, the franchisee has to be provided with the ingredients, recipe, and equipment to prepare the food. The specific requirements to produce each item need to be identified in the annex of contracts sign by both parties. Another important aspect of the contract should involve the delivery of supplies. In most instances, there are schedules set by both parties when the products would be delivered. The franchisor must ensure that proper inventory schemes are installed to improve the supply chain. The franchisee, on the other hand, also has to establish mechanisms to further improve supply levels. There have cases before when supply problems have ended franchises. To avoid this issue, the contract must be able to stipulate the roles of each party. Communication is always a key in successful franchises. The Griffith University survey mentioned that most respondents identified open communications as vital in the success of franchises. The give and take relationship is important because there should be an after sales service on the franchisor’s part. Also, communication helps in addressing disputes and when there are disagreements between both parties. The contract needs to provide ways on how the franchisor will communicate when the franchisees have needs. An article by Elizabeth Spencer (2006) noted that uniformity in contracts is crucial in the success of franchises. The franchisee and franchisor needs to identify sections of the contract that are non-negotiable and also draft circumstances that will allow flexibility for adjustment. Also, the article listed some of the factors that help sustain long term franchises. These include the service delivery of the franchisor, adjustable system administration, high financial gains and the manner in which the franchisor resolves issues and other disputes. 3.4. Termination of Agreement The Franchise Agreement Draft provided by Butterworths suggests termination clauses only on the side of the franchisor. There were several instances when the problem was on the side of the franchisor and there are no clear laws as to how this problem in addressed. A study conducted by CPA Australia (2006) underlined the observation that franchise agreements have been silent when dealing with franchisor failure. In cases of insolvency, franchisees are viewed as unsecured creditors much like an employee-company relationship. The current law suggests that there are no legal rights that a liquidator must recognize. Therefore, dealing with insolvency has to be indicated in the contracts signed between franchisor and franchisee. The relational contract model is a classic model that explains the basis for establishing franchises. Relational contracts try to document and include continuing process among entities with interest including business relations. The franchisor and franchisee are bound by the franchise agreements; however, the franchisor has the legal capacity to explore franchise possibilities. One of the challenges seen in this contract is that on parties on a contract can sue for breach of contract. Franchisees are usually disadvantaged because the privity of contract is applied and limits franchisee to sue only the entity where it has a contractual relationship. In most cases, franchisors conduct their business through multiple entities. The franchise model exhibits a relationship between a franchisor and a franchisee governed by contracts and should comply with the rules set by the Franchising Code of Conduct. Hadfield (1990) stated that franchisees own majority of the assets and the right to these resources are jointly determined by both parties. Franchisors usually place franchisees in a situation where the assets become vulnerable when the franchisor becomes insolvent. To present this from happening, the study suggested establishing a national franchising system, and including master franchises and area developers. The federal government serves are the regulator of insolvency in Australia. For individual franchisees, the Bankruptcy Act of 1996 serves as basis for making insolvency decisions. Group franchisees and franchisors are often referenced to the Corporation Acts of 2001 for insolvency issues. The general purpose of bankruptcy law is to allay a protective and ordered mechanism during financial distress; to facilitate the equal contact by creditors to a debtor’s assets in order to pay them for their loss; and to allow individuals to revive their livelihood (Keay and Murray, 2002). Unless a franchisee is a creditor, there is no opportunity in the insolvency rule for the former to have an impact in the franchisor’s insolvency and more importantly in the franchisor’s assets. The abovementioned models suggest that there is no clear policy as to how the franchisees could recover their losses due to franchisor insolvency. Perhaps the best way to tackle the issue is to ensure that such possibilities are detailed in the contract. Insolvency is certainly an event both the franchisor and franchisee want to avoid. But there are instances when such problems occur. The models above provide several ways in which both parties can manage insolvency problems. 3.5. Buying Back Franchises The Butterworths Draft suggests that the franchisor has the capacity to discontinue the franchise if the franchisee fails to perform according to the agreed terms. But there was nothing indicated that the franchisor can buy the franchise instead. Before establishing performance, there needs to be a standard criterion that should be followed and stipulated in the contract. One of the many issues involving franchises includes the presence of rouge franchisors. A House Inquiry conducted by the Australia Parliament has received several complaints about churning. This is the process where a franchisor buys back a franchise cheap then sells the franchise to a new franchisee above what was initially used for the buy back. One example was raised in West Australia where a franchisee continuously traded with the franchisor despite the franchisee’s insolvency. The trade continued to the point when the franchisor pressured the franchisee to sell the franchise at a lower price because of the latter’s increasing debt (About the House, 2008). The franchisor could be allowed to buy back the franchise only on these conditions. When the price of the buyback is fair as determined and agreed by both parties. The franchisor and franchisee would have their own computations and determine an agreeable price. Franchise buy back should be done only when there is an indication that the franchise is not profitable and the franchise has clearly affected the brand of the franchisor. The franchisor is not the sole determinant of this as third party consultants would be commissioned to provide the needed advice. Finally, there are to be a period wherein the franchisor is not allowed to sell the franchise upon buying back. Most important, the previous owner of the franchise is the priority if the previous franchisee has established capacity to operate the franchise. 4. Recommendations The Greasy Spoon franchise is expensive to operate hence the prospect of guaranteed profits should be discounted. The most important aspect of the franchise is that the franchisee will have full ownership of the assets hence profits will be determined by the franchisees success in managing the store. The group planning to setup the franchise needs to be educated as to how the industry operates as a whole. There are programs available conducted by institutions to boost the knowledge of the franchisees. Aside from knowing the macro, the group has to be aware of specific trends and the patterns observed among consumers. Although learning would mean additional cost, the returns would make such a wise investment. The Contract has to include the processes required to produce quality food within the Greasy Spoon standards. Manuals, training and guides have to be accorded and included in the must do list. In addition, communications schemes need to be outlined as well as the supply chain specifically delivery schedules. Finally, there are two other elements that must be present in the contract. The first involves processes to be used when a franchisor goes under. The arrangement has to be clear on what is next should there be insolvency. The second aspect involves the franchisor buying back the franchise. Although in essence there is nothing wrong with this practice, the contract needs to prevent abuses particularly churning. References About the House, (2008), “Hook, Line and Sinker” Retrieved, 10 October 2011, from: CPA Australia, “When the Franchisors Fail” Retrieved, 10 October 2011, from: Fraser, L., Weaven S., and Wright O. (2009), Griffith University, “Franchising Australia 2008 Survey” Franchise Council of Australia Griffith University, “Free Franchise Education turns 1”, Retrieved, 10 October 2011, from: < http://www.franchise.edu.au/articles/free-franchise-education-program-turns-one.html> Griffith University, “Go Sushi offers profit guarantee” Retrieved, 10 October 2011, from: < http://www.franchise.edu.au/blog558/Go-Sushi-offers-profit-guarantee.html> Hadfield, G. (1990), Stanford Law Review, “Problematic Relations: Franchising and the Law of Incomplete Contracts” Pp. 927-992 Keay, A. and Murray, M. (2002), Law Book Company, “Insolvency: Personal and Corporate Law Practice” Pp, 17-18 Spencer, Elizabeth, “Making the most of the franchise agreement” Retrieved, 10 October 2011, from: < http://www.franchisebusiness.com.au/c/Franchise-Council-of-Australia/Making-the-most-of-the-franchise-agreement-n856428> Read More