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Rebate or kickback?

Depends on which side of the relationship you're on

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Four key issues that continually come up in our letters and e-mails are: encroachment, marketing, support and supply-chain management. This month we look at one of the “third rails” of the franchise relationship—the supply chain.

A multi-unit franchisee, John has some issues with his franchisor's purchasing requirements. He's bothered that his franchisor earns revenue based on franchisee purchases and pockets some vendors' rebates. While John readily admits his overall cost of goods is lower than if he purchased them independently, he believes he could purchase some of the items at a lower cost if he could source them himself locally. Like many franchisees, John believes his franchisor is obligated to negotiate the lowest possible costs and that they should be passing on any income or rebates they receive from vendors to the franchisees to help them reduce their cost of goods. John thinks he is getting ripped off and wonders why his franchisor can't “live  off of its royalties”—like “all the other franchisors.”

When we reviewed John's disclosure document and the marketing material he received when he was first looking at the system, we found that the franchisor laid it all out: The system has set standards for purchasing; it requires franchisees to buy from approved suppliers; the franchisor is the sole supplier for some items; and the franchisor earns revenue based on franchisees' purchases.

In its franchisee marketing materials, the franchisor discussed indirectly that it had supplier relationships in place to benefit the franchisees, and if you read between the lines, they were trying to convey that their franchisees' cost of operations would benefit from those franchisor-established relationships. Almost any article on the benefits of becoming a franchisee touts the ability of franchisees to purchase inventory, supplies, equipment and other necessities at a cost lower than they could as an independent operator. But as John now realizes, lower costs do not necessarily mean the lowest costs possible and this realization has impacted how John views the entire franchise relationship.

Unraveling the chain

Franchisors routinely establish restrictions on what products, services and equipment a franchisee may buy and the sources they can use. It is not uncommon for franchisors to establish exclusive supplier relationships and sometimes that supplier is the franchisor or one of its affiliates. It is also not uncommon for the franchisor to use the supply chain as a source of corporate revenue and it is certainly reasonable for them to do so when they actively manage the process and may also be a supplier to the system. The question eating at John is: If he is already paying royalties, why does the franchisor need to make money off things he needs to buy for his business?

Let's begin with some basics. Consumers visit a brand name to lessen their risk. The expectation of brand consistency is the No. 1 driver that brings people through your doors. Establishing approved suppliers and setting product and service standards is one of the best ways franchisors ensure uniformity and consistency throughout the consumer brand experience, and that is the reason exacting standards in the supply chain are found in most franchise agreements.

But what about John's complaint that the franchisor is making money off his purchases, retaining his rebates and not passing on the lowest possible cost? In some franchise systems, and I would hope in most, management tries to negotiate the best vendor terms for its franchisees, including lower costs for the merchandise they buy. But is it realistic for the franchisor not to make additional revenue for that service or to forgo making a profit when it also sells goods to its franchisees? Franchisors that closely manage their supply chain fall into two basic camps—the ones that include those services without any additional compensation and the ones that earn additional revenue above and beyond the royalty payments. Both methods are common and appropriate. Because of pre-sale disclosure, it should never come as a surprise to any franchisee which approach their franchisor will be taking.

While I am certain some lawyers and franchisee advocates may disagree with me, generally speaking, so long as the overall pricing for the basket of goods and services from franchisor-required vendors is reasonable—and that does not necessarily mean the lowest possible price—the fact that the franchisor is making money on franchisee purchases should not be a cause of concern. After all, having a financially viable franchisor is in the interest of all franchisees, and whether the franchisor chooses to fund its supply-chain management solely through its royalty or to earn additional revenue based upon franchisee purchases, that business decision is disclosed at the front end of the relationship.

What really irks John, however, is not receiving supplier rebates for his purchases, and knowing that money is sent to the franchisor instead. The amount is considerable and would, if sent directly to John, have a positive impact on his bottom line. Rebate management in franchising is a particularly sensitive issue and methods vary but generally fall into four buckets:

• The elimination of most rebates in exchange for lower costs;

• The repatriation of all or a portion of the rebates to the franchisee;

• Keeping all or a portion of the rebates as corporate income; and,

• Contributing all or a portion of the rebates to the system's advertising or brand fund.

Our clients employ all these methods, but because of the emotions that surround rebate management and its potential impact on the franchisor/franchisee relationship, our preference generally is for our clients to contribute a portion, and in some cases all of the rebates, to the system's advertising or brand fund. This inclination is clearly philosophical, but in many cases also makes sense from a business standpoint. The larger the pool of funds available for advertising or brand management, the greater the system's ability to market the brand, which should translate into higher unit sales and higher royalties received. For clients that employ a brand fund rather than a simpler advertising fund, the rebates can be used to support programs including, but not limited to, free training, mystery shoppers or services that benefit the overall brand performance.

As to John's desire to cherry pick the basket of goods he purchases from local vendors at a lower cost—should that cause his franchisor or other franchisees any concern? It does if it impacts on the consumer experience or causes the vendor to raise its costs for the balance of the merchandise sold to the system. In most franchise agreements, the franchisee is free to propose alternative suppliers, and the franchisor is obligated to review those suppliers and decide whether they are acceptable. While the franchisee is looking at his costs first, the franchisor has to determine whether the proposed supplier can meet their standards and delivery schedule, and also, whether bringing in new suppliers might have a detrimental impact on the rest of the franchise system. Franchisors must view their supply chain decisions based on a macro evaluation, even when their decisions will impact some franchisees negatively.

Without a doubt supply-chain issues frequently find their way into disputes between franchisors and franchisees. Who is winning the battle? Recent court decisions support the fact that franchisors do not have “market power” by virtue of their unique brands to trigger any antitrust violations or possible “tying” concerns. When coupled with the necessity of setting brand standards and also the apparent “safe harbor” of disclosure in the UFOC, I would be surprised if franchisors find much to worry legally in this area. However, I leave to the lawyers the joy of discussing the esoteric subject of antitrust restraints and possible tying issues under the law.

Three great articles and presentation to look to for a concise overview of the current status of the law in this area were authored by Steve Feirman a partner at DLA Piper ( and Arthur Cantor a partner at Wiley Rein “The Legality of Rebates from Suppliers” (Franchise Law Journal 2003—Feirman), “Supply and Distribution Issues” (presented at The International Franchise Association 2004 Legal Symposium—Feirman) or “Tying, Exclusive Dealing, and Franchising Issues,” (presented at the Practicing Law Institute's 47th Annual Antitrust Law—Cantor).


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