INTERVIEW: Flip Flop Shops CEO Says Will Not Use Vendor Kickbacks, Will Change Contract

The feet of Flip Flop Shops' CEO

IRVINE, Calif. - Chief executive officer Darin Kraetsch discusses his new franchise venture, the Flip Flop Shops. Mr. Kraetsch, who helped Raving Brands launch Moe's Southwest Grill, has joined with executives from Cold Stone Creamery and Nike to kick off the franchise chain. Their niche footwear runs from $20 to $120 a pair. They see a growing need among the discriminating young consumers who typically must buy Reef, havainas, Roxy, OluKai and other brands online if they want to wear flip-flops they like in their locality.

A Blue MauMau blog was critical of the concept's franchise disclosure document regarding product kickbacks provided to franchise prospects. “The offering circular notes that the franchisor may require purchase of materials from companies which pay a 'rebate' to the franchisor, but does not specify details," the blogger wrote. "In the past, Raving Brands was accused by franchisees of obtaining vendor kickbacks, and Coldstone Creamery franchisees have complained of the franchisor charging fees for various required purchases.”

Mr. Kraetsch (size 10) decided to respond. “I understand that not everyone will like Flip Flop Shops and that some will voice concerns. I very much respect their right to say so,” he replies. “We simply want a chance to show you and the franchise industry that there are new franchise systems that are doing everything possible the right way.”

Q: Why should someone buy Flip Flop Shops? It seems like such a narrow market, when there are so many retail opportunities out there.

From a popularity standpoint, flip-flops are not going away. High school and college students are wearing them 365 days a year. It is a $20 billion industry and an industry that outsold athletic shoes in 2006, the first time in history. Nowadays you aren't just wearing the $3 shower slippers of the past to the beach or pool. Now you are talking about orthopedically correct insoles with heel cups and arch supports with premium leather and hard rubber. So you are talking about a completely different product from what used to be.

When you start asking why flip-flops, you really are talking about specialty retailers like Sunglass Hut. Can you imagine when the founders of Lids , a chain of hundreds of stores that specialize in just athletic hats, said, “Hey, we got a great idea. We are going to open up a little shop and all we are going to sell is baseball hats.”?

The reality is that in specialty retail, when you have a core focus that you spend all your energy being great on, then I think the tendency is that you provide a very good retail experience. We are not trying to be all things to all people. The inventory is easier to manage because you are only managing one product line. You aren't managing flip-flops, T-shirts, beanie babies and cotton candy.

The number one reason people are considering flip-flops is because of their incredible popularity and the fact that we are a shop that focuses on one core product. The cost of entry is relatively low compared to other retail opportunities such as, for example, food franchises.

Q: There are other $20 billion dollar or more industries out there. What did you see that made you decide to invest in franchising flip-flop shops?

Two things. Alexander Babbage, a retail research firm, did in-store consumer intercepts. They saw that our customer core was 16- to 28 year-olds and that 26 percent of the people that we got feedback from said that they had actually come to the regional mall to visit our Flip Flop Shops again. That information, along with data compiled since the opening of the very first Flip Flop Shops in September of 2004 (a temp shop in Boston) was used along with other industry data by Windsor Realty to create a custom predictive model for site selection.

When Chris Zimmerman, who is one of our advisory board members, an investor in the company and a former president of Nike, said this is really very special, we took notice.

Q: How many company-owned stores are there? Do any of your executives own Flip Flop Shops?

Flip Flop Shops, Irvine Spectrum Center, Calif.

I believe that it is important to put my personal money where my mouth is, so I purchased a shop from the founder prior to franchising the concept. I operate this shop with my brother in Arizona.

Q: Give a sense of the robustness of the systems you've put in place for selling and operating a franchise system.

We have invested heavily to ensure we set our franchise system up for success. We started with the creation of the franchise disclosure document (FDD), which we had prepared by DLA Piper. All of the principals attended a full day compliance class conducted by DLA Piper specifically for Flip Flop Shops.

Our FDD is registered with FranData system. We disclose sales information in Item 19. We provide detailed estimated cost information and a branded business plan template that franchisees can use if they wish. Our FDD clearly shows that we have experience not only in other systems, but also in Flip Flop Shops.

I believe that the business acumen of our team and our advisory board is very credible. We can agree that the systems referenced in the blog have had their issues and in fact have them now, but the experience that three of us have had in franchising for the last almost 15 years and a couple of thousand units has been quite a hands-on education. Between Alan, Brian and me, we have had direct oversight of every function area of a franchise organization. The founders are both  involved in the day-to-day operations of the franchise company and have been Flip Flop Shops entrepreneurs full-time since 2004. The bios for our advisory board speak for themselves and are on the website.

Q: What has your executive team learned from their experience with troubled Moe's Southwest Grill or Cold Stone Creamery that will help your system stand above the competition? Above mediocrity?

Unlike past systems, this management team will never lose sight of the one key ingredient of successful franchising that so many systems really don’t understand or have chosen to ignore — unit economics. One of the greatest lessons the founders of Flip Flop Shops taught us was how to understand the numbers. The shops that they have closed over the years have been locations that had rent factors that didn’t work for the concept. This is a lesson that Cold Stone Creamery never learned.

You have to always keep your finger on the pulse of unit economics. It can look good. It can taste good. It can feel good. But if the unit economics do not work, the franchise system will not work. First and foremost, this management team has a clear understanding of unit economics. We are setting up franchisees in places where unit economics will work.

There were great lessons learned on both sides of the street. Doug Ducey [former CEO] of Cold Stone Creamery had a very clear vision of where he wanted the company to go. 

I'm talking about doing analysis on the front end. Sometimes you start taking chances with franchise investment when the rent factor doesn't match unit economics. Franchisors can grow so fast that they lose touch with food, rent and cost of goods sold.

Doing the right thing is actually harder than doing the wrong thing. Franchisors are very good at talking about doing the right things. Flip Flop Shops has been laser focused to make sure that we are doing the right things for our franchisees.

There's a story about one of our franchisees in Galveston. Galveston got wiped off the map. We allowed her to move her franchise to Delaware and then gave her first right of refusal for Galveston, Texas for the rest of her life. It took me thirty minutes to explain that decision to a Yale-educated lawyer of ours. The addendum to the contract actually says, “for the rest of her life.” I made the lawyer put that in.

Q: What are your system's same-store earnings and store profits?

We disclose sales figures for the shops in Item 19 in the FDD. We haven't done our new FDD for '08, but same-store sales were down in '08 compared to '07. The one that I owned was the high number.

From Flip Flop Shops' 2007 franchise disclosure document, Item 19

I do think it is time that franchisors are forced to disclose earnings estimates. Our Item 19 FDD earnings disclosure this year will not be as rosy as they were in 2007. But, hey, they're real numbers. It is what it is. Now you have a business decision to make about what it is, what you think it will be and what you think you should do with it. We think franchise systems that don't disclose sales numbers in some form or fashion in Item 19 are doing a serious disservice to potential franchisees. I would support legislation that required it.

You want to protect franchisees? You let them have more information. That's how you do it.

We had a potential buyer call us from a discovery day for NexCen Brands [parent company of franchise chain The Athlete's Foot and other retail brands]. They spent all day in a formal suit and tie discovery day, called us from their hotel room and learned more about Flip Flop Shops in that phone call. Two weeks later, they were franchisees. They didn't feel everything was smoke and mirrors with us.

Q: Was your own store profitable in 2008?

Yes, it was profitable. However, retail sales were way down in '08, about as much as the industry.

Q: Sales were considerably down in the retail industry in 2008. How far down are we talking about with your store?

I think we are talking about (being down) in the 20-25% range in 2008.

Q: You wrote a response to a blog that although the Flip Flop Shops franchise agreement says it can use rebates (kickbacks), the company won't actually exercise that clause. Kickbacks are a notorious way for franchisors to increase their revenue stream by creating a hidden royalty that franchise owners cannot really monitor or know how much is going to the franchisor. If you don't plan to use kickbacks, why not just come out with that in your agreement?

The rebate language in the franchise disclosure document is very standard language and is a topic that we are especially sensitive to. As long as I am associated with Flip Flop Shops at any level, we will never use rebates for company profit. Period! At the present time we do not receive any and there are no plans to change that. If and when that ever changes we will disclose it and make it 100 percent transparent for the franchisees and use it to benefit them directly. We are all very impassioned about this issue. It is actually a great example of one of the many great lessons learned through our other experiences.

Hang on.

[Pause]

The president of Flip Flop Shops and I just made an executive decision while on the phone with you. In our next Franchise Disclosure Document that comes out, our language will be written to clearly state that any rebates from manufacturers will go to the benefit of franchisees. That's how committed we are to doing the right thing in our franchise system.

Lawyers tell us that it will affect the value when franchisors sell because the next group that comes in will be a bunch of money-hungry pigs. They are going to want to figure out how they can squeeze everybody. But you know what? We aren't going to let it happen. Not on our watch. Period.

I thank Blue MauMau for challenging us on that. That is just another example of doing the right thing, even though it is the hard decision. If you've been around this industry for ten minutes, the language in our FDD is standard. That is boiler plate language. We are going to raise the bar and do it differently. We are going to keep living the core value of doing the right thing.

Q: How much will it run to invest in a franchise?

$170 - $175,000, including the franchise fee and $30,000 in inventory. That is a turnkey number. It can go up and down on some factors. The franchise fee is $25,000. The royalty is 5 percent of [a franchise's] gross sales and the marketing fee is half a percent of sales.

I hope you respect the fact that we cared enough about our brand, our reputations and most importantly our franchisees to contact you directly with our thoughts as opposed to hiding and hoping it would pass. Let’s put it this way, since we have started Flip Flop Shops, we all sleep very well at night, first time in many years.

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Resources:

Flip Flop Shops 2007 franchise disclosure document for potential buyers