Implementing Change in a Franchise System

Changing with the Times

Changing with the marketplace is not an easy task. For franchise systems, addressing change is even more difficult. Keeping in mind that franchising is a method of distribution, not an industry, we must realize that a fully integrated company has one significant advantage over a franchised system. Decision-making is done from within, and no official or unofficial decisions of outsiders (other than lenders, and in some cases, owners) are necessary for a company to shift directions in its approach to the marketplace.

In contrast, franchisors are always going to be accountable, to some degree, to their franchisees. Franchise systems are derivatives of the system's franchise agreements, or, one might say, these agreements are in essence the Magna Carta. Together with the system's operating manual, they set the rules governing virtually every aspect of the franchise relationship. Unlike the fully integrated distribution system, a franchisor does not have the unfettered discretion to change the rules and to implement a major change in direction quickly. Nor may the franchisor simply tell the franchisee “adi's.”

Reforming a Franchise System: A Case in Point

A case study showing the challenges in trying to reform a franchise system is The UPS Store system, formerly known as Mail Boxes, Etc. The franchisor wanted to change the name of its brand, presumably because the new mark was a stronger brand due to the widespread distribution network of UPS (its new owner). Putting aside whether the franchisor was right or wrong about whether its contractual or common law rights permitted such a change, the result was chaos. At one point, and perhaps even today, many stores were operating under the old brand, but most had adopted the new brand, causing confusion in the marketplace and a divisiveness within the system, which in turn led to various inefficiencies. (The author represents the Area Representatives Association, which includes people who offer franchises for sale on behalf of The UPS Store and services the purchasers. He had no involvement in the litigation.)

The real tragedy, however, was manifested in the litigation that resulted from the decision by the franchisor to rebrand. A search of the databases shows that there have been multiple, complex, multi-plaintiff or class action cases, resulting in an incredible diversion of resources from growing the brand, to defending the franchisor's decision to rebrand. Management time and many dollars could have been better spent in moving the system forward, rather than sidewards or backwards.

The UPS Store example demonstrates that, unlike a fully integrated vertical system, a franchise system includes another layer of decision-makers, the franchisees, whose opinions must be considered when major changes are contemplated. Their contractual rights may restrict the direction in which the franchisor may move, and even if that is not the case, this subset must be onboard before change can be implemented. For example, in many systems there are restrictions on how much new capital a franchisee may be required to inject in his business when modernization programs are proposed. Alternatively, exclusivity provisions may prevent a franchisor from implementing a distribution program through the Internet.

Rights of Franchisees

Even if the legal rights of a franchisee will not be breached by a proposed system change, there may still be a challenge facing a franchisor in order to move its system forward. In well-established systems, the franchisees have often made an emotional investment in the enterprise, as well as a monetary one. Much like the Olive Garden tag line, “When you're here, you're family,” so too, do franchisees view their businesses as more than a meal ticket. The rights of the franchisees, legal and practical, need to be factored into any decision by a franchisor to implement a major change in its system. Moreover, feasibility of implementing change must be taken into consideration. If a re-imaging program requires cash input and the franchisees do not have access to the cash, the program will create chaos and disharmony, and is likely to fail.

Two Hurdles

How can change be implemented? There are two hurdles to jump ' first, the legal impediments, and then the practical issues of implementation.

From a legal perspective, how difficult the change will be to implement is a function of the franchise agreement. Simply put, does the franchise agreement permit or restrict the franchisor from implementing the change? If the change is clearly permitted, hurdle one has been cleared. If it is not permitted or if the franchise agreement is unclear, then the franchisor must adopt a strategy to overcome the contractual limitations.

For example, the franchisor must either persuade the franchisees that voluntary relinquishment of rights is a necessary step for the good and welfare of the system or the franchisor may offer incentives for the franchisee to relinquish those rights. The earlier franchise agreements in the quick service restaurant industry, for example, did not require contributions to national advertising funds. Thus, in order to encourage franchisees to go along with the establishment of a national marketing fund to which the franchisees would contribute, a franchisor might:

• Lower royalty rates or other payment requirements;
• Agree to provide additional services to the franchise system;
• Make a matching contribution to the fund; or
• Grant franchisees some control over the system's advertising strategies or the advertising fund's administration.

One problem always facing a franchisor is making the entire system accept a change. Franchise agreements are bilateral agreements ' that is, contracts between the franchisor and each individual franchisee. Thus, even though 99 franchisees may agree to implement a change, absent an appropriate provision in the franchise agreement, a franchisor cannot insist that Franchisee 100 join the program ' at least not prior to renewal time, which could be 10 or 20 years in the future. One way to end-run this problem is to include a “drag-along” provision in the franchise agreement, which would provide that if a certain percentage of the franchised units, or perhaps all units, approve a change, all other franchisees must implement the change. While these provisions cannot be unilaterally inserted in existing contracts on a moment's notice, a franchisor can start including them in its current franchise agreement so that when the time comes, this hurdle will have been eliminated with respect to a large percentage of its franchisee community.

And what if there is no drag-along clause and the franchisee simply says no to the change? Depending upon the nature of the change, the franchisor may simply conclude that breaching the franchise agreements of the naysayers will be an acceptable solution, and the franchisor will pay the damages resulting from the breach. In the case of implementing an advertising program, the franchisor may simply allow a franchisee who does not join the program to become a free-rider ' that franchisee will not receive the other incentives that franchisees agreeing to participate may receive, but it will not be required to contribute to the ad fund, yet still reap the benefits of the advertising.

If remodeling is the issue, then the franchisee can stay under the old brand image and sue for loss of business caused by the fact that other franchisees have taken away the non-conforming franchisee's customers, or that customers simply will not visit a unit with an out-of-date image. In either case, the franchisee is likely to have a difficult damage case to prove.

The real show-stopper occurs when the franchisee seeks an injunction to prevent implementation of the change by all units. The dissident franchisee, however, would have to prove irreparable harm ' not always an easy task.

And finally, when all else fails, the franchisor can try to purchase the naysayers. This is a common solution when a franchisor wants to buy a competing franchise system, but contractual provisions will result in unlawful encroachment because the target of the acquisition has units in the exclusive territory of the purchasing franchisor. Money solves many problems.

Practical Issues

Even if the legal hurdles can be avoided, the franchisor may not be home free. The franchisor must still deal with the practical and emotional issues. Too many franchisors try to implement change without working the system. They develop the changes internally and then spring them on the franchisees, without seeking their input in advance, and without testing the changes to the system.

Many years ago, one quick service food system tried to introduce a breakfast program ' something that the system desperately needed to keep up with the competition. In concept, the franchisees were in agreement. However, the breakfast program had what the franchisees considered to be operational and financial flaws. Breakfasts under the proposed operational system had to be made one by one person; thus, if it took two minutes to make a breakfast, a 10-person line would result in a 20-minute wait for breakfast ' not exactly quick service. The franchisees also perceived that the labor schedules would become more difficult to manage as a result of having a breakfast program ' thus adding cost which might not be offset by the increase in sales anticipated by the breakfast program.

In the end, the breakfast program failed. The franchisees were left with the equipment purchased to implement the breakfast program as a monument to its failure, and much of the franchisor's management found themselves looking for new jobs. No lawsuits followed, but the system did not then, and even today, has not been able to enter the breakfast market.

How Near Is the Future?

The lessons of the stories told above are that change is inevitable. It is not predictable, but the franchisor should take out its crystal ball and think of what the world might look like 10 and 20 years in the future. Given the speed of change in our society (even 10 years ago, who would have predicted that a hard copy of a book might become a dinosaur?), this is no easy task. But to compensate for this challenge, franchisors should examine their existing franchise agreements and cultures, to make sure that when the time comes for a change to be made expeditiously, the franchisor will have the mechanisms to meet the changing market conditions.

Rupert M. Barkoff is partner in the Atlanta office of Kilpatrick Townsend & Stockton, where he chairs the firm's franchise practice. This article also appeared in the New York Law Journal, an ALM sister publication of this newsletter.

Remember The Eugene Dietzgen Company? If you are under 40, you likely do not. Dietzgen was one of the world's largest makers of slide rules. But when was the last time you saw a slide rule? According to the Internet, the Dietzgen company is still around, but I suspect that it is a shadow of its former self.

And what about Howard Johnson's ice cream and restaurants? Back in the 1960s, HoJo ' as it was referred to ' was the premium ice cream chain. Today, there are a handful left, but what was at one time an industry leader has shrunk into near oblivion.

Dietzgen was not a franchise; HoJo was. But in either case, the point is the same. Our economy is not stagnant. It is ever-changing for various reasons. The slide rule was replaced by the more efficient pocket calculator, and in HoJo's case, competitors such as Baskin Robbins simply did a better job of marketing similar products and services. Baskin Robbins developed quality products, gave them exotic names, and focused on ice cream and related products, while HoJo's concept, in contrast, included full-scale restaurants that sold ice cream. In the end, we have thousands of Baskin Robbins units today, as well as outlets of numerous other brands such as Marble Slab Creamery and Bruster's, while Hojo, like Dietzgen, became a shadow of the past.

Changing with the Times

Changing with the marketplace is not an easy task. For franchise systems, addressing change is even more difficult. Keeping in mind that franchising is a method of distribution, not an industry, we must realize that a fully integrated company has one significant advantage over a franchised system. Decision-making is done from within, and no official or unofficial decisions of outsiders (other than lenders, and in some cases, owners) are necessary for a company to shift directions in its approach to the marketplace.

In contrast, franchisors are always going to be accountable, to some degree, to their franchisees. Franchise systems are derivatives of the system's franchise agreements, or, one might say, these agreements are in essence the Magna Carta. Together with the system's operating manual, they set the rules governing virtually every aspect of the franchise relationship. Unlike the fully integrated distribution system, a franchisor does not have the unfettered discretion to change the rules and to implement a major change in direction quickly. Nor may the franchisor simply tell the franchisee “adi's.”

Reforming a Franchise System: A Case in Point

A case study showing the challenges in trying to reform a franchise system is The UPS Store system, formerly known as Mail Boxes, Etc. The franchisor wanted to change the name of its brand, presumably because the new mark was a stronger brand due to the widespread distribution network of UPS (its new owner). Putting aside whether the franchisor was right or wrong about whether its contractual or common law rights permitted such a change, the result was chaos. At one point, and perhaps even today, many stores were operating under the old brand, but most had adopted the new brand, causing confusion in the marketplace and a divisiveness within the system, which in turn led to various inefficiencies. (The author represents the Area Representatives Association, which includes people who offer franchises for sale on behalf of The UPS Store and services the purchasers. He had no involvement in the litigation.)

The real tragedy, however, was manifested in the litigation that resulted from the decision by the franchisor to rebrand. A search of the databases shows that there have been multiple, complex, multi-plaintiff or class action cases, resulting in an incredible diversion of resources from growing the brand, to defending the franchisor's decision to rebrand. Management time and many dollars could have been better spent in moving the system forward, rather than sidewards or backwards.

The UPS Store example demonstrates that, unlike a fully integrated vertical system, a franchise system includes another layer of decision-makers, the franchisees, whose opinions must be considered when major changes are contemplated. Their contractual rights may restrict the direction in which the franchisor may move, and even if that is not the case, this subset must be onboard before change can be implemented. For example, in many systems there are restrictions on how much new capital a franchisee may be required to inject in his business when modernization programs are proposed. Alternatively, exclusivity provisions may prevent a franchisor from implementing a distribution program through the Internet.

Rights of Franchisees

Even if the legal rights of a franchisee will not be breached by a proposed system change, there may still be a challenge facing a franchisor in order to move its system forward. In well-established systems, the franchisees have often made an emotional investment in the enterprise, as well as a monetary one. Much like the Olive Garden tag line, “When you're here, you're family,” so too, do franchisees view their businesses as more than a meal ticket. The rights of the franchisees, legal and practical, need to be factored into any decision by a franchisor to implement a major change in its system. Moreover, feasibility of implementing change must be taken into consideration. If a re-imaging program requires cash input and the franchisees do not have access to the cash, the program will create chaos and disharmony, and is likely to fail.

Two Hurdles

How can change be implemented? There are two hurdles to jump ' first, the legal impediments, and then the practical issues of implementation.

From a legal perspective, how difficult the change will be to implement is a function of the franchise agreement. Simply put, does the franchise agreement permit or restrict the franchisor from implementing the change? If the change is clearly permitted, hurdle one has been cleared. If it is not permitted or if the franchise agreement is unclear, then the franchisor must adopt a strategy to overcome the contractual limitations.

For example, the franchisor must either persuade the franchisees that voluntary relinquishment of rights is a necessary step for the good and welfare of the system or the franchisor may offer incentives for the franchisee to relinquish those rights. The earlier franchise agreements in the quick service restaurant industry, for example, did not require contributions to national advertising funds. Thus, in order to encourage franchisees to go along with the establishment of a national marketing fund to which the franchisees would contribute, a franchisor might:

• Lower royalty rates or other payment requirements;
• Agree to provide additional services to the franchise system;
• Make a matching contribution to the fund; or
• Grant franchisees some control over the system's advertising strategies or the advertising fund's administration.

One problem always facing a franchisor is making the entire system accept a change. Franchise agreements are bilateral agreements ' that is, contracts between the franchisor and each individual franchisee. Thus, even though 99 franchisees may agree to implement a change, absent an appropriate provision in the franchise agreement, a franchisor cannot insist that Franchisee 100 join the program ' at least not prior to renewal time, which could be 10 or 20 years in the future. One way to end-run this problem is to include a “drag-along” provision in the franchise agreement, which would provide that if a certain percentage of the franchised units, or perhaps all units, approve a change, all other franchisees must implement the change. While these provisions cannot be unilaterally inserted in existing contracts on a moment's notice, a franchisor can start including them in its current franchise agreement so that when the time comes, this hurdle will have been eliminated with respect to a large percentage of its franchisee community.

And what if there is no drag-along clause and the franchisee simply says no to the change? Depending upon the nature of the change, the franchisor may simply conclude that breaching the franchise agreements of the naysayers will be an acceptable solution, and the franchisor will pay the damages resulting from the breach. In the case of implementing an advertising program, the franchisor may simply allow a franchisee who does not join the program to become a free-rider ' that franchisee will not receive the other incentives that franchisees agreeing to participate may receive, but it will not be required to contribute to the ad fund, yet still reap the benefits of the advertising.

If remodeling is the issue, then the franchisee can stay under the old brand image and sue for loss of business caused by the fact that other franchisees have taken away the non-conforming franchisee's customers, or that customers simply will not visit a unit with an out-of-date image. In either case, the franchisee is likely to have a difficult damage case to prove.

The real show-stopper occurs when the franchisee seeks an injunction to prevent implementation of the change by all units. The dissident franchisee, however, would have to prove irreparable harm ' not always an easy task.

And finally, when all else fails, the franchisor can try to purchase the naysayers. This is a common solution when a franchisor wants to buy a competing franchise system, but contractual provisions will result in unlawful encroachment because the target of the acquisition has units in the exclusive territory of the purchasing franchisor. Money solves many problems.

Practical Issues

Even if the legal hurdles can be avoided, the franchisor may not be home free. The franchisor must still deal with the practical and emotional issues. Too many franchisors try to implement change without working the system. They develop the changes internally and then spring them on the franchisees, without seeking their input in advance, and without testing the changes to the system.

Many years ago, one quick service food system tried to introduce a breakfast program ' something that the system desperately needed to keep up with the competition. In concept, the franchisees were in agreement. However, the breakfast program had what the franchisees considered to be operational and financial flaws. Breakfasts under the proposed operational system had to be made one by one person; thus, if it took two minutes to make a breakfast, a 10-person line would result in a 20-minute wait for breakfast ' not exactly quick service. The franchisees also perceived that the labor schedules would become more difficult to manage as a result of having a breakfast program ' thus adding cost which might not be offset by the increase in sales anticipated by the breakfast program.

In the end, the breakfast program failed. The franchisees were left with the equipment purchased to implement the breakfast program as a monument to its failure, and much of the franchisor's management found themselves looking for new jobs. No lawsuits followed, but the system did not then, and even today, has not been able to enter the breakfast market.

How Near Is the Future?

The lessons of the stories told above are that change is inevitable. It is not predictable, but the franchisor should take out its crystal ball and think of what the world might look like 10 and 20 years in the future. Given the speed of change in our society (even 10 years ago, who would have predicted that a hard copy of a book might become a dinosaur?), this is no easy task. But to compensate for this challenge, franchisors should examine their existing franchise agreements and cultures, to make sure that when the time comes for a change to be made expeditiously, the franchisor will have the mechanisms to meet the changing market conditions.

Rupert M. Barkoff is partner in the Atlanta office of Kilpatrick Townsend & Stockton, where he chairs the firm's franchise practice. This article also appeared in the New York Law Journal, an ALM sister publication of this newsletter.