SUPPLYING THE FRANCHISE SYSTEM
CO-SPRING 2010Author :
John Sotos 
Lawyer, Sotos LLP
John Sotos is a lawyer with Sotos LLP. He specializes in domestic and international franchise, licensing and distribution law with a large national and international client base. Represents franchisors in connection with franchise transactions, workouts, defaults, purchases and sales of franchise networks, master franchising and creditor and debtor rights on both franchisor and franchisee insolvencies.
Franchisors often regulate the supply of products that its franchisees must purchase in operating their particular unit in order to ensure a consistent and uniform guest experience for system customers. Standardization of supply can not only promote operational efficiency, but it may be necessary in order to protect the franchisor’s trade secrets and other confidential information. However, when deciding what form of supply system to implement, a franchisor must be careful to consider the reasons for compelling a purchasing requirement on the franchisee and to what extent it will be involved in setting the prices paid by the franchisee. If it does not do so, a franchisor will likely face backlash from its franchisees for the supply system that the franchisor adopts.
There are a number of methods that a franchisor can use to control the purchase of supplies by the system. On the most controlling end of the spectrum, the franchisor can require that the franchisee purchase all of its product requirements directly from the franchisor. This is most common where the goods ultimately being sold by the franchisee are of a proprietary nature and so the franchisee cannot obtain the goods from third-party suppliers. Where the franchisor does not produce or distribute goods itself, it may designate suppliers from which its franchisees must purchase. Under this method, the franchisor is involved in negotiating the supply contracts with the designated suppliers in order to obtain the lowest price and best terms for its franchisees. Some franchisors use this opportunity to take rebates and/or have the suppliers contribute to the system advertising fund.
Moving down the spectrum on levels of control, a franchisor may approve a number of suppliers as meeting its specifications for system product purchases, leaving the purchase decision to the franchisee of which approved supplier to buy from. Under the approved supplier method, because the franchisor cannot ensure any supplier of all of the system volume, the price is not likely to be as advantageous as in the case when all of the supply will originate from a particular source.
Finally, a franchisor may simply provide the franchisee with product specifications and expect the franchisee to source the product itself that meets the specifications that the franchisor provides. This method allows the franchisee to negotiate the prices it will pay so that it is not locked into prices set by the franchisor, but it doesn’t give the franchisees the benefit of collective purchasing power unless a buying co-operative is formed by the franchisees.
Another important consideration for a franchisor in deciding on how to implement the supply system is whether it wants to use the supply system as a profit centre. When the price being paid by the franchisees reflects a profit factor, the relationship between the franchisor and franchisees can become strained and deteriorate. One of the perceived advantages of buying a franchise versus an independent business is the collective purchasing power of the system. If the franchisee cannot procure its supplies at a better price than it could as an independent without any volume purchasing power, the business case for buying a franchise and paying royalty and other fees is significantly diminished. Affording the franchisee the benefit of collective purchasing power on the other hand allows the franchisee to be better able to respond to competitive forces in the marketplace. If the franchisee’s hands are tied because of high prices and it cannot properly adjust to external forces in the marketplace, there is a greater chance that the franchisee will fail and go out of business.
Although the most efficient system is using a designated supplier, there must be protection against treating it as an expanding profit centre. While using the supply system as a source of profit can be tempting for franchisors, some of the most successful franchisors do not profit from the purchase of supplies by their franchisees beyond recovering supply function costs and other reasonable amounts which benefit the system as a whole. In fact, Ray Kroc, the founder of McDonald’s franchising, was conscientious about avoiding friction with his franchisees and to this day McDonald’s does not profit from the supply relations of its franchisees.
Regardless of what form of supply system a franchisor selects, it is important to keep front line competitiveness as the primary guide to making this decision as opposed to tapping supplies as a profit centre. A decision to forgo revenue from this source may mean that the royalty needs to be adjusted upwards. If a franchisor does take supply monies, it is best to cap them by contract, otherwise the temptation to tap into such revenue source may be difficult to contain leading to franchisee dissatisfaction and system-wide litigation.
There are a number of methods that a franchisor can use to control the purchase of supplies by the system. On the most controlling end of the spectrum, the franchisor can require that the franchisee purchase all of its product requirements directly from the franchisor. This is most common where the goods ultimately being sold by the franchisee are of a proprietary nature and so the franchisee cannot obtain the goods from third-party suppliers. Where the franchisor does not produce or distribute goods itself, it may designate suppliers from which its franchisees must purchase. Under this method, the franchisor is involved in negotiating the supply contracts with the designated suppliers in order to obtain the lowest price and best terms for its franchisees. Some franchisors use this opportunity to take rebates and/or have the suppliers contribute to the system advertising fund.
Moving down the spectrum on levels of control, a franchisor may approve a number of suppliers as meeting its specifications for system product purchases, leaving the purchase decision to the franchisee of which approved supplier to buy from. Under the approved supplier method, because the franchisor cannot ensure any supplier of all of the system volume, the price is not likely to be as advantageous as in the case when all of the supply will originate from a particular source.
Finally, a franchisor may simply provide the franchisee with product specifications and expect the franchisee to source the product itself that meets the specifications that the franchisor provides. This method allows the franchisee to negotiate the prices it will pay so that it is not locked into prices set by the franchisor, but it doesn’t give the franchisees the benefit of collective purchasing power unless a buying co-operative is formed by the franchisees.
Another important consideration for a franchisor in deciding on how to implement the supply system is whether it wants to use the supply system as a profit centre. When the price being paid by the franchisees reflects a profit factor, the relationship between the franchisor and franchisees can become strained and deteriorate. One of the perceived advantages of buying a franchise versus an independent business is the collective purchasing power of the system. If the franchisee cannot procure its supplies at a better price than it could as an independent without any volume purchasing power, the business case for buying a franchise and paying royalty and other fees is significantly diminished. Affording the franchisee the benefit of collective purchasing power on the other hand allows the franchisee to be better able to respond to competitive forces in the marketplace. If the franchisee’s hands are tied because of high prices and it cannot properly adjust to external forces in the marketplace, there is a greater chance that the franchisee will fail and go out of business.
Although the most efficient system is using a designated supplier, there must be protection against treating it as an expanding profit centre. While using the supply system as a source of profit can be tempting for franchisors, some of the most successful franchisors do not profit from the purchase of supplies by their franchisees beyond recovering supply function costs and other reasonable amounts which benefit the system as a whole. In fact, Ray Kroc, the founder of McDonald’s franchising, was conscientious about avoiding friction with his franchisees and to this day McDonald’s does not profit from the supply relations of its franchisees.
Regardless of what form of supply system a franchisor selects, it is important to keep front line competitiveness as the primary guide to making this decision as opposed to tapping supplies as a profit centre. A decision to forgo revenue from this source may mean that the royalty needs to be adjusted upwards. If a franchisor does take supply monies, it is best to cap them by contract, otherwise the temptation to tap into such revenue source may be difficult to contain leading to franchisee dissatisfaction and system-wide litigation.