About 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 Terms Franchising 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 Terms Franchising 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 of Franchises Types of 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
Commercial economics week 5

…continued

Types of Franchises Types of 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 Pros and Cons of The Pros and Cons of Franchising Franchising
Pluses Formalized training Financial assistance Proven marketing methods Managerial assistance Quicker startup time Overall lower failure rates Minuses Franchise fees Royalties Restrictions on growth Less independence in operations Franchisor may be sole supplier of some supplies Termination/renewal clauses

Figure 3-2 Commercial economics week 5

The Advantages of The Advantages of Franchising Franchising
 Proven marketing concept and customer

base  Training  Financial assistance  Operating assistance

Commercial economics week 5

Financial Assistance Financial 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 Assistance Operating 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 and Cons of Franching Pros and Cons of Franching
 Advantages

 Limitations

– Probability of success  Proven line of business  Pre-qualification of franchisee – Training  Franchisorprovided – Financial assistance  Franchisor assistance – Operating benefits  Franchisor-aided

– Franchise costs Initial franchise fee  Investment costs  Royalty payments  Advertising costs – Restrictions on Business Operations – Loss of independence

Commercial economics week 5

Limitations of Franching: Limitations of Franching: Restriction of Business Restriction of 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 Franchise Evaluating 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 of Costs Explanation of Costs
 Franchise fee  First and Last Month’s Rent  Leasehold Improvements  Equipment  Furniture and Fixtures  Signage

 Insurance, Licences    

and Permits Training Initial Inventory Working Capital Royalty

Commercial economics week 5

Global Franchising Global 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 the Franchise Investigating the Franchise Candidate Candidate
 Three sources of information:

– independent third party sources – franchisors – existing and previous franchisees

Commercial economics week 5

Selling a Franchise Selling a Franchise

Why would a businessperson wish to become a franchisor? Three benefits can be identified:
1. 2. 3.

Reduction of capital requirements Increase in management motivation Speed of expansion
Commercial economics week 5

…continued

Selling a Franchise Selling a 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 Frauds Franchising 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 transactions
Transaction imperatives

Cross border

Key tax and financial considerations  Income stream  Entry strategy  Financing options  Debt structuring  Cash repatriation  Exit considerations Case Study  Business reorganisations  Leasing transactions

Key tax and financial considerations

Commercial economics week 5

Cross border transaction imperatives
Business Environment Cultural Issues Business Dynamics Accounting treatment

Cross Border Transactions
Legal & regulatory framework Tax regimes & treaties

Identifying and delivering synergies

Commercial economics week 5

Key tax and financial considerations
2 1
Income flows and their taxability Entry Strategy

3
Financing options

6

Cross border transactions
Exit considerations

4
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

Capital gains

TS and royalty would typically flow to an operating entity, which possess technical capabilities

Interest Others: royalty / brand fees / technical services / management services

Principal drivers are tax costs associated with dividend flows and gains on disposal of 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 party) Quasi Debt (Preference stock – mezzanine instrument ) Medium to long term Dividend Term Pay outs Tax rate Tax credit Long Tem Dividend Medium to long term Interest

DDT payable @ 14.025% Withholding tax @ 0 / 10 / DDT would be payable @ 15 / 20% 14.025% Not available under most Treaties (check domestic laws of home country) No restrictions Tax withholding on interest Not available under most available Treaties (check domestic laws of home country)

Usage

Restriction on usage as No restrictions per ECB guidelines (see next company can be highly leveraged if it meets No thin capitalisation norms and hence an Indianslide)

commercial requirements Deductibility Dividends and DDT not Interest allowed as Dividends and DDT not Leveraging deductible Indian company using overseas debt subject to restrictions in ECB Guidelines (see next deduction (arm’s length deductible; consider slide) principle) double dip deduction

Commercial economics week 5

4 Debt structuring
• Internationally recognized sources (international banks, capital markets, multilateral financial

Lenders

Institutions, equipment suppliers, foreign collaborators) • 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 • 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)

Amount/ maturity

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 of debt Prepayment

• ECBs with minimum average maturity of 3-5 yrs: 200 bps above six month LIBOR • 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 average maturity period
MUSD means million United States Dollars

Commercial economics week 5

5 Cash repatriation
Suitability

Dividend distribution Simplest and most common

Profit making company Ease of repatriation

Capital reduction Court regulated process, involving repayment of share capital – comparatively complex and time consuming – amount paid to the extent of accumulated profits of the company would be taxable as dividend in India Share buyback Repurchase of shares – restricted amount of repatriation – income taxable as capital gains in hands of the shareholder
Broad mechanics of each of the above options have been discussed in detail in Annexure 1 Commercial economics week 5

Cash rich company with low reserves Loss making company with cash reserves Maximum amount of repatriation desired Profit making company Foreign Co desires to classify the income as ‘capital gains’ instead of ‘dividend’ – possible treaty benefits

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

Commercial economics week 5

Overview of the structure
Case Study to suggest mechanism to achieve business objectives of US Corp & Indian Partner US Corp (conglomerate)
USA
100%

Business strategy
US Corp Phase I Asian strategy - acquire control of Target Co Foods business of F&P to be consolidated with Target Co Phase II Target Co sells trademark to US Corp US Corp licenses trademark to Target Co US Corp receives royalty Indian Partner

• •

Mauritian Co*
Mauritius
43%

100%

• •
Target Co (Foods)

India
57%

*Consider Singapore jurisdiction

Indian Partner Auto ancillary

Foods & Packaging

Redefining strategy Focus on core business - auto ancillary Exit non-core business

Commercial economics week 5

Case study - modes of acquisition
Increase in stake

Direct increase Acquisition of shares

Passive increase Preferential allotment of shares Capital reduction of identified shares Share buyback

Business restructuring

Merger Demerger Sale of business undertaking/ sale of assets

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 Co Indian Partner

51% 43% Merger

Target Co
57% 49%

Foods & Packaging

Present scenario Post Merger

Issue of shares to Mauritius Co. as consideration of food business

Fiscal and regulatory implications of merger Company Law Implications Special resolution Court approved process Dissolution of F&P under Court order without winding up Tax Implications Broadly tax neutral on satisfying conditions Transfer of tax losses and tax benefits of F&P Tax losses available for fresh lease of 8 years Stamp duty costs significant Other Implications Valuation of companies No foreign investment approvals, subject to conditions No cash outflow for Mauritian Co No consideration to Indian Partner on indirect dilution of its stake

Commercial economics week 5

Phase II – Sale and license back of trademark
Mechanics Mauritian Co Target Co transfers its Trademark (‘TM’) to Mauritian Co. Subsequently Mauritian Co licenses TM back to Target Co
License of trademark – royalty income Sale of trademark – capital gains

Mauritius India

51%

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 Lessor is the legal and the economic owner Finance lease Lessor is the legal owner Lessee is the economic owner

Risks and rewards associated with the asset not substantially transferred

Risks and rewards associated with the asset are substantially 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 Lessor • Royalties - Section 9(1)(vi) Or • Section 44BBA - 5% of deemed profits Lessee • Lease rentals allowed as deduction • Depreciation allowed to lessor Dry lease Lessor • Royalties - Section 9(1)(vi) Or • Section 44BBA – 5% of deemed profits Lessee • Resident - Lease rentals would be 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

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