Alternative methods to franchising for commercialisation and expansion

August 2009 by Paul Kirton, Principal & Michele Laks-Belzycki, Senior Associate Macpherson & Kelly Lawyers www.mk.com.au

alternative methods to franchising for commercialisation and expansion

While franchising is one proven model for business growth, we now examine some of the alternative methods for commercialisation and expansion through direct selling, sales agents, licensing arrangements or distribution networks.

The franchising code places many restrictions on a franchisor and so these alternatives are often seen as preferable. The key is to know whether the code applies as the courts have been very harsh on those that have crossed the line unwillingly.

DIRECT SELLING

The first and most obvious option is direct selling. Sales can be increased in many ways; expanding the sales force, depending on the nature of your client’s products, opening company owned retail outlets, expanding through new sales channels, e.g. internet sales; and increasing the advertising budget.

What are the benefits?

  • Maintaining control of brand
  • Maintaining control of method of distribution
  • Potentially higher margins (eliminating the ‘middle man’)
  • Obtain market intelligence from direct experience
  • Build customer base and increase goodwill

What are the drawbacks?

  • Requirement for larger capital investment and working capital
  • Managing resources and having the logistical capability to service customers
  • Having a sufficient sales force and marketing team to get the same or better penetration in the market than, say, a distribution network
  • Much higher overheads due to retail premises, larger sales force and logistics.
  • Managing a larger workforce and dealing with associated employment issues
  • Lead time to generate customer base and sales

AGENCY

Another option to consider is that of agency. A manufacturer or supplier can enter into agency arrangements with sales agents. The sales agent and its staff are not directly employed by the supplier but act as an agent on behalf of the supplier. Sales agents do not purchase or sell products in their own name. All contracts are made either directly between the supplier and the ultimate customer or by the agent on behalf of the supplier.

In most cases the supplier imposes relatively few restrictions on its agents. These restrictions usually relate to:-

  • the price, which the products are sold;
  • what the agent can say about the supplier’s products;
  • the terms and conditions of sale;
  • territorial restrictions; and
  • restriction on whether the agent can also represent competitors

The agent is typically paid on a commission basis as incentive to sell the supplier’s products. This can act as a strong incentive for sales, particularly when carefully structured.

Other benefits are similar to those experienced in a distribution relationship (see below). The key disadvantage is that the agent’s actions bind the supplier, which then exposes the supplier to unexpected liability and risk. Again, there have been many instances where an agent’s comments or promises have left the supplier with the liability!

DISTRIBUTION/DEALER NETWORK

A distributor is an independent third party appointed by the manufacturer or supplier to market and sell its goods. Distinct from an agency arrangement, the distributor purchases the goods and sells them under its own name. There is usually no connection between the business name of the distributor and the name of the supplier of the goods. The supplier also does not regulate the day to day way in which the distributor operates its business.

However the supplier will often impose obligations necessary to protect its reputation, intellectual property and minimise its risk. In many cases, the distributor is also granted “sole” or “exclusive” rights of distribution.

The obligations are much less restrictive than the obligations/restrictions which a franchisor seeks to impose on its franchisees. Furthermore, the distributor does not pay any royalties to the supplier. The supplier generates its profits from the margins it makes on the goods sold to the distributor/dealer.

The benefits of utilizing a distribution or dealer network:

  • Use existing logistical resources of the distributor
  • No additional overheads as use of distributor/dealer’s capital/resources to set up infrastructure necessary to distribute goods
  • No need to have additional workforce
  • Only need to deal with a single or handful of distributor’s rather than directly with hundreds of customers
  • Minimise the risks if relating to creditworthiness
  • Exploitation of distributor’s existing customer base, contacts and industry knowledge
  • Distributors succeed on basis of their own efforts

The disadvantages:

  • Method only works if selling products or product ranges not business concepts
  • May decrease margins on products by introducing middle man.
  • If distributor is non-exclusive – distributor is likely to be selling competitive or non-competitive products which takes focus away from supplier’s products
  • May have to pay commission to distributor
  • Success of products will depend on the efforts of the distributor/dealer
  • May be higher cost to end consumer as a result of using a distributor leading to weakened competitiveness of the products in the market.
  • Customer list and goodwill generated by distributor and owned by distributor
  • Hard to change from an incumbent distributor

Key Issues to consider in a distribution/dealer agreement

Distribution arrangements can vary significantly on the main commercial terms. The important issues to consider in the development of any distribution contract include:

  • exclusivity and territory;
  • product or service requirements;
  • minimum performance criteria – including minimum orders or sales;
  • pricing structures and payment;
  • supply arrangements;
  • obligations and responsibilities;
  • termination;
  • product warranty and product recall;
  • promotion and marketing;
  • intellectual property; and
  • the long term goal of the arrangement.

LICENSING

Your client may have a product concept or business concept but does not have the resources or ability to produce or commercialise that concept. In this case, your client may want to consider entering into a licensing arrangement.

The most straightforward licensing arrangement involves the owner of intellectual property rights or know-how, having licensed to a manufacturer. The manufacturer can then manufacture and/or sell goods by using this intellectual property or know-how. The licensor benefits through payment of a fee or royalty, usually based on the number of products produced using the intellectual property.

Having protected intellectual property rights is usually a prerequisite to this type of relationship. Generally, there is little ongoing involvement by the owner, save to ensure its intellectual property is properly used. However, depending on the technology, the owner may be requested to provide technical assistance and support.

This is the realm of the inventor and many great success stories exist of where a great idea, that was properly protected, then generated income for years to come with little or no effort, expenditure or employment if capital or people. Unfortunately, there are many more stories where after lots of R&D and investment the great idea/product was never commercialised effectively.

Advantages of licensing

  • licensee usually risks their own capital and therefore has incentive to succeed
  • licensor requires little if any capital but receives ongoing passive income from royalties
  • licensor carries little, if any, commercial risk

Disadvantages

  • no real control over how concept is commercialised
  • less potential commercial benefit than if the licensor had gone to market themselves
  • success depends on licensee’s abilities to manufacture and sell the products and therefore no guarantee of return
  • protection of intellectual property is critical, and an agreement can end if intellectual property is successfully challenged

In each case, the written licence agreement must provide for strict quality control in order to preserve the reputation and intellectual property rights of the owner.

OTHER ISSUES

No matter whether it is a distribution agreement, licence agreement or agency, it is vital that the rights and liabilities of the parties be defined with precision in a written agreement. Particular care must be taken not to infringe the Trade Practices Act by entering into “anti-competitive” agreements. It will also be vital to carefully consider the taxation implications.

If a distributor, agent or licensee is already a competitor, proper consideration of the TPA is absolutely critical.

A ‘license agreement’ or ‘distribution agreement’ will be governed by the Code if it meets the key elements of a ‘franchise agreement’ (as discussed in our last article). The name given to an agreement is not relevant in determining whether it is to be characterised as a franchise agreement and therefore governed by the Franchising Code of Conduct.

We have come across many instances where clients were looking to establish distribution networks or licensing arrangements. However, because of the way those networks were operating or the arrangements were structured it was in fact a franchise. There are many examples that highlight this issue including proceedings brought by the ACCC in 2004 against Contact Plus, which sold “licences” to use intellectual property for the purpose of operating employment and recruitment services. The court found those licences were in fact “franchise agreements” under the Code. Consequently, the court imposed injunctions and ordered a fine and costs against the sole director of that company.

It is therefore essential to ensure that any licensing or distribution agreement is structured correctly so that it does not fall foul of the Franchising Code.

Disclaimer: Whilst all reasonable efforts have been made to substantiate the information contained in this update it is of a general nature only. Comments do not represent specific advice therefore you should not try to act on this information. If you require personal advice you should contact Macpherson+Kelley. No responsibility can be accepted if the information is incorrect or inaccurate. To unsubscribe from M+K mailings, please contact Macpherson+Kelley.

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