Adapting to lockdown restrictions has never been easy for any of us, but restaurant owners have found the pandemic especially hard as they struggle to pay rent with no customers and no revenue. Only a few businesses have been able to survive those conditions, let alone make any profit. Adaptation is more important now than ever, but what are the options? Many have adopted and seen great success with cloud kitchens. In this article, we will discuss the trending business model cloud kitchens, and the thought-provoking issues the model may present under a franchise arrangement.

What is a cloud kitchen?

A cloud kitchen is a commercial space offering professional kitchen facilities for one or more restaurants operating on a delivery-only basis. The idea has been around for a few years and has seen some success in cities around the world. In response to the pandemic, many traditional restaurants are now looking to this business model to stay afloat until in-person dining is safe and popular again, and some might choose to make this the core of their business even after the pandemic has passed.

Why cloud kitchens?

Huge investment costs, maintenance, and rent are needed to get a restaurant functional, and eat up a lot of the profits in the food and beverage industry. With food delivery services more convenient now than ever and lockdowns more frequent than diners, some restaurant owners are now adapting to the new business model whereby they only enough space for a kitchen and a strong online presence to sell their foods, rather than having fully functional dining facilities. With less space and fewer staff needed, the operating expenses would be significantly lower than that of a traditional restaurant.

Who does it suit?

Reducing costs and increasing profit; the benefits of a cloud kitchen are clear, but unfortunately the model is not suitable for all businesses. Strong branding and a prominent online presence with their own website and availability on multiple delivery platforms are key to keeping the restaurant in customers' minds and make this model successful. Brands that can take advantage of their established reputation and operate on a larger scale are likely to excel, so it seems to be a logical choice for those big names, whether they operate by themselves or through a franchise system.

What to consider?

Brand-owner outlets will be less of an issue as they can elect which models, whether conventional or cloud kitchen ones, they think are best. However, things are a bit different in a franchise model. One of the very first questions to address is who should undertake a cloud kitchen. As mentioned previously, how much a business can benefit from a cloud kitchen will depend on brand awareness, marketing and promotional activities. In particular, brand-wide or cross-platform promotions need to supplement each other to reach the highest sales. This would best suits to the roles of the franchisors. Whereas the lower investment costs and higher profits of the cloud kitchen model make it attractive to franchisees (where royalty payments are calculated on the revenue and not the profit of the franchisee).

Below are key commercial and legal considerations that franchisors and franchisees should consider from a commercial and legal aspect before entering into a franchise agreement.

  • Exclusivity. Some franchisors offer "exclusivity" to the franchisee, especially to those franchisees who make a significant investment. However, if the franchise agreement was made some years ago, it is likely that such exclusivity clause may not address whether the franchisor is able to open their own cloud kitchen themselves.
  • Sales vs physical presence. In addition to a supply chain and operation that must be able to accommodate a cloud kitchen model, franchisors should consider whether they are willing to sacrifice the physical presence of their brands, which is a key element for many, in return for the potential increase of sales for their franchisees (and, in turn, increased royalties). If they are, they need to consider what percentage cloud kitchens should make up of their entire portfolio. This will set the tone and direction for the business going forward.
  • Commitments, incentives and fees. Franchisors and franchisees should consider what will be the proper commitments, incentives and fees that will encourage franchisees to meet their goals. For example, if cloud kitchens are as important as traditional outlets, this format may be counted towards a new outlet-opening commitment as usual (despite significantly less investment). If it is not, the franchisee may need more than one cloud kitchen to fulfil that obligation. Relevant incentives and fees should follow in a similar fashion.
  • Marketing fees. The success of cloud kitchens hinges on branding and online presence. Inevitably, online marketing will play a pivotal role, and doing so will require tremendous effort and resources (whether from the franchisors or franchisees). Franchisors may have to rethink their marketing strategy and, in turn, the marketing fees and expenses charged to franchisees in order to cover this costly exercise.
  • Non-competition. It is common for non-compete clauses to be imposed on franchisees, but cloud kitchens are a relatively new model and may be overlooked from this restriction. Therefore, franchisors should re-evaluate the scope of their non-compete clause, and consider whether to include cloud kitchens or keep as is.
  • Franchise guidelines. Lastly, franchisors must take into account an unfair trade practice guideline from the Trade Competition Commission regarding franchises, which covers franchisor's obligations concerning the opening of new branches or outlets including the rights of existing franchisees to open new outlets within nearby proximity. Accordingly, franchisors will have to consider the rules and criteria between the parties that will meet both their objectives and the legal guidelines, while ensuring that businesses will excel. Franchisors should also be mindful of the requirements to be imposed on franchisees, such as required promotions or marketing, so that they will not violate the trade competition law.

Whether you are a franchisor who wants to understand the impact cloud kitchens would have to your franchising model or a franchisee who wants to leverage the benefits of a cloud kitchen, our Consumer Goods and Retail Industry Group is well equipped to help you navigate through this dynamic trend from both commercial and regulatory perspectives in order to support your long-term success and grow your business.