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Outsourcing franchise sales

Growth strategy or desperate move?


Published:

 

Elizabeth Dillon, an
associate, and Gaylen Knack,
a principal, in the franchise
practice at Gray Plant Mooty in Minneapolis, can be reached at elizabeth.dillon@gpmlaw.com
and gaylen.knack@gpmlaw.com,
respectively.

Franchising has been riding a wave of success for the past five years, with new concepts forming every day. In 2005 alone, FRANdata reported that approximately 500 new franchise programs were launched. While the number of franchise systems has increased, the pool of potential franchisees has been unable to keep pace. National unemployment rates remain low (4.5 percent as of May 1, 2007) and U.S. stock markets continue to attain new highs.

In an increasingly competitive market, many franchisors are finding it more difficult to recruit talented franchisees. New franchise companies with lean executive teams find it especially challenging and are desperate to establish a solid base of franchisees. More established franchisors maintain an internal sales staff, supplemented by independent broker or lead referral networks. Smaller growth and start-up franchise systems often cannot afford to maintain an internal sales staff and have little or no track record to garner attention from large lead referral networks. Left with few other options, an increasing number of franchisors are looking at a seemingly attractive option—outsourcing franchise sales.

Under most outsourcing arrangements, the third-party sales agent agrees to handle all aspects of the franchise marketing and sales process. The franchisor often enters into an exclusive arrangement with the sales agent, meaning that only the sales agent can market and sell franchises in the identified territory. The franchisor may agree to provide a certain level of funding and typically retains the right to accept or reject (with some limitations) franchisee candidates screened by the sales agent. The sales agent differs from a lead referral network in that the sales agent controls the franchise sales process. On the other hand, a lead referral network typically generates pre-qualified leads and forwards them to the franchisor but does not replace the role of the franchisor in the sales process. For franchisors that have struggled to sell franchises through more conventional methods, the outsource option appears to be a roadmap to system growth.

Unfortunately for a number of franchisors, however, the outsourcing option has failed to produce the desired results. The anticipated franchise sales growth simply has not occurred or, when it has occurred, the franchisor is so economically shackled by the fees paid to the sales agent that the franchisor cannot cover expenses necessary to invest in and operate the franchise system. Many outsourcing programs require the franchisor to exclusively use the sales agent, forcing the franchisor to rely on the competence and aggressiveness of the agent to grow the system. The sales agent generally does not commit to limit the number of franchisors it may service and the franchisor may be forced to rely on watered down minimum sales quotas to insure that the sales agent satisfies its obligations. In outsourcing the franchise sales component, the franchisor loses control over the selection and training of sales persons, important concerns in an area that is fraught with legal liability.

Certain outsourcing programs also place significant economic burdens on the franchisor. Some programs require the franchisor to pay the sales agent approximately 50 percent of the initial fee for each new franchisee and as much as 20 percent of the ongoing royalty fees generated from the franchisee. The obligation to share the royalty stream with the sales agent may continue through each renewal period. Agreements that require a franchisor to share the ongoing royalty stream with the sales agent essentially rob the franchisor of most or all of its potential profits. Past International Franchise Association-sponsored studies suggest that only the most successful early-stage franchisors (operating for five years or less) are able to realize profit in excess of 20 percent of total revenue. If a sales agent is successful in generating franchise sales on behalf of the franchisor, and receives 20 percent of the franchisor’s ongoing royalties, the franchisor will be fortunate to recover any profit from operations. Less profitable franchisors may actually find that their losses mount as the sales agent sells more franchises. Once caught in this situation, a franchisor’s only option is to negotiate a buyout of the sales agent agreement. This proposition may be expensive. Some sales agent companies generate significant revenue from contract buy-outs.

What to consider

Of course, not all outsourcing arrangements contain such onerous provisions and, in the right situations, may assist an emerging franchisor in achieving a critical mass of franchisees necessary to build a sound franchise system. Franchisors must carefully consider the potential value, and drawbacks, in outsourcing any portion of the franchise sales functions. Most importantly, determine to what extent you are willing to permit a third party to play a role in the franchisee selection process. Many outsourcing models all but remove the franchisor from the evaluation process which is so important in selecting the right franchisees for the system.

You also should determine whether there are any alternatives to the outsourcing method that allows you to achieve your development goals without relinquishing control over the sales process. Can you develop franchise sales expertise internally and supplement it with some outside assistance? Separately, the franchisor should never remove itself completely from the important role of selecting the right franchisees for the system. For this reason, avoid agreements that grant the sales agent the exclusive right to market and sell franchises. In addition, avoid agreements that do not work economically. Conduct business modeling to determine if the expense structure allows the franchisor to meet its financial objectives or places financial handcuffs on the franchisor. Avoid any sharing of the royalty stream unless it is limited in time and amount. Finally, conduct due diligence on any potential sales agent and examine their track record with other franchisors. How many other franchise systems do they serve? Do you have a comfort level as to the sales agent’s integrity? Spell out the sales agent’s obligations in the agreement.

The franchise sales process creates significant legal risks for franchisors and an unscrupulous sales agent can cripple a franchisor’s future. Outsourcing the franchise sales function is a drastic measure and should only be considered following a thorough evaluation of the franchisor’s sales process and the outsourcing opportunity presented. In taking these precautions, franchisors can avoid the franchise sales nightmares.

Elizabeth Dillon, an associate, and Gaylen Knack, a principal, in the franchise practice at Gray Plant Mooty in Minneapolis, can be reached at elizabeth.dillon@gpmlaw.com and gaylen.knack@gpmlaw.com, respectively.

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