This is part two in the Potential Pitfalls of Franchising series

In the first article of this series we referred to the need for prospective franchisees, when considering the acquisition of a franchised business, to balance specific risks of franchising with the benefits that the franchisor and franchisee relationship provides to franchisees.

In part two of this series, we consider the specific risks that arise from a requirement that is found in many franchise agreements for the franchisee to purchase approved products, or to purchase products from approved suppliers.

There are several benefits that a franchisee may obtain from an obligation to purchase approved products, or to purchase products from approved suppliers.  These benefits may be direct or indirect.

One direct benefit may arise from arrangements the franchisor enters with a supplier for the supply of products are competitive prices for the products because, at the franchise network level, the franchisor and all its franchisees are purchasing a high volume of products from a supplier. Franchisors often refer to this benefit as bulk buying power, in extolling the virtues of a franchise and the benefits to a potential franchisee of the purchase of a franchise from the franchisor.

Another benefit from the requirement to acquire products from approved suppliers is that the franchisee does not need to search the market for suitable products at competitive prices and supply terms and appropriate for franchise system because the franchisor has done this work for all franchisees.

An indirect benefit is the interest of the franchisor and each franchisee participating in a franchise network of maintaining uniformity and consistent standards in the product or service that a franchisee and other franchisees in the franchise network are providing to consumers.  This is intended to protect the franchise brand.

If one franchisee sells products which are not approved products, or not products from approved suppliers, the products may be of an inferior quality, or the supply of the products may be unreliable.  This may damage not only the franchised business of the franchisee and the franchisee’s relationships with customers and may damage the reputation of the franchise network and its brand.

Unfortunately, the benefits to franchisees of a franchisor’s or franchise network’s bulk buying power may be undermined by arrangements which divert the benefit of bulk buying arrangements with suppliers from the franchisee to the franchisor in the form of rebates, kickbacks or commissions.

There is a risk that the franchisee may not obtain the benefit of competitive prices from bulk buying arrangements between the franchisor and suppliers. The franchisee may in fact be locked into paying prices that are not competitive and above the price of substitutable alternative products from alternative suppliers that are of equivalent or even better quality to the products supplied by approved suppliers.

The importance of this risk is recognised in the Franchising Code of Conduct (Code).  Annexure 1 of the Code sets out the form of a disclosure document to be provided by franchisors to prospective franchisees.  Item 10.1(j) of Annexure 1 requires the franchisor’s disclosure document to disclose whether the franchisor or an associate of the franchisor receives a rebate or financial benefit from the supply of goods or services to franchisees including the name of the supplier.  Item 10.1(k) of Annexure 1 requires the franchisor to disclose whether any rebates or financial benefit are shared directly or indirectly with franchisees.

The benefit to the franchised network overall, and specifically to each franchisee, of uniform and consistent standards may be superficial and no more than an excuse to oblige franchisees to obtain products from approved suppliers to the advantage of the franchisor.  For example, if equivalent products at lower prices are available from alternative suppliers that are substitutable for the approved products in terms of characteristics, quality and supplier terms of trade, or even an improvement on approved products then the approved product or approved supplier obligations of the franchise agreement potentially become a burden and not a benefit to the franchisee.  The franchisee then finds itself in the position where it cannot reduce the costs of goods sold by entering into arrangements with alternative suppliers to acquire products of equivalent or better quality to the approved products but at a lower price.

The potential burden of a requirement to purchase approved products may be exacerbated in franchise systems in which the terms of a franchise agreement provide that the franchisee must maintain a minimum level of inventory or acquire a minimum quantity of approved products.  This is a matter that the Code requires to be disclosed in the disclosure document provided to a prospective franchisee.

There is also the risk that the approved suppliers may not be willing or able to supply approved products when they are needed by a franchisee.  This may be a problem for franchisees in regional areas.  For example, franchisees that provide fresh food to customers may be at a disadvantage in a regional area if the supplier only delivers fresh products to the franchisee’s store once or twice a week and not daily.  This can be very frustrating for franchisees who are aware of local suppliers, who are not approved suppliers, who are able to deliver equivalent or substitutable products each day.

The need to balance between the risk of supply problems from approved suppliers which may impact on one of more franchisees and the benefit to the franchisor and franchisees of uniformity and consistency achieved from an obligation to use only approved suppliers and approved products is recognised in some franchise agreements by terms which provide a mechanism for franchisees to nominate and seek approval from the franchisor to the use of alternative suppliers not previously approved from the franchisor.

This contractual mechanism in the franchise agreement and/or franchisor’s operating manual may include the following elements:

  • written notice by the franchisee to the franchisor of the type and quantity of the products that the franchisee is seeking to purchase from a proposed alternative supplier;
  • the name and address of the proposed alternative supplier;
  • the price the proposed alternative supplier shall charge for each item of the product to be supplied;
  • delivery by the proposed alternative supplier to the franchisor of a sample of the product to be supplied by the proposed alternative supplier to the franchisee;
  • obtaining from the alternative supplier, and providing to the franchisor, a written statement specifying the period (if any) that the price for the product or service will be fixed or capped and the terms and conditions of the supply;
  • satisfying the franchisor that the proposed alternative supplier shall maintain continuity of supply of the product;
  • satisfying the franchisor that the product to be supplied by the proposed alternative supplier meets the franchisor’s minimum quality requirements, and that the product is substitutable for those products supplied by approved suppliers.

Franchisees often complain that the contractual mechanism for approval of alternative suppliers is uncommercial and cumbersome because it takes too long, does not address immediate or urgent supply problems and because alternative suppliers may not be prepared to engage in a time-consuming approval process with the franchisor.  Franchisees may decide to endure continuing supply problems or prices that are not competitive rather than spend considerable time seeking approval of products from alternative suppliers, when ultimately the approval is not obtained.

When franchise agreements contain terms requiring prospective franchisees to acquire approved products or products from approved suppliers, franchisees need to think very hard about the potential benefits and burdens of such arrangements. This is one area of risk-benefit analysis that deserves through investigation by a prospective franchisee.

Bill Morgan is a consultant at Morgan Mac Lawyers and has been involved in complex commercial litigation for over 20 years.  Much of his practise involves franchise law and the resolution of franchise disputes.  Morgan Mac Lawyers have acted for over 40 franchisor or franchisee clients over the last 2 years.

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Bill can also be contacted via linkedIn here.