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May, 01 2006

Minimum Guarantee Is it required?

A franchise agreement also includes various supports that a franchisor would extend to his franchisee

Why has franchising, today, become so popular across the country?

From the perspective of a franchisor, franchising represents an efficient method of rapid market penetration and product distribution without the typical capital cost associated with the internal expansion. From the viewpoint of a franchisee, franchising offers a method of owning a business but with a mitigated chance of failure due to the established brand name of the company, proven concept and initial and ongoing training and support services offered by the franchisor.

It might seem that this business model does not extend any benefit to the consumer. That is not true. In the franchise model, there is something for everybody. Franchised outlets offer a wide range of products and services at a consistent level of quality and at affordable prices, thus, enabling a win-win situation for everybody.

The franchising models can be summarised into: business format franchise management contract format, and hybrid format.

In the pure franchise format, the franchisee contributes in all the investment, be it in store or stocks, and also manages the day-to-day operations. The returns to the franchisee come from the margins on the sales he is able to achieve from his store. Thus, the primary business risk remains with the franchisee.

On the other hand, in the management contract format, while the franchisee makes substantial upfront investments, the franchisor contributes through stocks, and day-to-day management of the store. The franchisee is assured of some fixed plus some variable returns.

The structure of the hybrid format depends on the relative negotiating power of the franchisor and the franchisee.

In the formats mentioned above there is no incidence wherein the franchisor makes all the upfront investments, manages the store, provides stocks on consignment basis, and also gives a minimum guarantee to the franchisee.

Method of operation

In order to attract franchisees, the franchisors act discerningly and propose minimum guarantee (a minimum amount of commission, irrespective of the sales). The concept of minimum guarantee was, thus, introduced into the business of franchising in order to ensure that the franchisees receive a certain annual gross profit. The franchisors in doing so ensure that the franchisees enjoy some degree of corporate security. The franchisor does fix an annual income target, and if this does not reach the level set for the franchisee, the franchisor guarantees a preset annual gross profit.

The franchisee bears the costs attached to the property, and the franchisor bears the costs of the merchandise. Marketing expenses are shared in a pre-determined proportion, and the franchisee receives a commission that is worked out as a percentage of his sales. With the inception of minimum guarantee concept, the franchisee insulates himself against business risks.

Accordingly, the franchisor invests in stock as well as property, while the franchisee has to manage the shop. Generally, the stock and all other investments are made by the franchisor, and hence, there is a lower rate of return to the franchisee.

In such a system, there are two options available.

One: In certain chains, the franchisor gives a minimum remuneration, or return, of say, Rs 30,000 per month, if the sales of a particular month does not give an income (to the franchisee) of more than Rs 30,000. If the sales commission is more than Rs 30,000, then the franchisee gets commission and not the minimum amount. The percentage of sales commission is less in this system because of the risk taken by the franchisor.

Second: The franchisee gets a fixed remuneration, irrespective of the sales made. This is similar to a company showroom owned and managed by the company itself. This system has become more prevalent today as there are less takers of franchisees of new brands.

Feedback from franchisors

Most franchisors feel that the principle of a franchise arrangement is to share the risk of business with someone who shares the conviction for the brand. Expressing his opinion on minimum guarantee, Mr Chitranjan Dar, Divisional Chief Executive, Lifestyle Business Retailing Division, ITC, says that both the brand and the franchisee want to earn profit from a retailing relationship. He continues, “The focus, therefore, should be on selecting a franchisee with the right attitude and aptitude ready to start business in an appropriate location.” He personally feels that minimum guarantee is a secondary consideration.

Mr Kunal Sachdeva, CEO, Hidesign, believes that, “It (minimum guarantee) is definitely an easier way to attract franchisees, but I am not convinced that it is the best way to work on a franchisee arrangement. The purpose of giving a franchisee is to partner with someone who will share the risks of the business with you, and is, therefore, offered a sales/profit-linked proposition. But a minimum guarantee transfers a significant part of the risk back to the brand.”

Also toeing the same line, Mr K.S. Dhillon, General Manager (Franchise), Woodland, says, “A new franchisee certainly does not understand the potential of the franchisor's brand. Therefore, minimum guarantee is basically a mental security against perceived operational or exit losses. Minimum guarantee does not ensure profits. Needless to say any franchisee module which involves lesser exit risks attracts more franchisees.”

Contradicting Mr Dhillon, Ms Farah Malik Bhanji, ED, Metro Shoe, expresses, “It depends upon the profile of the franchisee. As the minimum guarantee is generally provided at 60 to 70 per cent of the market rate, it is not very attractive unless the franchisee has a confidence in the franchisor’s ability of achieving the targeted sales and thereby earning full commission.” Mr Uttam Rathod, Manager Marketing Retail, Concept K-Lounge, also does not believe in giving minimum guarantee to the franchisees. He says, “It is against our business policy.”

Mr Shyam Sukhramani, Head, Dockers, feels, “Minimum guarantee do not ensure that franchisees flock to brands, although the spirit of a minimum guarantee is to assure a minimum level of return on the investments made by the franchisee. Hence if the franchisees/investors are interested in retailing as a long term opportunity, they would take a long term view of their investments, which will give them a greater level of return than a fixed rate of annual return.”

Mr Aniruddha Deshmukh, President, The Raymond Shop, feels, “The franchisee has lots of costs to bear and minimum guarantee covers his rental expenses and other things like that. Minimum guarantee is good for franchisees as the rentals are too much and the margins do not cover the expenses.” On asking whether Raymond give minimum guarantee, Mr Deshmukh replies, “No, we do not give minimum guarantee. The proposition of Raymond is strong enough and do not feel that minimum guarantee is needed.”

Mr Sachdeva says, “The only situation where the minimum guarantee should be considered would be where the brand is directly involved in operations so that the risk for the brand is minimised. In which case it becomes more like a variable rental agreement where the brand runs the store, but is willing to share part of the growth with the franchisee for a more modest upfront cost of occupancy. This may not always be possible and, therefore, it limits the number of such arrangements.”

Mr Dar believes that minimum guarantee helps a brand in getting into a location where it thinks it can do good business. He adds, “It is, however, necessary to frame it in a manner that the franchisee has incentives for managing the outlet well and is not merely happy 'earning' the minimum guarantee.”

Mr Uttam belives that by giving minimum guarantee, a franchisor can easily get a franchisee without any efforts.

Mr Dhillon’s firm does not offer minimum guarantee for a new store. He says, “In our format, we first lease out the property on our own, run it for a minimum period of six months, assess the potential of that particular store and then we franchise it. In such cases, it is very easy to work out a win-win deal for both the franchisee as well as the franchisor.”

Mr Deshmukh further believes, “With minimum guarantee, the franchisor is able to get a franchisee without much effort. And if the franchisor’s brand is new then minimum guarantee really helps. On the other hand, if the revenues are not coming then the franchisor is bound to give minimum guarantee to the franchisee.”

Some leading franchise companies were not ready to comment on this area.

How to assess minimum guarantee

About assessing the positives and negatives traits of minimum guarantee from a franchisor’s point of view, Mr Shyam says, “We need to apply two filters for the assessment; state of business/brand; and positioning of brand.” He goes on to elaborate these as:

State of business/brand, i.e., whether the business is an established busi-ness, or in the growth mode, or at the seeding level, and Positioning of the brand, i.e., does it necessitate a high level of investment, mid level of investment or low level of investment.

Positives and negatives, if we apply the first filter, would be as follows: If the business is established then the franchisee should be confident on the returns in the long term and, hence, willing to invest. Therefore, the question of minimum guarantee may not arise. In case the business is in a growth/seeding mode, then minimum guarantee enables the business to rope in investor/franchisee capital that can scale-up the business in a shorter time frame in comparison to the capital deployment being completely from the business. In this case there is a pressure on working capital though for the business, as the business will not generate the expected level of returns from the initial period. This will impact the bottomline.

Positives and negatives, if we apply the second filter, would be as follows: If the brand requires a high level of investment, then a minimum guarantee facilitates bringing in franchisee capital, which, however, will impact the bottomline as the payouts would be substantial, in case the business is not established. If the brand does not require a high level of investment, then it can attract a large base of franchisees/investors. However, in this case the franchisees/investors might not enable brand building and just seek the base level of return, which is detrimental in the long term.

Acceptance of the clause

On being asked about the acceptance of minimum guarantee in terms of expansion, Mr Dar said, “We have opened less than 20 per cent of our outlets through minimum guarantee.” Mr Sachdeva, on the other hand, said, “We do not have a single pure franchisee with a minimum guarantee, but we do have a couple of stores where we have a variable rental principle linked to growth. This is out of a total of 35 exclusive Hidesign stores that we operate today. So the percentage is less than 10 per cent.”

According to Ms Farah, “Metro Shoes has opened 23 per cent of their stores through minimum guarantee.” On the other hand Mr Shyam does not want to comment on this as he feels, “It varies from business to business and brand to brand.”

Consequences of the clause

From a mere addition in the franchise contract, minimum guarantee has become an indispensable point of discussion between the franchisor and the franchisee before the signing of the contract. It has come to such a pass that whichever brand offers a higher minimum guarantee wins the game.

Though introduced with the intention of attracting more franchisees, minimum guarantee is, to an extent, ruining the franchise market. However, it is observed that the franchisees do not feel any pressure in terms of pushing up sales, or attracting visitors, or improving marketing strategies as they seem satisfied with the amount they receive every month.

The way forward

Giving his views on the prospect for franchising in the minimum guarantee perspective, Mr Sachdeva said that though his company was expanding fairly aggressively through the franchisee route, they did not seek minimum guarantee in the agreement. “For us,” he said, “this would be a way to expand brand presence in smaller towns where we do not have a presence yet, and we would like to partner with people who have retail experience and local knowledge of the market to assess how the brand is likely to do.”

Saying that one has to be very selective as far as minimum guarantee is concerned, Mr Dar suggests, “Given the fact that modern retail locations are expensive and franchisee may not be willing to take risks in certain locations, minimum guarantee may be a way out.”

According to Mr Deshmukh, “Minimum guarantee will be there and in fact, in the near future lots of brands will give minimum guarantee just to get the retail space.”

With change in priorities, a franchisor first acquires a real estate, gets the investment from the franchisees, and finally develops a strong distribution network. But, a study of the global franchise model shows that a franchisor's primary objective is to involve an entrepreneur with local skills, setting aside all other issues.

In countries like the US, UK and Australia where franchise financing is readily available, the emphasis is more on quality franchising because the company directly acquires the real estate.

In a diverse country like India, a local entrepreneur can bring in special sets of expertise to the franchise system. In times to come, the Indian model will give a lot of emphasis to local entrepreneur skill. Franchise should not be the solution to real estate acquisition. With minimum guarantee having taken the front seat in the franchise industry, the viability of the business should first be taken into consideration. Simultaneously, local entrepreneurship should be promoted to help grow the business.

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