Recent disputes highlight franchisors' use of vendor rebates

Most franchisors receive such funds to run their supply chains, but franchisees often push back as their prices increase.
Photograph courtesy of Subway

As it tries to convince franchisees to buy into a 2-for-$10 Footlong deal scheduled to start this week, Subway is offering them something just about everybody wants: cash.

Those franchisees who agree to sell the sandwiches at the discounted price would get $700 per month as long as they run the offer, set to last through the end of August, or $2,100. At a time when restaurant operators need as much cash as they can get, the funds would seemingly be welcome.

Operators vehement opposition to the offer, however, stems at least in part from the source of that cash: rebates from Coca-Cola, Subway’s beverage vendor.

Vendor funds “should be available to all stores without strings attached since vendor funds are never ‘given’ but negotiated as a trade-off for higher food costs or longer contracts,” the North American Association of Subway Franchisees, or NAASF, said in a letter to its members last month.

The dispute sheds a light on franchisors’ use of rebates from vendors. Most systems receive rebates from food, technology or other vendors. The level of rebates varies by restaurant chain, and the use of such rebates also varies.

But they also can become the source of major disputes within a system. That’s because vendors who give out these rebates charge franchisees higher prices or get longer contracts. When systems’ sales stumble, or franchisees’ profit margins thin, operators push back. And rebates can be ripe for abuse by franchisors who see the funds as too tempting to ignore.

“That’s been a source of litigation for years,” said John Gordon, a restaurant consultant out of San Diego.

One such lawsuit, for instance, was filed by Tim Hortons’ U.S. operators, who accused the company of “price gouging” on supplies sold to franchisees. The franchisees said the company was converting the brand “into a supply chain business disguised as a franchise system.”

In a franchise system, franchises typically require their franchisees to use certain vendors for all sorts of supplies. They do this to ensure consistency of product, for instance, so a chicken sandwich is the same quality in Missouri as it is in California.

As part of this process, franchisors and vendors will typically negotiate prices that franchisees are required to pay for things like paper products or protein products or beverages.

To win that business, vendors will frequently offer franchisors rebates, or cash payments. The vendors then charge franchisees higher prices or get longer contracts in exchange for these rebates.

To the franchisor, this is a potentially lucrative business. Many franchisors get a lot of money off of this business.

Subway, for instance, generated $116 million in 2019 from vendor rebates, nearly double the amount it received the year before, according to the company’s franchise disclosure document.

Such revenues can be important for a franchise system, offsetting their costs for negotiating deals while ensuring the franchise is sustainable. And many argue that the practice of developing a workable supply chain is a separate business from operating a franchise.

“Look at the overall business, and you define the business as a franchise, and there’s a supply chain component,” said Michael Seid, founder and managing director of franchise consulting firm MSA Worldwide. “Royalties are not meant to subsidize the supply chain. Many systems don’t have a managed supply chain. Many do. Where the franchisor has a managed supply chain, the franchisor entity is entitled to earn revenue on that work.”

“Now you get into the question of how much,” Seid added. “That’s where the discussion always pops up.”

The prospect of using franchisees as a captive customer base to generate high levels of rebates can prove to be tempting.

When franchises negotiate large rebates, it can drive franchisees’ cost up to the point where it’s more expensive to get their products through the designated supplier than if they were to purchase them on their own at a place like Restaurant Depot or Costco.

Many argue that this is not how a franchise is supposed to work. Theoretically, a franchise should be able to get better rates because all of these restaurants are banding together to negotiate deals.

If franchisees’ costs grow too large, they lose one of the bigger theoretical benefits to operating a franchise brand.

Ron Gardner, a franchise attorney at the Minneapolis law firm of Dady & Gardner, argues that most franchisees don’t care about rebates so much as they care about their final costs. Most operators, he said, are perfectly fine with franchisors making money off their supply chain, but they have a problem when they make so much money that their own costs become prohibitive.

“As long as the franchisee pays less than the market, then the franchise is using their buying power, I don’t think franchisees would complain,” Gardner said. “It’s when they’re worse off” that they have problems.

As fast-casual burger chain Burgerim began struggling late in 2018 after not collecting royalties, it turned to rebates for revenues. The company used its growth numbers to negotiate large rebates from vendors, which in turn drove operators’ prices higher and contributed to the company’s collapse in late 2019.

Maybe the most infamous example of an aggressive supply chain business came from Quiznos, which generated considerable revenues for years, even as franchisees complained bitterly about their food costs—frequently deriding rebates as “kickbacks.”

Yet, it turns out, Quiznos needed those revenues to pay off some $800 million in debt. “They needed it to survive,” Gordon said. Franchisees started closing stores by the dozens in 2009, and the chain is now less than one-tenth of its peak size.

To a number of observers, one of the primary issues is disclosure. Gardner, for one, believes that disclosure rules do not provide prospective franchisees with a true picture of just how much money a franchisor makes off of rebates.

The regulations simply require franchisors to disclose how much. They do not require them disclose a franchisee’s expenses or any detailed financials of a typical location at all—which can make it challenging for prospects to understand how much rebates influence a restaurant’s cost structure.

“Once you’re in a franchise system,” Gardner said, “there’s not a lot you can do.”

Seid, for his part, says it’s rare for franchisors to charge prices that are too high. “There are guardrails on a franchisor charging too much,” he said.

While acknowledging that disclosure rules could be better, he also stressed the importance of prospective franchisees doing their research before buying into any system. That means talking with existing operators about their cost structure.

“Look at whether the cost structures are fair and reasonable,” Seid said. “If it doesn’t give you a sustainable return on investment, then don’t invest in the franchise.”

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