The issue of identification and management of risk is always important in business and finance. For example, the old adage, ‘don’t put all your eggs in one basket’ identifies a risk that may apply to an investor. The risk identified is investing in one asset that sharply falls in price. The investor manages this risk by holding a diversified portfolio of different assets in different asset classes.
In franchising risks are distributed between the franchisor and the franchisee by means of the franchise agreement and the franchise system. What does this mean? Well we can start by recognising that the primary risk in business is not making profits and business financial failure.
Franchisors recognise this risk and use various devices to manage this risk primarily by distribution of risk of business failure so that it falls heavily on the franchisee. The main device to achieve this favourable outcome for the franchisor is the term in the franchise agreement that provides for a royalty or franchise fee to be paid by the franchisee as a percentage of turnover or gross income.
Imagine if the royalty was based on a percentage of profits. If the franchisee’s franchised business makes no profits, then the franchisor earns no royalties even though the franchisor may provide services such as support and training to the franchisee. If there are too many franchisees in the franchise network not making profits, then the franchisor’s business, which is managing the franchise network and earning income at least in part from franchise royalties, would be at greater risk of financial failure.
Franchisors know this and they want to be paid no matter how the franchisee is going in the franchised business. If the franchisor obtains a percentage of the franchisee’s gross income, even if the franchisee after payment of expenses such as wages, rent and electricity, makes a loss then the franchisor will be entitled to payment of the royalty even if the franchised business is failing.
This does not mean that the franchisor wants the franchisee’s business to fail. There remain risks to the franchisor if the franchisee’s business fails including the risk of legal disputes (franchisees tend to blame the franchisor), the difficulty of finding a new franchisee if the franchisor is holding the head lease for the franchisees business premises, the reputational damage inside and outside the franchise network, and the triggering of certain disclosure obligations to prospective new franchisees about the closure of the franchisee’s business. Despite these risks, the mechanism of charging royalties based on gross income or turnover tilts the distribution of risk of business failure heavily towards of the franchisee to the benefit of the franchisor.
Other terms of the franchise agreement can reinforce the benefit of the royalty structure to the franchisor and distribution of risk towards the franchisee. For example, even with the royalty structure we have discussed, the franchisee may withhold payment of royalties if the franchisee is making trading losses. A practical self-help attempt to even out the ‘risk’ score.
Would that work? Not so fast. There may be a term in the franchise agreement that prevents such self-help measures by the franchisee and allows the franchisor to collect all the income paid by customers of the franchised business and take its royalty before distributing the balance to the franchisee. Alternatively, there may be a term requiring a direct debit be set up that allows for the automatic debiting of the franchisee’s bank account to ensure payment of the royalty.
Now on top of these arrangements and the effect that have on distributing risk to the franchisee, imagine a clause that obliges the franchisee to buy goods or products needed in the franchise business, in many cases for on sale to customers, from the franchisor or preferred suppliers of the franchisor. Imagine further that the prices the franchisee pays are not the best prices that franchisee could obtain from sourcing alternative suppliers not preferred by the franchisor who offer comparable or better quality products.
The franchisor may enjoy the preferred supplier arrangements with the preferred supplier and may receive a benefit from the supplier but it may not be a good outcome for the franchisee. Of course, the franchisor will justify the obligation imposed on franchisees to buy goods from preferred suppliers by stating it is to ensure uniformity in the franchise network’s product offering and to obtain benefits from bulk buying if all franchisees (particularly in a large franchise network) buy from the preferred supplier.
The risk of such arrangements falls on the franchisees. If the price they pay the preferred suppliers are not market competitive then the franchisee may struggle to make sales to customers if the franchisee adds a decent mark-up or to make sales the franchisee will need to cut the margin they add to the price they paid the preferred supplier.
The above terms in a franchise agreement show how risk is easily transferred to a franchisee. The franchisee is obliged to pay an agreed and fixed percentage of turnover to the franchisor as a royalty, This may often in our experience be between 6 to 10%. It must pay this regardless of whether its business expenses are so high that it is making trading losses or experiencing cashflow difficulties. To make matters worse, if turnover is particularly bad one week or month the franchisee simply cannot defer or withhold payment of royalties (although many franchisors who care about franchisees may give them payment relief) because certain terms in the franchise agreement may prevent the franchisee withholding payments until sales improve. On top of this the cost of sales may be unnecessarily high or gross profit margins reduced by uncompetitive prices the franchisee must pay preferred suppliers from whom the franchisee must buy products.
This unfavourable distribution of risk is not a reason for a franchisee not to buy a franchise and there are often corresponding benefits in the franchise business model. The above scenario is plausible but many franchise systems are not this severe in practice. However, it shows the need for franchisees to recognise that franchise systems are designed and franchise agreements drafted to transfer risks to the franchisee and minimise risks to the franchisor. It is important that franchisees recognise this and obtain commercially orientated legal advice that inform them of such risks and the legal consequences of such risks.