Franchiser, Franchisees Hammer Out a New Deal

In most franchise systems, the franchisee signs an agreement that boils down to this: you either do what the franchiser says, or you stuff someone else's tacos. But increasingly sophisticated franchisees have begun to challenge that patriarchy, demanding more accountability, flexibility and exclusivity from their franchisers.

The Wall Street Journal
October 8, 2000

Franchiser, Franchisees Hammer Out a New Deal
Christopher Caggiano

Let's say you're looking to buy a fast-food franchise. So you send away for a bunch of marketing brochures, including one from Taco John's International, a chain of 427 Mexican restaurants with sales of $165 million. Initially, the Taco John's material reads no differently from everything else you have spread out across your kitchen table. The literature is peppered with cloying references to "Taco John's and You" and even quotes from satisfied customers and (no kidding) restaurant critics. Standard fare. Then you get to the following passage: "[The Taco John's] Franchise Agreement is one of the most progressive in the industry … the first ever to be developed cooperatively with a franchisee association." Big deal.

Actually, it is.

In most franchise systems, the franchisee signs an agreement that boils down to this: you either do what the franchiser says, or you stuff someone else's tacos. But increasingly sophisticated franchisees have begun to challenge that patriarchy, demanding more accountability (for example, in how their advertising contributions are spent), flexibility (multiple vendors for supplies), and exclusivity (protected territory) from their franchisers. The upshot: franchiser/franchisee relations are often mired in an oh-yeah-says-you mentality not unlike what you'd find at a grammar school playground or a congressional hearing.

In 1992 Taco John's decided to take steps to avoid the legal cat fighting. Its executives hoped a new agreement would also remedy some costly inefficiencies. Since its founding, in 1968, Taco John's had modified its agreement several times to comply with mounting regulations from the Federal Trade Commission, eventually finding itself bound to eight different documents. The varying language made enforcing operational standards difficult. Different agreements also caused franchisees to grumble about inequities.

The folks at Taco John's also sought to add some sizzle to its franchise-unit growth, which had been stagnant for about three years. A more progressive agreement, executives figured, might make Taco John's more appetizing to a more ambitious breed of franchisees. "If someone wants to invest in fast food, they look at the big ones first," says Barry Sims, chief financial officer. "They're never going to look at us in the same light as McDonald's."

Rather than simply presenting new guidelines to franchisees, Taco John's chose to get franchisees more involved. Each side appointed representatives, including Sims on the franchiser side, and Dennis Batteen, president of the Taco John's franchisee association, owner of seven franchises in the South Dakota area, and a practicing lawyer. All agreed on one point up front: they didn't want their attorneys to control the process.

Even so, at one point the negotiation nearly reached an impasse. The subject, interestingly enough, was conflict resolution. Both sides agreed that arbitration was the preferred route. But they differed about how to resolve "class action" cases. Sims was leery. "If a majority of franchisees got together, it could hurt the whole system," he says. But the franchisees wanted to be able to pool their claims.

Eventually, they found compromise in "consolidated" arbitration. This allows claimants to pool together, as long as they don't exceed 15% of total restaurants. Both sides accepted that arbitrary percentage as large enough for the franchiser to take notice, but not so large as to imperil the entire company.

Sims's goal, however, was to avoid arbitration entirely by increasing franchisees' involvement, partly through the franchisee association, which the new agreement formally recognized. The agreement also reorganized the operations committee to include four franchisees. "Franchisees get an early-on look at future product development, and aboveboard disclosure of product markup," says Batteen. "So we deal with any operational problems before they get out of hand." The result: Taco John's has reduced the lawsuits listed in its offering circular from four pages of suits to just four suits. And whereas many franchisers retain a lot of in-house counsel, Taco John's has a legal staff of one.

Sims also reports that operational standards have improved: the average quality, service, and cleanliness (QSC) score for franchisees has risen from 70 to 80 (out of 100). Batteen says 85% of franchisees have voluntarily signed the new document, an indication they're happy with it. "And if you have happy franchisees," he adds, "you have a lot fewer problems to deal with."

Resolving the Tough Issues
Here's how Barry Sims and Dennis Batteen resolved the toughest issues in writing a franchising agreement.

Protected territory is always a thorny issue. Franchisers want (and often have) the power to open new franchises nearly anywhere they want – even right across the street from an existing franchise. Franchisers call it "market penetration." Franchisees call it encroachment and have been demanding some kind of exclusive territory.

"We will not establish, operate, or grant a franchise for the operation of a Taco John's Restaurant within the 'Protected Territory.' … In the event …we or a prospective franchisee identifies a location within one (1) mile outside the boundary of your Protected Territory which we believe to be suitable for the development of a Taco John's Restaurant; or we or a prospective franchisee identifies a location within your Protected Territory which we believe to be suitable for development of an Affiliated Business (as defined below) … we shall first offer you a franchise for such location under the terms and conditions of our then-current franchise agreement for a Taco John's Restaurant… . [Y]ou may exercise your right of first refusal by identifying another accepted location in that trade area within the sixty (60) day notice period."

Under the old Taco John's agreements, most franchisees did not have protected territories. Territory is now generally defined as a five-minute-drive radius around the store, plus an additional one mile wherein the franchisee has right of first refusal. Sims knew this might hamper the growth of Taco John's, but he believed franchisees would act sensibly. Says Batteen: "If they can make the case that there should be another store in my area, I say go ahead. I'll put it in myself."

"We will not allow the distribution of [our] products … through a retail outlet located in your Protected Territory unless we receive the approval of the majority of those franchisees in whose protected territories such retail outlets are located… . An 'Affiliated Business' as referred to above shall be defined as a Mexican food restaurant or other Mexican food distribution outlet (other than a Taco John's Restaurant as defined below) which is operated by us or our affiliates under the Marks or other marks where we or our affiliates have the right to grant franchises for such restaurant or outlet."

One of the first tests of the new agreement and negotiation process came this year when Taco John's rolled out Taco John's Mexpress, an alternative distribution system using freestanding carts and kiosks. The franchiser figured since the carts and kiosks weren't entirely new franchises, they didn't represent significant competition. The franchisees disagreed — loudly. But, says Sims, Taco John's eventually came to see that "our franchisees played an integral role in building our brand, too." The agreement was modified to say that Taco John's won't expand Mexpress in a franchisee's protected area without written franchisee authorization.

* * *

Supplies. Most franchisers require franchisees to buy supplies or ingredients from one source or a list of approved sources, even if items can be found cheaper elsewhere. This purportedly provides economies of scale, protects trade secrets, and helps the franchiser maintain product consistency. The Taco John's franchisees, although they recognized the need to control product quality, wanted to be free to shop around. "But too many sources for a company our size is not economically feasible," argues Sims. "We don't have the same distribution clout as Hardee's or Burger King." They compromised with multiple sources for all equipment and non-proprietary items. Franchisees who find a better price from an unapproved source can submit a request to get the source approved.

"You agree that the Restaurant will: purchase all food products and beverages; menus; paper and plastic products; packaging or other materials; and utensils, only from distributors and other suppliers we have approved… If you would like to purchase any items from any unapproved supplier, you must submit to us a written request for approval of the proposed supplier."

* * *

Advertising. Another common franchisee complaint is that while franchisees must contribute a percentage of their sales toward an advertising fund, they have no say over how that money gets spent. At Taco John's, both sides knew they were being outspent on media (where and when advertising will run) and production (the actual creation of ad materials). The old contract specified a franchisee media contribution of 2% of sales, but competitors were spending 4% and up. They compromised on 3%. They also set the advertising production contribution, which had varied in previous agreements, at 0.5%. Either side can change these percentages: the franchiser needs approval from a majority of franchisees, whereas the franchisees can adjust the rates with a two-thirds majority vote. And while the franchisees have no say in media allocations, they do control the advertising production committee, so if they don't like how a campaign has been designed, they can simply vote not to give it a production budget.

"You agree to pay us … an advertising media fee … equal to three percent (3%) of the Net Sales of the Restaurant… . The Advertising Media Fee may be increased or decreased by no more than one-half of one percent (0.5%) per calendar year upon the affirmative vote of two-thirds (2/3) of the Taco John's franchisees… .

"You agree to pay to the Advertising Production Fund … [a] fee of one-half of one percent (0.5%) of the Net Sales of the Restaurant… . The Advertising Production Fund will be administered by … the 'Advertising Production Committee' … which will be made up of both Franchisees and our representatives… . The Advertising Production Committee will determine what materials will be produced using the Advertising Production Fund… . "

* * *

Franchise standards. The franchisees wanted the franchiser to have the power to come down on franchisees who weren't complying with standards. "We didn't want to take any teeth out of the document," says Batteen. The agreement grants a period of 30 days for franchisees to remedy any transgressions. (Many agreements specify a 30-day period for the franchiser but none for the franchisee.) The franchiser doesn't have to wait 30 days if there's a risk to the entire system, like a rogue franchisee endangering the public health with an Escheresia coli problem. "This protects our investment," says Batteen. Some franchisors yank licenses first and ask questions later. "We would like to have had more teeth here: how much more can you be harmed in 30 days?" says Sims.

"To renew the Franchise, the Franchisor, the Franchisee and its owners shall execute the form of standard franchise agreement … we are then customarily using in the grant or renewal of franchises… . Those agreements may contain royalty, advertising and other fees that differ from those contained in this Agreement… . "

Franchisee advocates have griped about how inequitable it is for franchisees to have to sign a different agreement when they renew after their initial term expires. But Taco John's management and the franchisee representatives believed that there's no way the franchisor could look 20 to 30 years into the future. "Who knows what the industry will look like in 2015?" says Sims. "There's got to be the flexibility that you get a then-current document when you renew." Says Batteen, "They could really put it to us and change things completely. But the new agreement also gives us remedies we could use against them," such as the aforementioned arbitration.

"We shall have the right to terminate this Agreement effective upon delivery of notice of termination to you, if you … [f]ail to develop or open the Restaurant as provided in this Agreement … provided that you will have thirty (30) days from receipt of written notice from us to cure any of the aforementioned defaults provided however that termination by us will not be arbitrary or capricious when compared to our actions with respect to other franchisees in similar circumstances. Furthermore, we shall have the right to terminate this Agreement … if you … [o]perate the Restaurant in a manner that imminently endangers the public health and safety… . "

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Risks: Ineffective marketing, Secret kickbacks and rebates, Gouging on supplies, Encroachment (too many outlets in area), Franchisee association, independent, Must buy only through franchisor (tied buying), McDonald’s of…, McDonald’s, Advertising fund use disagreements, Renewing contract much tougher, Franchisees more willing to speak up, United States, 20000808 Franchiser

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