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Franchising
and Leasing

Commercial economics week 5


Describe the significance of franchising
Identify the major advantages and limitations of franchising
Discuss the process for evaluating a franchise opportunity.
Evaluate franchising for the franchisor’s perspective.
Describe the franchisor/franchisee relationship.

Commercial economics week 5


Franchising
Franchising Terms
Terms
Franchising
 A marketing system revolving around a two-party
legal agreement, whereby the franchisee conducts
business according to the terms specified by the
franchisor
Franchise contract
 The legal agreement between franchisor and
franchisee
Franchise
 The privileges conveyed in the franchise contract

…continued

Commercial economics week 5


Franchising
Franchising Terms
Terms
 Franchisee
 An entrepreneur whose power is limited by a
contractual agreement with a franchisor
 Franchisor
 The party in the franchise contract that specifies the
methods to be followed and the terms to be met by
the other party

Commercial economics week 5


Types
Types of
of Franchises
Franchises
Product and Trade Name Franchise
 Grants the right to use a widely recognized
product or name
Business Format Franchise
 Provides an entire marketing system and
ongoing guidance from the franchisor
Piggyback Franchising
 The operation of a retail franchise within the
physical facilities of a host store
…continued

Commercial economics week 5


Types
Types of
of Franchises
Franchises
Master Licensee
 An independent firm or individual acting as a sales agent
with the responsibility for finding new franchises within a
specified territory
Multiple-Unit Ownership
 Holding by a single franchisee of more than one franchise
from the same company
Area Developers
 Individuals or firms that obtain the legal right to open
several franchised outlets in a given area

Commercial economics week 5


The
The Pros
Pros and
and Cons
Cons of
of
Franchising
Franchising
Pluses Minuses
Formalized training Franchise fees

Financial assistance Royalties

Proven marketing Restrictions on growth


methods
Less independence in
Managerial assistance operations
Franchisor may be sole
Quicker startup time supplier of some
Overall lower failure supplies
rates Termination/renewal
clauses

Figure 3-2

Commercial economics week 5


The
The Advantages
Advantages of
of
Franchising
Franchising
 Proven marketing concept and customer
base
 Training
 Financial assistance
 Operating assistance

Commercial economics week 5


Financial
Financial Assistance
Assistance
 Start-up business costs are normally high and
thus by teaming up with a franchise
organization, the individual can increase
her/his chance of receiving financial help.
 The franchisor might chose to use liberal
payment schemes to the franchisee in order
to get over the initial financial hurdle.

Commercial economics week 5


Operating
Operating Assistance
Assistance
 The franchisor provides a range of operating
services including site selection, bulk
purchasing of equipment, and inventory.
 Other areas of assistance include the use of
an established, nation-wide brand

Commercial economics week 5


Pros
Pros and
and Cons
Cons of
of Franching
Franching
 Advantages  Limitations
– Probability of success – Franchise costs
 Proven line of
business
 Initial franchise fee
 Pre-qualification of  Investment costs
franchisee  Royalty payments
– Training  Advertising costs
 Franchisor-
provided – Restrictions on Business
– Financial assistance Operations
 Franchisor – Loss of independence
assistance
– Operating benefits
 Franchisor-aided

Commercial economics week 5


Limitations
Limitations of
of Franching:
Franching:
Restriction
Restriction of
of Business
Business
Operations
Operations
 Restricting of sales territory
 Requiring site approval and
imposing requirement on the
outlet’s appearance
 Restricting the goods/
services that can be sold
 Restricting the resale of
the franchise without their permission
 Restricting advertising and hours of operation

Commercial economics week 5


Evaluating
Evaluating Franchise
Franchise
Opportunities
Opportunities
 Locating a Franchise Opportunity
 Investigating the Potential Franchise
 Information sources
 Independent, third-party sources
 Franchisors themselves
 Existing and previous franchisees

Commercial economics week 5


Explanation
Explanation of
of Costs
Costs
 Franchise fee  Insurance, Licences
 First and Last Month’s Rent and Permits
 Leasehold Improvements
 Training
 Equipment
 Furniture and Fixtures
 Initial Inventory
 Signage  Working Capital
 Royalty

Commercial economics week 5


Global
Global Franchising
Franchising
Opportunities
Opportunities
 Historically, many Canadian franchisors have
expanded into the United States.
 Canadian franchising enterprises are now
expanding into countries beyond North
America.

Commercial economics week 5


Investigating
Investigating the
the Franchise
Franchise
Candidate
Candidate
 Three sources of information:
– independent third party sources
– franchisors
– existing and previous franchisees

Commercial economics week 5


Selling
Selling aa Franchise
Franchise
 Why would a businessperson wish to
become a franchisor? Three benefits can be
identified:
1. Reduction of capital
requirements
2. Increase in management
motivation
3. Speed of expansion
…continued

Commercial economics week 5


Selling
Selling aa Franchise
Franchise
 Drawbacks associated with franchising from
the franchisor’s perspective.
1. Reduction in control
2. Sharing of profits
3. Increase in operating support

Commercial economics week 5


Franchising
Franchising Frauds
Frauds
 The Rented Rolls Royce Syndrome
 The Hustle
 The Cash-Only Transaction
 The Boast
 The Big-Money Claim
 The Couch Potato’s Dream
 Location, Location, Location
 The Disclosure Dance

Commercial economics week 5


LEASING
and
Cross border
transactions
Transaction imperatives

Key tax and financial considerations


 Income stream
 Entry strategy
 Financing options
 Debt structuring Key tax and financial considerations
 Cash repatriation
 Exit considerations

Case Study
 Business reorganisations

 Leasing transactions

Commercial economics week 5


Cross border transaction
imperatives
Business
Cultural Issues
Environment

Business Accounting
Dynamics treatment

Cross Border
Transactions
Legal & regulatory Tax regimes &
framework treaties

Identifying and
delivering synergies

Commercial economics week 5


Key tax and financial
considerations
2 Entry Strategy

1 3
Income flows and Financing
their taxability options

Cross border
transactions
6 4
Exit considerations Debt Structuring

5 Cash repatriation

Commercial economics week 5


Income stream and
1 their taxability
Income streams Principles for evaluation

Dividends Interest, TS and royalty can flow independent


of ownership pattern
TS and royalty would typically flow to an
Capital gains
operating entity, which possess technical
capabilities
Interest
Principal drivers are tax costs associated with
dividend flows and gains on disposal of
Others: royalty / brand fees / technical
services / management services shares
Brand fee would flow to the IPR company

Key elements – arm’s length principle, documentation, overall tax costs and foreign tax credits

Commercial economics week 5


3 Financing options
Parameters Equity Debt (related & third Quasi Debt (Preference
party) stock – mezzanine
instrument )

Term Long Tem Medium to long term Medium to long term


Pay outs Dividend Interest Dividend
Tax rate DDT payable @ 14.025% Withholding tax @ 0 / 10 / DDT would be payable @
15 / 20% 14.025%
Tax credit Not available under most Tax withholding on interest Not available under most
Treaties (check domestic available Treaties (check domestic
laws of home country) laws of home country)

Usage No restrictions Restriction on usage as No restrictions


per ECB guidelines (see
next slide)
No thin capitalisation norms and hence an Indian company can be highly leveraged if it meets
commercial Dividends
requirements
Deductibility and DDT not Interest allowed as Dividends and DDT not
Leveraging deductible
Indian company using overseasdeduction (arm’s length
debt subject to restrictions in deductible;
ECB consider
Guidelines (see next
slide) principle) double dip deduction

Commercial economics week 5


4 Debt structuring
• Internationally recognized sources (international banks, capital markets, multilateral financial
Institutions, equipment suppliers, foreign collaborators)
Lenders • Foreign equity holder if:
 ECB up to 5 MUSD – minimum equity of 25%
 ECB above 5 MUSD – minimum equity of 25% and debt-equity ratio not exceeding 4:1

• Upto 20 MUSD – Minimum average maturity of 3 years, can have call / put option
Amount/
maturity • Over 20 MUSD to 500 MUSD – Minimum average maturity of 5 years
• ECBs outside the above limits/ maturity period need specific approval

• Investment in real sector (capital goods, new projects, modernization/ expansion of units)

End use • Investment in Infrastructure sector (power ,telecommunication, railways, roads, ports etc)
• Not to be utilized in capital market transactions, real estate, acquisition, working capital,
repayment of Rupee loans

Total cost • ECBs with minimum average maturity of 3-5 yrs: 200 bps above six month LIBOR
of debt • ECBs with minimum average maturity of more than 5 yrs: 350 bps above six month LIBOR

• ECBs upto 200 MUSD can be pre-paid without approval subject to compliance with minimum
Prepayment
average maturity period

MUSD means million United States Dollars

Commercial economics week 5


5 Cash repatriation
Suitability

Dividend distribution Profit making


company
Simplest and most common Ease of repatriation

Capital reduction Cash rich company with


low reserves
Court regulated process, involving repayment of share capital – Loss making company
comparatively complex and time consuming – amount paid to with cash reserves
the extent of accumulated profits of the company would be Maximum amount of
taxable as dividend in India repatriation desired

Share buyback Profit making company


Foreign Co desires to
Repurchase of shares – restricted amount of repatriation – classify the income as
income taxable as capital gains in hands of the shareholder ‘capital gains’ instead of
‘dividend’ – possible
treaty benefits
Broad mechanics of each of the above options have been
discussed in detail in Annexure 1

Commercial economics week 5


6 Exit considerations

Capital gains

No Objection Certificate requirement for setting up new venture – Press note


1 of 2005 (refer Annexure 2 for process)
Shareholder’s agreement and implications thereof –
Right of First Refusal; Tag Along rights; Drag Along rights

Liquidation process – long drawn and Court approval process

Commercial economics week 5


Case Study – acquisition of
business
Target Co
US Corp Mauritian Co Indian Partner
Indian

Global Controls US Corp’s Leading Indian


conglomerate significant strategic holding company (not
engaged in share of the company for part of US Corp
diversified Indian foods Asian group)
businesses market investments Holds majority
Aggressively Leading Has a wholly equity in Target
targeting Asian exporter to owned Indian Co
foods markets Asia subsidiary, F&P,
Has significant Strong track engaged in two
experience in record and businesses -
the foods substantial foods and
business and reserves packaging
commands a F&P has
powerful brand accumulated tax
name losses

Commercial economics week 5


Overview of the structure
Case Study to suggest mechanism to achieve business objectives of Business strategy
US Corp & Indian Partner
US Corp

US Corp Phase I
(conglomerate) • Asian strategy - acquire
control of Target Co
USA 100% • Foods business of F&P to
be consolidated with
Target Co
Mauritian
100%
Co* Phase II
Mauritius • Target Co sells trademark
43% to US Corp
• US Corp licenses
Target Co trademark to Target Co
(Foods) • US Corp receives royalty
India
Indian Partner
57%
Redefining strategy
Focus on core business
*Consider Singapore Foods &
Indian Partner - auto ancillary
jurisdiction Packaging
Auto ancillary Exit non-core business

Commercial economics week 5


Case study - modes of
acquisition
Increase in
stake

Direct Passive Business


increase increase restructuring

Acquisition of Preferential Merger


shares allotment of Demerger
shares Sale of business
Capital reduction undertaking/
of identified sale of assets
shares
Share buyback

The case study however discusses the implications arising under the
merger option, in detail in following slides

Commercial economics week 5


Phase I - Mechanics of
merger
100%
Mauritius 51%
Co 43%
Foods &
Target Co Merger Packaging
Indian 57%
Partner
49%
Present scenario
Issue of shares to Mauritius Co. as consideration of food business Post Merger

Fiscal and regulatory implications of merger

Company Law Implications Tax Implications Other Implications

Special resolution Broadly tax neutral on Valuation of companies


Court approved process satisfying conditions No foreign investment
Dissolution of F&P under Transfer of tax losses and approvals, subject to
Court order without tax benefits of F&P conditions
winding up Tax losses available for No cash outflow for
fresh lease of 8 years Mauritian Co
Stamp duty costs No consideration to Indian
significant Partner on indirect
dilution of its stake

Commercial economics week 5


Phase II – Sale and license
back of trademark
Mechanics

Mauritian
Co

License of trademark –
Target Co transfers

capital gains
Sale of trademark –
its Trademark (‘TM’) 51%
to Mauritian Co. Mauritius

royalty income
Subsequently
India
Mauritian Co
licenses TM back to
Target Co

Target Co

Arm’s length nature of sales and licensing of trademark


May entail service tax and Value Added Tax

Commercial economics week 5


Leasing transactions
Salient features of leasing transactions
Wet lease

Lease of equipment with resources to operate the equipment


Lessor continues to control the operation of the equipment and its maintenance
Example– Lease of an aircraft along with flight crew; lessor responsible for
selection/ hiring of flight crew, operation and maintenance of
aircraft, etc

Dry lease

Lessor merely provides the equipment at a particular


location
Lessee operates the equipment using his own resources
Example – Lease of aircraft without crew
Forms of dry lease:
 Operating lease
 Finance lease

Commercial economics week 5


Operating Lease vs. Finance
Lease
Operating lease Finance lease

Lessor is the legal and the Lessor is the legal owner


economic owner Lessee is the economic owner

Risks and rewards associated Risks and rewards associated


with the asset not substantially with the asset are substantially
transferred transferred

Risks include losses due to idle capacity, technological obsolescence & changing
economic conditions. Rewards include expectation of profitable operation over economic
life of asset and gain from appreciation in value or realisation of residual value

Source: Accounting Standard 19 issued by the Institute of Chartered Accountants of India

Commercial economics week 5


Taxation of leases – domestic
law
Wet lease Dry lease
Lessor Lessor
• Royalties - Section 9(1)(vi) • Royalties - Section 9(1)(vi)
Or Or
• Section 44BBA - 5% of deemed profits • Section 44BBA – 5% of deemed profits

Lessee Lessee
• Lease rentals allowed as deduction • Resident - Lease rentals would be
• Depreciation allowed to lessor allowed to the lessee
• Depreciation would be allowed to the
lessor
• Section 10(15A) – exemption from tax
withholding extended

May entail service tax and Value Added Tax

Commercial economics week 5