THE COVID-19 CONUNDRUM IN FOOD FRANCHISING
The fall-out from the Covid-19 pandemic has been felt in all areas of the economy, with the food and beverage sector taking a spectacular knock as it fought closures during lockdown, sporadic openings, alcohol bans and even closures. According to Statistics South Africa, during February 2021, the sector declined 24.6% year on year, with bar sales falling 49,3% and food sales down by 22.5%. The only silver lining seems to be in the fast food and take-away sub-sector that, surprisingly in February 2021, was up by 0.1% – no great shakes, but at least a positive growth.
According to Eric Parker, Partner and Consultant at franchise consultancy Franchising Plus, “for many franchises, building on or introducing take-out and delivery options was a lifeline and the difference between having to close your doors or eking out an existence until things improved. Whilst that is definitely a silver lining to this pandemic, the fly in the ointment (or should it be the sauce!) is the impact of delivery service charges on franchise royalties/management service fees.”
This led to the big question of how should franchise royalties be paid in the instance of using a third-party delivery service i.e., should royalties be charged on gross sales or net sales?
“The problem” says Parker “soon became one that would affect the franchise not only operationally and financially but it also raised the legal question of would franchise agreements need to be updated in light of the consequences of lockdown?. To solve the conundrum, we roped in franchise specialist attorney Maria D’Amico of D’Amico Incorporated Attorneys to give her assessment and try and make sense of this conundrum. This is what she has to say[MD2] .
The problem as we see it
The lockdown regulations have resulted in an exponential increase in the use of a third party delivery service provider (the delivery provider) in the delivery of products from the store owner to the customer. For example, when a customer wishes to order cooked and convenient food products, generally classified as “fast food” (the food item) from a franchised store which is operated by a franchisee (the store):
- the delivery provider will collect the food item from the store,
- the store will give the delivery provider a till slip/receipt reflecting the amount that the customer must pay,
- the delivery provider then delivers the food item to the customer, and the customer pays the delivery provider the amount reflected on the till slip/receipt.
- the delivery provider will then proceed to deduct their delivery charges from the paid amount and (in due course) pay over the net amount to the store. This procedure is not limited to the fast food industry but relates to all industries where products are sold to a customer through a delivery provider.
When level 4 lockdown was announced, the regulations stated (amongst other things) that certain hot foods which were ready for consumption by the customer could only be sold by way of home delivery. In this instance, if a store wished to sell such hot food, and as it could only be sold by way of home delivery, such store had to either employ staff to deliver the food item to the customer’s house or appoint the delivery provider to do so.
Let us look at an example when the store appoints a delivery provider and how the income is split between them.
For simplicity sake, the VAT implications, including which party is required to pay the VAT, will be disregarded.
- The normal selling price for the food item by the store is: R79,99
- The increased price (mark-up of 20%) when purchased through the delivery service is: R95.99
- The amount paid (30%) to the delivery provider is: R28.80
- The amount paid (70%) to the store after delivery is: R67.19
The store will ring up a till slip/receipt of R95.99. The delivery provider receives this amount from the customer when delivering the food item. The delivery provider then deducts their delivery fees of R28,80 and pays over to the store the amount of R67.19. In this instance, the store will not receive R79,99 which would have been its normal selling price but only R67,19. In instances where the delivery is done through a delivery app, the payment is deducted before the food item is delivered but the store (on the above example) will still only receive R67.19 instead of the normal selling price of R79,99.
Adjusting the Franchise Agreement
Many franchise agreements stipulate that the franchisee will pay royalties on a percentage of the store’s turnover, e.g.,6% of turnover being the rate of royalties payable by the franchisee. In the example above, the turnover is R95.99 and the franchisee will be obliged to pay 6% (using the rate assumed) on that amount which amounts to R5,76. However, the franchisee only received R67.19 and 6% of that amounts to R4,03. The franchisee (instead of paying R4,03) is now obliged to pay R5,76 for selling that food item as R95,99 is the amount reflected as the turnover amount i.e., the amount reflected on the till slip/receipt. This difference will (over time) negatively impact the franchisee’s financial situation as its operating expenses have increased and in certain instances may make the store financially unsustainable.
In the present example, the selling price of the food item was increased to accommodate part of the delivery charge but not the whole delivery charge. As a result of this way of doing business, the store (the franchisee) now has to absorb the extra cost in having the food item delivered to the customer.
One could argue that as a result of using the delivery provider the store’s volume of sales will increase. However, this does not detract from the fact that the store must now pay royalties on the deemed selling price which is not the amount the store actually receives after the delivery charge has been deducted on each food item sold.
Once a franchise agreement has been signed between a franchisor and their franchisee the franchisor is not legally obliged to vary the 6% royalty in light of the new circumstances which in this instance is an unforeseen increase of the store’s operating costs as a result of the delivery charges. Some franchisors are not prepared to negotiate a variation of the rate of royalties despite the changed circumstances.
Franchisors are reminded that the success of their franchisees reflects on the success of the franchisor and the franchised brand and should a franchisee fail, it could reflect badly on the franchisor and the franchised brand, especially if there are a number of franchisees (within a franchised group) that fail.
Where franchisors are amendable to varying the royalty rate in light of the above circumstances, then all that is required is to conclude an addendum between the franchisor and their franchisees and amend the definition of “turnover” so that where the food item (or any product) is sold by a delivery provider then the turnover in that instance will be equivalent to the amounts paid to the franchisee after the delivery charges have been deducted.
What we think franchisors should consider
Franchisors must bear in mind that when they prepared their initial financial projections that formed part of their disclosure document, such financial projections may not have included the impact of a delivery charge by the third-party delivery provider. If the delivery charge now becomes an expense to the store and increases the store’s operating costs, that franchisor will be obliged to update their financial projections in their disclosure document to incorporate this expenditure. If the franchisor still insists on receiving 6% (as an example) royalty on turnover, regardless of the increased operating costs, then the store may not be financially sustainable and a prospective franchisee (when s/he peruses the financial projections) will not want to conclude a franchise agreement with that franchisor because the business model may now have become financially unsustainable.
Concludes Maria D’Amico, “the consequences of lockdown have created exceptional circumstances and there has been an exponential increase in the use of delivery providers for the delivery of products from a store to a customer (with the concomitant cost), which has in certain instances resulted in a decrease in net sales for the franchisee. Franchisors are urged to give consideration to a downward variation of the rate of royalties payable on the franchisee’s turnover, or an exclusion of the additional delivery costs from the amount of turnover on which the royalty is calculated, so that the payment of royalty is sustainable to the franchisor as well as their franchisees.”
This controversial conundrum will be tackled by both Eric Parker of Franchising Plus and Maria D’Amico of D’Amico Incorporated Attorneys at the Franchise Association of South Africa’s ‘Franchising in Africa’ virtual conference taking place on the 25th and 26th August 2021. For further information and to attend visit www.fasa.co.za
Article prepared by Franchising Plus and legal comment by D’Amico Incorporated
This article has been compiled for information purposes only and does not constitute legal advice. D’Amico Incorporated cannot accept liability for any loss or damage caused to any individual or entity that has acted or omitted to act based on this information.