April 2012 Archives

California is rightly the envy of all for its commitment to public education, consumer protection and sophisticated agribusiness.

However, the current legal franchise model allows franchisors to either deliberately or inadvertently skirt their civic responsibilities.

First, Franchising needs to return to its roots, in which the franchisor set quality control standards for a reason and not just to trap the franchisee into paying for high fees to the preferred suppliers, who then kickback  money to the franchisors.

The standards which protect the food supply chain are too important to leave to the federal government to enforce.  We need the unintended good consequences of brands maintaining quality control and funding the appropriate training and education.  

We don't need, however, a kickback economy.

Second, the current legal franchise model has an unbalanced picture when it comes to information: there is no legal balance between what the franchisor markets the benefits of the system and what the franchisor is contractually obligated to perform.

Private Brand Standards and Public Safety

To understand the first benefit of Bill AB 2305, we have to return to 1950-1970, when McDonald's enforcement of private brand standards were of assistance to the public good and helped maintained a safe food supply chain.

Ray Kroc's franchise model - complete with Hamburger University and passing on volume pricing rebates to the operators- had quality control standard which had a beneficial and unintended good consequence. Kroc's enforcement of private standards produced a safer food supply chain for the public. Sadly, Kroc's vision is not upheld by many modern franchisors.

To see how Kroc's system worked, we have to pay attention to some details.

In the 1970's, Kroc and McDonald's set quality control standards and operating standards. But, the operators purchased food from local sources.

Here is just one clever example of how the private brand's standards had a public benefit. Kroc shipped hamburger buns in package containing enough to make 100 hamburgers. The operating standard was that an operator should go through 100 patties for each package of buns. If the operator went through more, say 110 patties, then:

"Either his meat man was shorting him or someone else was stealing from him."

A meat man who would cheat on weights and measurements is a risk to public safety.  Kroc would have the meat man dead to rights, if he was found to be cheating.  

Today, we have more difficult contamination problems to detect and solve.

But, today many brands set standards for a different reason.  They require the operators to purchase from preferred vendors. Many of these preferred vendors are simply competing on cost - how much money they can rebate to the franchisor? There is no legal requirement for the vendors to compete on value and safety.

To understand why the modern franchise standards don't produce a public good, we have to understand how legal kickbacks work in the franchise industry.

Current Brands - The Kickback Problem

The franchisors you hear from today will tell you how strong their standards are. But, what they will not tell you is is the reason for these strong standards.

Many franchisors have used the current legal model to primarily obtain kickbacks or commercial bribes from their suppliers. The franchisor mandates that the franchisees purchase supplies, at an artificially high price.  The supplier then splits all or some of this extra price with the franchisor. This is perfectly legal as long as it is adequately disclosed.

The franchisor may elect, and many do, to report these kickbacks as essentially royalty income on their intellectual property and transfer the money out of state without paying California state income tax.

But, you will rightly feel uncomfortable with this arrangement, whether or not legal. Kroc was appalled by it.

A supplier who was being richly reward by his business relationship asked Kroc what he might like in return.

"Let's get this straight. I want nothing from you but a good [safe] product. Don't wine me. Don't dine me. If there are cost breaks, pass them on to the operators."

Promises to the Small Business Operator and Consumer

The second benefit of Bill AB 2305 is to protect the consumer, the consumer of information seeking to purchase a franchise. If the brand markets to prospective purchasers by making promises about volume rebates, quality standards, or continuous training, then their legal obligations in the franchise contract will have to match these promises.

Currently, most brands are only contractually required to provide sufficient training to open a location.

Further, the brands are only required to disclose somewhere in the fine print of a 500 page plus "Disclosure" document in legalese that the operator can only expect sufficient training to open a location and there are no price discounts.

But, of course these truths make hard marketing. Bill AB 2305 simply requires the brands balance their marketing hype with what the franchise document delivers by not allowing the brands to disclaim or ignore its marketing promises by disclaiming them in the franchise agreement.

The Benefits of Balance

A return to a balance in which quality standards are used to strengthen a brand, and indirectly contribute to public safety, franchisors who live up to their marketing promises will protect the small business operator and consumer.  We can do no better to reflect upon Kroc's view of franchising.

"We are an organization of small business [operators].  As long as we give them a square deal and help them make money, we will be amply rewarded."

Bill AB 2305 provides that square deal for franchisees, and the franchisors, consumers and public will be amply rewarded by its passage.

Californians need jobs.  Franchising has historically provided those jobs in the hotel, restaurant and service industry. Without a change which rewards franchisees as owners, risk capital will not be attracted to California. California will lose out on job creation, and its budget woes will be worsened if the Level Playing Field for Small Business Act of 2012 is not passed, Bill AB 2305. 

California, the spiritual home of franchising

California and San Bernadino are the spiritual home of franchising.  In the late 50's, the McDonald brother's restaurant routinely recreated the secular miracle of feeding the hungry with a nutritious and delicious 15 cent Hamburger Meal -burger, fries and a milk-shake.

But, it took the owner of a franchised business, franchisee Ray Kroc from Chicago, to export California's golden miracle. Ray Kroc formalized the McDonald's brother's system. Ray Kroc created the scalable restaurant system - as a franchisee.

Before he bought out the McDonald's brothers, Ray was a master franchisee, a company that was granted a master license. Ray was a supply chain genius, and had an operator's understanding of what made a restaurant profitable. He was constantly challenging the supply system to scale and grow the franchise system.

In the 1950's, Ray broke every rule in his license or franchise agreement, and ended up paying a penalty of some $5 million to the McDonald brothers. He was brilliant, ungovernable, yet made many of his operators millionaires — enriching the middle class and contributing to many state's coffers.

Ray could attract a variety of operators in the 1950's and 1960's because he could legitimately offer them the prospect of real wealth. 

Passing Bill 2305 will stimulate job growth

The current franchise legal model allows the franchisor to exercise so much control over the franchisee as to be an employer. This legal model creates employees where there should be owners. This is the fairness issue is being addressed by Bill AB 2305:  the problem of too much control and not enough sharing. Such a model does not attract risk capital.

Today many franchisees are nothing more than employees who pay good cash money to obtain jobs. No serious minded entrepreneur is attracted to this business model. The growth of franchising is largely fueled by those who are seeking to buy a job.

Without AB 2305 being passed, franchising will stagnant because it will not and cannot attract the Ray Kroc's as franchisees - the operators with boots on the ground who have the experience and capital to implement systems that scale and deliver value to the consumer.

It is not merely a matter of downloading these payments to the franchisee/employees.  It is a matter of making the franchisee nothing more than an employee who pays for the right to work.

The California example, United Parcel Service franchises

The widely and rightly praised United Parcel Service Company (UPS) has used the current franchise legal model in this manner.

Prior to acquiring the franchising firm Mailboxes Etc. in San Diego, Atlanta-based UPS had a series of depots and unmanned drop-off boxes to process returns. UPS makes money when more packages are shipped, and their business model is to increase this volume.  Some packages must be returned from where they were shipped to: the part is defective, the address is wrong, or the customer has lost interest in the product.

United Parcel Service would need to recruit employees to man and manage the returns and could have done so by expanding their depots. They did not hire more employees. Instead, they acquired an existing franchise system, Mailboxes Etc. out of bankruptcy. They changed the franchise agreement, giving the franchisor more control. They put their signage in front and the public now believes that they are dealing with UPS employees.

UPS achieved their business goals: they effectively turned these franchisees into employees who will not be a payroll expense to the franchising firm. All of this is currently legal —as many court filings in California's courts show.  It was also a very shrewd business decision.

But it is time to end this overreaching and return balance and fairness to franchising.  

Franchisors avoid taxes due to California

Now, you will hear from franchisors about how important franchising is as an industry. But what you will not hear from the franchisor corporatist apologists is this secret: the current franchise legal model is detrimental to California's public interest.

The current legal model allows the franchisor, which is the company who grants a franchise license to a local business, to escape or evade paying state taxes compared to other firms trading in California.

This is how it is done. A franchisor incorporates a company in Delaware and that company owns the franchisor's trademarks and other intellectual property.  Delaware does not tax royalty payments made to the holders of intellectual property.  A franchisor funnels the royalty payments made by its California franchisees to Delaware - minimizing or sometimes eliminating the correct amount to remit to California for income tax.

This tax issue is not addressed by Bill AB 2305.  But, you need to be aware of it when the franchisor apologist  urges upon you the value of the great economic engine of franchising.  Such industry does exist - what benefit is it to California if the surplus is untaxed and moved out of state?

Proper risk and reward between franchisor and franchisee will create wealth

California, in particular Silicon Valley, creates great immediate weatlh. For that wealth to become capital, it makes sense to woo those individuals into investing into a restaurant, hotel or service franchise — creating permanent jobs in the restaurant, hotel and service industries in California.  

But the current franchise legal model is not hospitable to risk capital. Proper balance between control and reward must be restored.

Bill AB 2305 is aimed at correcting or restoring this imbalance. By returning the franchise legal model model to the correct balance, where the franchisor creates and mantains brand standards, while the franchisee executes those standards and everyone shares in the surplus value as owners, Bill AB 2305 creates a hospitable environment for operator and supply chain geniuses like Ray Kroc.

Jobs and growth will follow.

One fine day, a franchisor, a preferred vendor, and some franchisees decided to build a franchise system together.

They found many good locations and built a number of great units.

The franchisor asked the preferred vendor to divide up what they had accomplished together.

So, the preferred vendor made up three roughly equal parts and let the franchisor chose.

Angered by the vendor's lack of grace, the franchisor revoked the preferred vendor's status for cause- bankrupting the vendor and acquired all the vendor's confidential information.

After that, the franchisor told the franchisees to propose a division of all that they had accomplished together.

The franchisees put together the vastly greater part of all they had accomplished together in one pile and in the other they put only scraps. When they had prepared the two parts, they called the franchisor and invited him to choose.

The franchisor, quite delighted with this arrangement, took the vastly greater part of all they had accomplished together and said to the franchisees:

"My esteemed colleagues, who taught you to divide things up so well?"

The franchisees answered through clenched teeth:

"None other than the preferred vendor and what happened to him, sir!"

With the scraps, the franchisees rushed off, tails between their legs, to bitterly complain in some small, far off location where the franchisor could pretend not to hear them.

This fable or wisdom story dates back to what Cialdini calls the First Era of Persuasion - which ended badly for the persuaders. It is known as the fable of the Lion, the Donkey and the Fox.

Moral: A partnership with the economically powerful is untrustworthy. If you want to partner with your franchisor, create an modern Independent Franchisee Association working for all of you.

It pays to be a member, both as franchise owner and supplier.

Are you a supplier that wants to get increased exposure to franchise owners?

Do you have a product or service that solves a problem for some, even if not all, franchisees in a system?

And would it help if Franchise-Info made franchise owners more acutely aware that they have this problem?

Then, you need to market directly to franchise owners. Connect me directly on LinkedIn. Ask about "Preferred Vendor Marketing"