About Franchising and Leasing

1. About Franchising and Leasing Commercial economics week 5

2. 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

3. 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

4. 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

5. 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 …continued Commercial economics week 5

6. 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

7. Pluses Minuses Formalized training Franchise fees Financial assistance Royalties Proven marketingmethods Restrictions on growth Less independence inoperations Managerial assistance Franchisor may be solesupplier of somesupplies Quicker startup time Overall lower failurerates Termination/renewalclauses The Pros and Cons of Franchising Figure 3-2 Commercial economics week 5

8. The Advantages of Franchising • Proven marketing concept and customer base • Training • Financial assistance • Operating assistance Commercial economics week 5

9. 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

10. 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

11. Pros and Cons of Franching • Advantages • Probability of success • Proven line of business • Pre-qualification of franchisee • Training • Franchisor-provided • Financial assistance • Franchisor assistance • Operating benefits • Franchisor-aided • Limitations • Franchise costs • Initial franchise fee • Investment costs • Royalty payments • Advertising costs • Restrictions on Business Operations • Loss of independence Commercial economics week 5

12. Limitations of Franching: Restriction of Business 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

13. Evaluating Franchise 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

14. 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 Explanation of Costs Commercial economics week 5

15. Global Franchising 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

16. Investigating the Franchise Candidate • Three sources of information: • independent third party sources • franchisors • existing and previous franchisees Commercial economics week 5

17. Selling a Franchise • Why would a businessperson wish to become a franchisor? Three benefits can be identified: • Reduction of capital requirements • Increase in management motivation • Speed of expansion …continued Commercial economics week 5

18. Selling a Franchise • Drawbacks associated with franchising from the franchisor’s perspective. • Reduction in control • Sharing of profits • Increase in operating support Commercial economics week 5

19. 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

20. LEASING and Cross border transactions Transaction imperatives • Key tax and financial considerations • Income stream • Entry strategy • Financing options • Debt structuring • Cash repatriation • Exit considerations Key tax and financial considerations • Case Study • Business reorganisations • Leasing transactions Commercial economics week 5

21. Business Environment Cultural Issues Business Dynamics Accounting treatment Cross Border Transactions Legal & regulatory framework Tax regimes & treaties Identifying and delivering synergies Cross border transaction imperatives Commercial economics week 5

22. 2 Entry Strategy 1 3 Income flows and their taxability Financing options Cross border transactions 4 6 Exit considerations Debt Structuring 5 Cash repatriation Key tax and financial considerations Commercial economics week 5

23. Income stream and their taxability 1 Income streams Principles for evaluation • Interest, TS and royalty can flow independent of ownership pattern • TS and royalty would typically flow to an operating entity, which possess technical capabilities • Principal drivers are tax costs associated with dividend flows and gains on disposal of shares • Brand fee would flow to the IPR company Dividends Capital gains Interest Others: royalty / brand fees / technical services / management services Key elements – arm’s length principle, documentation, overall tax costs and foreign tax credits Commercial economics week 5

24. Financing options 3 • No thin capitalisation norms and hence an Indian company can be highly leveraged if it meets commercial requirements • Leveraging Indian company using overseas debt subject to restrictions in ECB Guidelines (see next slide) Commercial economics week 5

25. Debt structuring 4 • Internationally recognized sources (international banks, capital markets, multilateral financial 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 Lenders • 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 Amount/ maturity • Investment in real sector (capital goods, new projects, modernization/ expansion of units) • 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 End use Total cost of debt • 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 Prepayment MUSD means million United States Dollars Commercial economics week 5

26. Cash repatriation 5 Suitability • Profit making company • Ease of repatriation Dividend distribution Simplest and most common • Cash rich company with low reserves • Loss making company with cash reserves • Maximum amount of repatriation desired 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 • Profit making company • Foreign Co desires to classify the income as ‘capital gains’ instead of ‘dividend’ – possible treaty benefits 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

27. Exit considerations 6 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

28. Case Study – acquisition of business Target Co Indian US Corp Indian Partner Mauritian Co • Controls significant share of the Indian foods market • Leading exporter to Asia • Strong track record and substantial reserves • 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 • Global conglomerate engaged in diversified businesses • Aggressively targeting Asian foods markets • Has significant experience in the foods business and commands a powerful brand name Commercial economics week 5

29. Indian Partner Auto ancillary Overview of the structure Case Study to suggest mechanism to achieve business objectives of US Corp & Indian Partner Business strategy US Corp • Phase I • Asian strategy - acquire control of Target Co • Foods business of F&P to be consolidated with Target Co US Corp (conglomerate) USA 100% Mauritian Co* 100% • Phase II • Target Co sells trademark to US Corp • US Corp licenses trademark to Target Co • US Corp receives royalty Mauritius 43% Target Co (Foods) India Indian Partner 57% • Redefining strategy • Focus on core business - auto ancillary • Exit non-core business Foods & Packaging *Consider Singapore jurisdiction Commercial economics week 5

30. Case study - modes of acquisition Increase in stake Business restructuring Directincrease Passive increase • Merger • Demerger • Sale of business undertaking/sale of assets • Acquisition of shares • Preferential allotment of shares • Capital reduction of identified shares • Share buyback The case study however discusses the implications arising under the merger option, in detail in following slides Commercial economics week 5

31. Phase I - Mechanics of merger 100% 51% Mauritius Co 43% Foods & Packaging Target Co Merger Indian Partner 57% 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 • Court approved process • Dissolution of F&P under Court order without winding up • 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 • 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

32. 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 51% Mauritius License of trademark – royalty income Sale of trademark – capital gains India Target Co Arm’s length nature of sales and licensing of trademark May entail service tax and Value Added Tax Commercial economics week 5

33. Leasing transactionsSalient 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

34. Operating Lease vs. Finance Lease Operating lease Finance lease Lessor is the legal and the economic owner • Lessor is the legal owner • Lessee is the economic owner Risks and rewards associated with the asset are substantially transferred Risks and rewards associated with the asset not 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

35. Taxation of leases – domestic law Wet lease 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 • Lessor • Royalties - Section 9(1)(vi) • Or • Section 44BBA - 5% of deemed profits • Lessee • Lease rentals allowed as deduction • Depreciation allowed to lessor May entail service tax and Value Added Tax Commercial economics week 5