Rafi Mohammed

Fried Chicken + Tying + Antitrust = TROUBLE

Posted on May 4th, 2007 (1 Comments)

Theorem #1 in pricing: do NOT tie the sale of your product with others. By tying, I mean requiring customers that purchase your product to buy other products from you. This is an absolute “no no” in antitrust law and can result in a scenario worse than an ambush by 60 Minutes…the Antitrust Division of the Department of Justice knocking at your door with a search warrant.

That said…let me ask an obvious philosophical question...what’s wrong with tying your product with another? It’s a free market and consumers always have the choice to thumb their noses at companies requiring tie-in sales.

Imagine this…you’ve created the most incredible recipe for fried chicken and developed a restaurant concept of selling your chicken for takeout only. To grow your business and capitalize on your intellectual property (“secret” recipe and restaurant concept), you’ve decided to sell franchises. So…what price do you charge? Perhaps a royalty percentage per revenue dollar…yawn…how “cost plus.” C’mon, this royalty rate doesn’t capture the fact that in terms of profit, all pieces of chicken are not created equal. For example, a drumstick in a three piece meal is more profitable than a drumstick in a 15 piece bucket. How do you charge a franchise fee that both captures the value of your intellectual property and is fair to your franchisees (i.e., doesn’t penalize franchises that primarily sell buckets of chicken and better profits from those that predominantly sell 3 piece meals). This is the exact pricing scenario that the restaurant chain Chicken Delight faced.

Chicken Delight came up with an ingenuous fix to this pricing challenge; the company gave away its franchises for free but required franchisees to purchase products (including paper products) from Chicken Delight. Chicken Delight then baked (oh…I mean deep fried) its royalties into the packaging. Thus, prices for three piece meal paper boxes implicitly had a higher royalty per chicken piece than 15 piece cardboard buckets. Pretty clever, eh? Now guess what the franchisees did? They signed the contracts and then claimed the tie-in provision violated the Sherman antitrust act because it restrained trade in the paper goods market. And if you can believe it, the courts sided with the franchisees and ruled the contracts invalid!

Of course, technology now allows companies to circumvent tying, yet still achieve the same value-capturing results. Today, Chicken Delight could audit franchisees’ cash register records to “count” how many meals and buckets they sold, and then apply the appropriate royalty rates – that’s legal. Now, it should be clear why HP’s new copiers use electronic sensors to detect how much ink is used in printing, as opposed to “requiring” leasees to purchase HP ink cartridges and bake the royalty rate into ink cartridges.

So do you agree with the court’s decision? I absolutely don’t. Franchisors knowingly entered into a contract that required them to purchase paper products from Chicken Delight in lieu of a dollar royalty rate. The market was very competitive – there were plenty of franchise opportunities available…no prospective fried chicken seller had a gun to their head to sign on the dotted line. Nor did Chicken Delight try to change its terms in the middle of the contract – it was all on the up and up. And really, do you believe that Chicken Delight’s tie-in requirements were going to adversely affect the market for paper products – a highly competitive market with low entry barriers?

Isn’t it time to reexamine the underlying philosophy of our tying laws? But until that day comes, tying contracts need to be your numero uno “no no.”

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Readers' Comments on This Blog Entry

From Bill Taylor on May 4th, 2007
Rafi- Based on my experience, I'm all for the tying laws, and here's an example why - I have a client in a rural area of KY, I know that's an oxymoron but anyway, who had a Blimpie's franchise. Trust me, he and his partner did this without getting any outside advice. Because they were the only franchise in the area, paper costs for the offical Blimpie's products was excessive.