Seizing an Opportunity: Supplier Contracts and System Health

Contracts with the suppliers that provide the "secret sauce," hats with logos, on-time delivery, and other key ingredients of a franchise system sometimes take the back burner compared with those agreements that drive system expansion, such as the negotiation and execution of franchise and development agreements. In today's dynamic marketplace, where a focus on the system's supply chain can significantly affect their bottom line, franchisors are wise to focus on their contracts with suppliers as part of an overall supply chain strategy aimed at reducing costs, increasing efficiency, and staying ahead of competitors. These contracts provide significant opportunities for improving a franchise system.

Supply contracts

There are several structuring options for franchise system supply chains, including approved supplier designations, the franchisor as a supplier, franchisees' selection of suppliers with product specifications, and buying groups such as purchasing cooperatives. Which structure a franchise system selects depends on the type of products and services offered, the degree of control the franchisor chooses to retain, the size of the system, and the location of the franchised units. Further, there is not a one-size-fits-all solution, and franchise systems often use a combination of supply chain strategies, depending on the product or service, and the geographic area. Although this list is certainly not exhaustive, a franchisor will often encounter one of the following supply contracts:

• master supply agreement--manufacturer or producer agrees to supply a particular product or service to the entire system (typically used for proprietary items);
• unit supply agreement--most often used in connection with commodities and fungible goods, often between a franchisee and manufacturer or producer;
• 3PL agreement--third-party logistics provider offers warehousing, transportation, freight forwarding, and inventory management; and
• distribution agreement--distributor supplies products to outlets.

Key considerations

Often, contracts with manufacturers, suppliers, and logistics providers (warehouse, freight, etc.) are short forms provided by the supplier of products or services and provide scant protection for the interests of the purchaser (or its franchisees). While there is law available to fill in the gaps (Article 7 of the Uniform Commercial Code, for example, regarding warehouse receipts, bills of lading, and other documents of title), a franchise system can miss a significant opportunity to pursue more favorable terms and/or to form a partnership with a product or service provider that will strengthen the franchise system.

In their supplier agreements, franchisors will want to ensure they are using standardized, streamlined agreements with provisions tailored to their franchise system. This will allow the franchisor to keep track of the many different contracts, sometimes numbering in the hundreds for larger systems, and to ensure that the contracts provide similar rights to the franchisor and address subjects important to the franchisor and the success of the system. The following are some of the topics that should be addressed in a supply contract for a franchise system:

Protection of intellectual property

• Use of trademarks in the production and distribution of products.
• Prohibition on reverse engineering of products.
• Use of franchisor's specifications, and as needed, nondisclosure of specifications to franchisees or others.

Quality assurance

• Conformity with specifications to produce uniform products and trace products from production to sale to consumers.
• Plan/provision for unexpected delays or shortages.
• Plan to handle increased growth, e.g., the use of additional warehouse space or increased production during key selling seasons.
• Monitoring of supplier's performance, e.g., by using key performance indicators.

Franchisor-franchisee relationship

• Sharing of information regarding franchisees and their purchases between supplier and franchisor.
• Allocation of products and/or services among franchisees in the event of a shortage, e.g., deferral to franchisor's instructions or first come, first served.
• If supplier rebates will be shared with franchisees or paid directly to an advertising fund.

System economics

• Forecasts and whether franchisor and/or franchisees will give a binding forecast.
• Payment and credit terms and potential fallout if the franchisor or a large franchisee fails to pay a key supplier for the system in a timely manner.
• Risk management, such as adequate insurance (and which parties are covered), allocation of responsibility for risks, and any limitations on consequential damages.

Disclosure considerations

As a final note, a franchisor must consider the impact that a new supplier relationship may have on Item 8 of its FDD. Item 8 must include the disclosure of certain requirements concerning franchisor-imposed restrictions on sources of products and services. A franchisor must disclose, among other information: 1) whether it or any affiliates are approved suppliers, 2) certain information regarding benefits or rebates, and 3) information regarding the approval of alternative suppliers. No matter which specific supply chain option(s) a franchisor selects, it is essential for any franchise system looking optimize profits, maintain healthy growth, and set itself apart from competitors to understand the role that supplier contracts can play in the successful operation of a franchise system and the opportunities that strong supplier contracts and relationships can bring.

Suzie Trigg and Emma Ricaurte Harker are attorneys in the Franchise and Distribution Practice Group of Haynes and Boone, LLP. They can be reached at suzie.trigg@haynesboone.com and emma.harker@haynesboone.com.