[penci_text_block block_title_align=”style-title-left” custom_markup_1=””]By: Clark Harrop and David Shaw, Dale & Lessmann LLP
(The authors gratefully acknowledge the assistance of Emilie Attia, an associate at Dale & Lessmann LLP, in researching and writing this article.)

The phenomenon of ghost kitchens has increasingly sparked the interest of many in the restaurant industry.  With COVID-19 especially, delivery represents a large and growing proportion of the foodservice industry.  For franchisors, this presents both an opportunity and a challenge.  COVID-19 has disrupted travel patterns and an increasing number of people have embraced working from home.  There are fewer workers in the central business districts of cities and malls are down significantly in total customer traffic.

As a result, many franchisors are looking at their location footprint and finding that their locations are no longer optimized for serving their customers.  Embracing delivery has helped many restaurants retain sales during the COVID-19 pandemic, but a central challenge persists: Are your locations where your customers want you to be?

The flip-side of this question is the opportunity.  For multi-unit restaurant groups and franchises, there is a significant opportunity for brands that are able to expand their service areas and reach new customers.

Ghost kitchens are one possible tool for franchisors looking to accelerate their growth and expand their brand into new markets.  There is a great deal of variation within ghost kitchen operating models – this article will focus on the opportunity presented by managed cloud kitchens and host kitchens.

What are ghost kitchens?

The term “ghost kitchen” is problematic because it has been used indiscriminately to describe a number of different business models.  In fact, many participants in the rapidly expanding food delivery ecosystem avoid using the term “ghost kitchen” and use their own nomenclature instead. One of the well known participants in this part of the delivery market is named Ghost Kitchens Brands, which only adds to the confusion of this term.  This makes it challenging to discuss the legal issues and implications of ghost kitchens and franchise systems because there is no consistent terminology that is universally accepted.

For purposes of this article, we will adopt the following terminology to refer to different business models within what are broadly described as “ghost kitchens”:

• “Dark kitchens” are restaurants that operate to fulfill delivery orders only and do not have the typical customer-facing elements, including exterior signage and in-restaurant dining rooms. Dark kitchens are operated by both franchisors (as company-operated units) or by franchisees and have been constructed and equipped to optimize fulfillment of delivery orders.  Dark kitchens as a business model pre-date the rise of online ordering apps and third-party delivery aggregators but continue to evolve.
• “Cloud kitchens” are foodservice establishments that are purpose-built to allow multiple brands to operate in a facility designed specifically for fulfilling delivery orders. They may be constructed as a large commissary-style kitchen with multiple workstations or may be subdivided with demising walls into separate kitchens.  Cloud kitchens provide a capital-light way for franchise systems to expand into new geographic markets without constructing a brick-and-mortar restaurant location, but requires the franchisor, or its franchisee, to staff and operate the kitchen.  Cloud kitchens are beneficial to franchise systems because they expand their capacity and reach for fulfilling delivery orders without committing to long-term leases or time-consuming or costly restaurant build-outs.  This allows franchise systems to expand quickly and to potentially test new geographic markets in advance of committing capital on building out a new restaurant.
• “Managed cloud kitchens” are cloud kitchens that are operated and staffed by a foodservice operator. Rather than renting kitchen space, managed cloud kitchens staff the kitchens and fulfill delivery orders under license from the brand owner.  Franchisors who wish to expand through managed cloud kitchens will license their trademarks and proprietary recipes, specifications and procedures.  In essence, managed cloud kitchens are non-traditional franchisees or licensees.
• “Host kitchens” are existing foodservice establishments such as restaurants, hotel kitchens, catering kitchens and commissaries that supplement their primary business by fulfilling delivery orders using another concept, typically under license from the brand owner. In the majority of instances, host kitchens operate like managed cloud kitchens, with the operator of the host kitchen staffing the kitchen and fulfilling delivery orders using the brand and proprietary recipes, specifications and procedures of the franchise system.

Franchisors are likely to be attracted to expanding their reach and brand presence through managed cloud kitchens and host kitchens.  After all, franchisors have already put in place the systems and processes required to franchise their concept.  This includes development of a brand and trademarks, proprietary recipes, specifications and procedures.  It also includes comprehensive training on the production and presentation of menu items, along with a supply chain capable of delivering raw and prepared ingredients, along with branded packaging materials.  Having invested in the systems and processes required to support franchising, most franchisors are already well equipped to add managed cloud kitchens and host kitchens into the mix.

Managed cloud kitchens and host kitchens have already invested capital in building out their kitchens and can begin producing a franchisor’s concept and menu items within a short period of time.  Without the need to find suitable real estate and build-out new locations, the timeline to open new locations is reduced from months (or years) to mere weeks.

The process for onboarding a managed cloud kitchen or host kitchen is primarily focused on (1) establishing the supply of proprietary ingredients and packaging to the new kitchen, and (2) training the new kitchen’s staff on the production of the franchisor’s menu items.

In some respects, the steps to onboard a managed cloud kitchen or host kitchen are similar to those to onboard a new franchisee.  There are, however, many important differences between traditional franchised restaurants and managed cloud kitchens or host kitchens.  These include:

• There are likely to be menu differences. Franchisors should consider creating simple “delivery-only menus”, focusing on their best-selling menu items and those menu items that package and travel well during delivery.  Traditional franchisees are capable of producing more complex products, from more ingredients, and can do so with greater consistency.  They are also capable of adding limited time offers to the menu.  They can do this because their operations focus on a single concept.  Managed cloud kitchens and host kitchens fulfill delivery orders from multiple brands and cannot be expected to have the same training and high levels of operational execution.
• Managed cloud kitchens and host kitchens are not going to want to invest in a proprietary point-of-sale system (POS), so franchisors need to rethink how sales are reported. Managed cloud kitchens may have their own proprietary POS and will have their own processes for reporting sales and paying fees. For host kitchens, franchisors may wish to consider insisting on access to the host kitchen’s account and dashboards with the third-party delivery aggregators.  Direct access to third-party aggregator accounts can be used as a substitute for traditional processes for sales reporting.
• There are likely to be supply chain and supplier issues. Managed cloud kitchens and host kitchens will already have existing suppliers for many of their ingredients and may wish to share common ingredients amongst the various brands being produced in their kitchens.  Franchisors who are used to requiring the use of specific ingredients and approved suppliers should determine which ingredients and suppliers cannot be substituted without negatively impacting menu items and being flexible on the others. Many franchise systems operating successfully in the host kitchen space rely on a small number of proprietary sauces, spices and seasoning mixes and permit managed cloud kitchens and host kitchens to source other ingredients in their discretion.
• Significant thought should be given to whether managed cloud kitchen or host kitchens will be required to contribute to the franchisor’s advertising fund. Both managed cloud kitchens and host kitchens are likely to want to negotiate out any contributions to an advertising fund, or any other fees or financial commitments that are likely to decrease their margins.
• Training programs and operational procedures may need to be modified for managed cloud kitchens and host kitchens.

While the foregoing issues should not be underestimated, the ability of franchisors to solve these problems creates a large and scalable opportunity to accelerate growth using managed cloud kitchens and host kitchens.  Ultimately, this is an expansion strategy that can be used to fill-in underserviced areas within the franchisor’s existing footprint and to expand into new markets.

Legal Issues for the Franchisor

Agreements with managed cloud kitchens and host kitchens

If managed cloud kitchens and host kitchens will be used within a franchisor’s system, the franchisor should consider whether these locations will operate under a separate form of agreement or under the franchisee’s existing franchise agreement for a traditional restaurant premises.  While there are similarities between traditional franchised locations and those operated as managed cloud kitchens or host kitchens, it is important to recognize that the level of support and control provided to managed cloud kitchens and host kitchens differs in significant ways.

For instance:

• Franchisors are unlikely to control the kitchen design, layout or equipment for managed cloud kitchens or host kitchens (except for any proprietary equipment that may be required);
• Franchisors are unlikely to exert any control over staffing levels or uniforms;
• Franchisors are unlikely to inspect or audit managed cloud kitchens or host kitchens in the same manner or frequency as would be typical for traditional franchised locations;
• Managed cloud kitchens and host kitchens are likely to have existing supplier relationships and, except for proprietary ingredients, spice mixes or sauces, are likely to wish to continue purchasing supplies through their existing suppliers;
• Franchisor’s training is likely to be limited to how menu items are produced, packaged and served; and
• Managed cloud kitchens and host kitchens will continue to produce food for other systems and concepts, and may compete with the franchisor’s own concept and menu items.

Many managed cloud kitchens have their own form of license agreements to govern the relationship between the franchisor/brand owner and the cloud kitchen.  These license agreements typically grant the managed cloud kitchen the right to use the franchisor’s trademarks and to produce and sell the franchisor’s menu items, in exchange for a license fee (typically structured as a percentage of sales).  The franchisor is typically required to provide initial training, but will not inspect or audit the managed cloud kitchen or host kitchen in the same manner, or with the same frequency, as it would a traditional franchised location.

For this reason, franchisors that prefer to use their standard form of franchise agreement for managed cloud kitchens or host kitchens will need to revise them to reflect the lower level of support and control inherent with these operating models.  Our experience has been that the franchisor’s interests can be protected by negotiating the managed cloud kitchen’s form of license agreement.

Similarly, when working with franchisors on a host kitchen operating model, we have typically found it beneficial to use a different form of agreement from the franchisor’s standard form franchise agreement.  While there may be significant overlap between the content of a host kitchen agreement and the franchisor’s standard franchise agreement, our experience has been that host kitchen operators are intimidated by the length of today’s modern franchise agreement and that many of the provisions of a full franchise agreement are inappropriate or unnecessary in the typical host kitchen relationship.

The operating model for managed cloud kitchens and host kitchens is more transactional than a typical franchise relationship.

• The duration of the relationship may be short. Franchisor’s will frequently look at managed cloud kitchens or host kitchens as an opportunity to expand delivery into new markets, with a view to opening traditional franchise locations once brand awareness and demand has increased.  On the other side, both managed cloud kitchens and host kitchens are likely to want short term arrangements which permit them to terminate the relationship and move on to different concepts relatively easily.
• From the standpoint of the managed cloud kitchen or host kitchen, there is relatively little investment to add the franchisor’s concept and menu. These are already fully equipped and staffed locations that can be made ready to sell the franchisor’s menu items in as little as a week.  This makes it a low-risk model for both sides and allows the parties to take a “fail fast” approach of opening and then quickly shutting down locations that are not financially viable.
• The managed cloud kitchen or host kitchen isn’t getting into a new business, but is expanding its already existing business. They are seldom making an investment in signage and branding and can just as easily de-brand to remove the franchisor’s concept. In fact, delivery customers may not be aware that the managed cloud kitchen or host kitchen is the source of the franchisor’s menu items.

For these reasons (and others), managed cloud kitchens or host kitchens may be exempt from the requirement to deliver a franchise disclosure document.  That said, a thoughtful analysis must be undertaken, as determining whether or not a disclosure document is required is a very fact-specific exercise.  Depending on the level of support provided, or control exercised, by the franchisor, the relationship with the host kitchen may not rise to that of a franchise.  Even if it does rise to the level of a franchise, it may be exempt from disclosure because the term is less than one year, because the investment is less than the minimum investment threshold, or because the revenues that are expected will meet the requirements of the fractional franchise exemption. These are all potential disclosure exemptions that could be explored.

Notwithstanding the potential availability of exemptions from disclosure, we often recommend that franchisors intending to make host kitchens a significant part of their expansion plan provide a tailored form of disclosure document to host kitchens.  The reasons for this approach are twofold.  The first is that regardless of whether an exemption from disclosure is available, providing disclosure supports the establishment of a relationship of trust and transparency.  The second is that the failure to provide a disclosure document – even where an exemption is available – may increase the risk of host kitchen seeking rescission or disclosure-related remedies.  Providing a disclosure document at first instance will avoid any future disputes regarding whether a disclosure document was required.

Franchise system considerations

For franchisors considering the use of managed cloud kitchens and host kitchens, it is critical to consider whether there are any legal impediments resulting from the rights and obligations previously granted to the franchisor’s existing franchisees.  This may include reviewing all existing franchise agreements to determine the following:

• Did the franchisor expressly reserve the right to engage in delivery through alternate channels?
• Do franchisees have exclusive territories that would preclude the ghost kitchen from operating from the proposed location?
• Is the grant of a license to a managed cloud kitchen or host kitchen likely to result in the diversion of sales away from one or more existing franchised locations?
• Are franchisees likely to feel they have been denied a growth opportunity?
• Will the sharing of the franchisor’s proprietary recipes and supply chain diminish the value of the franchise system in the eyes of existing franchisees?

The foregoing considerations may reveal no legal impediment to growing with managed cloud kitchens and host kitchens but may reveal relationship concerns within the franchisee community.  The relationship between the franchisor and its franchisees is as important as a strict legal analysis if managed cloud kitchens and host kitchens are to be used successfully within a franchise system.

Key takeaways

Having worked with a number of franchisors on the successful implementation of managed cloud kitchens and host kitchens within their systems, we have reached the following conclusions:

1. Adding host kitchens and managed cloud kitchens requires significant work: It should be done as part of a thoughtful expansion strategy and not as a “one off” opportunistic tactic.
2. Supply chain and training considerations should be addressed at the outset: How are the new locations going to match the franchisor’s current quality and experience?
3. Franchisors should give strong consideration to having a separate form of license agreement specific to host kitchens: Your standard franchise agreement isn’t appropriate.
4. Disclosure documents can be very helpful: Don’t be in a rush to rely on a disclosure exemption, when a tailored disclosure document can be an important tool to onboard host kitchens.
5. Communicate effectively with current franchisees: Host kitchens and managed cloud kitchens should complement your existing franchise network.

About the Authors

Clark Harrop is a partner and business lawyer in Dale & Lessmann LLP’s Corporate/Commercial group.  He joined the firm after spending close to two decades in-house with two of the world’s best known franchise systems, Tim Hortons and McDonald’s.

Clark is a strong advocate for taking a strategic approach to legal matters, with a keen focus on achieving business outcomes and helping his clients drive growth.  He is known for having a global viewpoint, with extensive experience leading cross-border and international initiatives for his clients.

Clark is known as a thought-leader in the franchising industry and is dedicated to sharing his knowledge of franchising and business.  He is the co-author of a chapter in Fundamentals of Franchising, Canada (2nd edition) published by the American Bar Association.  He is a member of the Business Law Modernization and Burden Reduction Council, advising the Ontario government on reforms to Ontario’s business laws.  Clark is a frequent speaker on legal and business issues at seminars and conferences.

David Shaw is a Partner and Business Lawyer that heads up Dale & Lessmann LLP’s Corporate and Commercial group.  David regularly advises clients in a wide range of industries on franchise and distribution law matters, including the negotiation and preparation of master franchise agreements, area development agreements, single-unit franchise agreements, disclosure documents and related documentation.  He also advises and assists clients with respect to system rebranding, regulatory compliance, franchise acquisitions and divestitures, and terminations.

David has been widely recognized as a leading Canadian franchise lawyer for many years in The Best Lawyers in Canada; Chambers Canada: Canada’s Leading Lawyers for Business; Who’s Who: Legal; Who’s Who: Canada; The Canadian Legal Lexpert Directory; and Franchise Times.  He is the Past Chair of the Executive of the Ontario Bar Association’s Franchise Law Section following previous years serving as its Chair, Vice Chair, Secretary and CPD Liaison.  He is also a member of the Canadian Franchise Association’s Legal & Legislative Affairs Committee and its Legislation and Regulations Subcommittee and serves as the Chair of the Legal & Legislative Affairs Committee’s Editorial Advisory Subcommittee.  David has presented seminars and workshops and facilitated roundtable discussions at many franchising conferences and has written numerous articles relating to franchising including co-authoring the “Structuring an Expansion to Canada” chapter of the ABA Forum on Franchising’s Fundamental of Franchising, Canada textbook published in 2017.

DISCLAIMER: THIS ARTICLE SHALL NOT BE CONSTRUED AS LEGAL ADVICE.

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