Rajiva Madugalle and his partner Olga still remember the excitement and trepidation of quitting their jobs and borrowing against their family home to fulfil a dream of owning their own business.

In early 2017, after extensive research, they decided to enter the booming laser hair removal and botox industry and forked out hundreds of thousands of dollars for a Laser Clinics Australia (LCA) franchise. “We took the plunge and gave up two good jobs, uprooted our two young daughters and drove down to Melbourne, leaving behind our family and friends and our property in Sydney,” the couple says.

Before signing up, the couple sought financial advice from their accountant, who was impressed with the financials provided by LCA. The slick marketing pitch of taking on the world under a 50/50 partnership model that supported and trained its partners was the clincher.

Yet just two years later, they were up to their eyeballs in debt. Their marriage was on the rocks, Rajiva was suffering depression, anxiety and drinking excessively. Olga says she was also depressed as she battled to keep the family together. They struggled to pay the bills, including royalties and other fees owed to LCA, which had been sold to private equity juggernaut KKR soon after the couple had bought in.

Rajiva and Olga are among the many aggrieved franchisees The Sydney Morning Herald and The Age have spoken to as part of a two month investigation into LCA, the largest operator in Australia’s $4.5 billion a year laser hair removal and cosmetic injectables industry. Most requested anonymity due to confidentiality agreements and fears of retribution.

LCA franchisees say the company has gouged them on costs for equipment and supplies, while forcing them to conduct aggressive discounting that makes it difficult for them to cover their costs and has conditioned customers to expect unsustainable prices. At the same time, they say head office has not provided franchisees with adequate support.

Owners of 52 of the firm’s franchised clinics have now lodged a 140-page letter of dispute and are seeking compensation of more than $80 million from LCA. If mediation fails, the dispute is likely to end up in court.

It is the latest controversy to hit the $180 billion franchising sector, which has been subject to multiple federal parliamentary inquiries following major scandals at prominent chains such as Domino’s Pizza, 7-Eleven and Pizza Hut.

KKR takes control

LCA franchisees say the chain’s original founders, former ­actuary Babak Moini and legal IT expert Alistair Champion who opened the first clinic in 2008, were passionate about the business and responsive to their franchise partners.

Things started to unravel when the founders sold down their stake to Sydney private equity firm Archer Capital in 2014. Then in 2017, KKR bought 100 per cent of the chain for $650 million.

Famously referred to as “barbarians at the gate,” the historic American private equity giant replaced some key people at LCA with people who didn’t understand the business. It ramped up the rollout of clinics from 60 to more than 160, expanded into New Zealand and the United Kingdom, making LCA the biggest non-surgical aesthetic network in the world. (The LCA network includes 123 franchises in Australia, company owned clinics and clinics overseas). But while this rapid expansion took place, it also cut back on support.

KKR turned a multi-pronged strategy of sales promotions into prolonged and systemic price discounting. Franchisees say this created expectations from customers of prices that are not sustainable in the long term. Leaked documents and a procession of insiders, including current and former LCA franchisees and staff, say the focus of the private equity giant is to fatten up the network for a trade sale or ASX listing, regardless of the impact on individual clinics.

They point to the recent successful ASX listing of rival Silk Laser Australia at $3.45, which valued the 53 franchised and company-owned clinics at $162 million. Its shares have since soared to $4.61 as demand for laser, injectable products and skin care booms. The non-surgical aesthetics industry is forecast to grow from $5.4 billion to $7.8 billion by 2024 and KKR wants to capitalise on its investment.

Multiple franchisees told The Age and Herald they bought into the network believing it was a 50/50 partnership with LCA.

Yet under KKR, LCA effectively calls the shots with little consultation with its “partners” or support. “It became all about winning at any cost,” one franchisee says.

“We are treated just like we are just a number, to shut up and do what you are told,” another franchisee taking part in the action says. “We went from passionate people to feeling trapped and we can’t get out.”

The claim for more than $80 million in compensation is based on the estimated mark-ups LCA allegedly receives from products and laser machines sold to franchisees, the cost of discounting on the business and some of the fees flowing into a marketing fund which costs franchisees 3 per cent of sales.

According to the notice of dispute, the marketing fund fails to adequately show where money is being spent. The document cites a recent federal court case that found Ultra Tune contravened the Franchising Code by failing to provide adequate disclosure to marketing expenditure.

The dispute notice also highlights the damage to the business of systemic and sustained price discounting. It estimates that half of the trading days over the past two years involved product and services discounts of up to 50 per cent.

Some discounts mean the services offered by franchisees barely cover their costs. For instance offering laser Brazilian/Underarm hair removal at a 50 per cent discount barely covered the cost of the room. A 30-minute dermabrasion at a 50 per cent discount didn’t cover the overall cost of the service, according to calculations sent to head office by a franchisee.

“To go on was not the right option for us financially, mentally and emotionally. We realised that we were standing alone”

Rajiva and Olga Madugalle

The latest promo being spruiked on social media is a 50 per cent off laser hair removal and skin treatments.

Internal sales figures reveal that in January this year LCA customers forked out more than $14 million on laser hair removal, $6.8 million on injectables like Botox and fillers, $2.1 million on skin treatments and $2.1 million on the LCA-owned Skinstitut range of products, owned by KKR.

LCA and KKR were sent a list of 22 detailed questions for this story. LCA declined to respond to the questions, citing impending mediation, but said it strives to maintain a positive, supportive relationship with its franchisees. It had acted lawfully and professionally and fully compliant with its franchise agreement and the Franchising Code of Conduct.

“LCA directly co-invests in each franchise, so LCA has an interest in the profitability of each franchise, as well as gross revenue,” it said in a statement. “LCA is even more motivated to see each individual franchise succeed, as it is sharing the risk on each franchise.”

It said during extended lockdowns during the pandemic last year it supported its franchisees in a number of ways including waiving management fees, saving each clinic $1000 a week, and a credit of $8500 against royalty fees per franchise agreement.

Shortly after the questions for this story were sent, LCA fired off a letter to franchisees, clinic managers and support staff warning them to expect a media story in coming days and a reminder that if they were approached for comment by media, “do not comment” and direct any queries to head office.

Waving the white flag

In November 2019, Rajiva Madugalle and his partner Olga put up the white flag and negotiated an early exit, trying to get something back for the hundreds of thousands of dollars they had invested. “To go on was not the right option for us financially, mentally and emotionally. We realised that we were standing alone, our partner, the franchisor, did not stand next to us to support our clinic through this,” the couple said.

Part of the problem for them was competition as LCA continued to open clinics in close proximity to their clinics, which cannibalised sales and contributed to the underperformance of their business. This coupled with near-constant discounting meant sales promotions lost their potency and made it difficult for the franchise to stay afloat.

A confidentiality and non-disparagement clause prevents them saying much but some in the network said when the business struggled, they received little support from their joint venture partner.

In Menai, NSW, another franchisee went belly up early last year – three years after paying more than $300,000 to enter the network - and in a report to creditors the insolvency was attributed to “the operation of the franchise business model, its business location and the consequential increase of product costs leading to decreased profit margins.” It said it was apparent that the company’s sales were insufficient to meet the costs of the business at almost all times subsequent to its inception.”

The LCA business model is largely based on franchisee growth, with head office taking a 10 per cent royalty from every sale. Australians purchase more than 3 million laser hair removal, fillers and skin treatments a year from LCA clinics.

The company also makes money selling products and equipment to the clinics. In 2020 LCA’s annual sales took a hit due to the global pandemic which caused closures of clinics for periods of time. Nevertheless they almost hit $250 million, compared with $264 million in the previous year and $232 million in the 2018 year.

LCA clinics on average sell for $500,000, depending on size and location. Then there’s a franchise fee of about $50,000.

Costs include rent, salaries, utilities, service contracts on equipment, an IT levy, a 10 per cent royalty fee on every sale, a 3 per cent marketing levy on sales and a $1100 a week management fee.

LCA and KKR make money from the products sold to franchisees including the Skinstitut skincare product range, which it owns. They also make money from other products provided including bedsheets, razors, needles, as well as rebates on machines and dermal-fillers. Franchisees cite incidences where they have been able to obtain quotes cheaper than the prices provided to them by the Franchisor.

‘5231′

In the quest to boost sales, a bonus and target system known as “5231” has been put in place to encourage beauty therapists to upsell products and services. Each day therapists must sell a minimum of five add on services such as laser treatment, three skincare products, two conversations with a customer to discuss full leg treatments and prices with a client and one conversation with a customer to book a consult with a nurse for a cosmetic injectable treatment.

When targets aren’t achieved the area manager team applies pressure to the franchisee. “I have noticed they [5321] submissions have dropped and been getting low weekly,” an email sent to a franchisee earlier this year says.

The email suggests the franchisee correct the matter by creating a 5321 submissions WhatsApp group and send a photo of proof “when they submitted at the end of the day and make this an end of day duty”. Two officers were included in the WhatsApp groups so they could see if they have submitted. “Do you think this is something you would implement for your team to take control and hold them accountable for? … Can you please come back to me with a plan on how you will get submissions to the 100% mark?”

A franchise agreement obtained by The Age and the Herald reveals the franchisees are subjected to targets and if they miss head office can hit them with a breach notice. If a franchisee gets enough breaches the contract can be terminated.

“Many of us have put our life savings into these businesses, we cannot afford to lose them”

LCA franchisee

In year one the franchisee has a target of cash sales of $300,000 a quarter; rising to at least $375,000 a quarter in year two and $450,000 a quarter in year three, or cash sales agreed between LCA and the franchisee in writing.

Internal sales figures indicate that at least 15 clinics weren’t reaching this target.

Other ways LCA makes money is through rebates and markups on products sold.

Insiders estimate that LCA pockets up to 10 per cent of a rebate collected from a supplier of Botox and dermal-fillers. This is despite the franchisee placing the orders directly with the supplier, receiving the orders directly from the supplier and paying the invoices directly to the supplier. “The franchisees are of the view that the rebates retained by the franchisor are disproportionate to any value added by the franchisor, particularly as the franchisor does not have the risk of purchasing, storing or delivery of any stock or any liability relating to the Product,” the statement of notice says.

It estimates that annual purchase of Botox and dermal-fillers is about $81 million a year and LCA takes about $4.5 million in rebates.

The dispute notice lists a number of examples based on internal emails and invoices. One referred to a laser machine sourced by LCA at $101,500 but LCA proceeds to quote the price to a clinic at $181,500. After bargaining with the franchisee, LCA offers the machine at $142,000, saying “this is substantially below market rate for individual buyers” yet a tax invoice of an individual purchase for the identical machine states $119,000 plus GST.

It alleges this type of behaviour is in breach of a franchisor’s obligation to act in good faith under the code.

The fractious relationship between the 52 clinics and LCA dates back over a year when three franchisees and the Australian Association of Franchisees’ Mike Sullivan raised concerns at a meeting with the boss of LCA and its legal counsel.

Little changed and the franchisees enlisted lawyers who advised them to put together a notice of dispute.

LCA responded to the notice with an open letter to all clinics in January 2021 saying it disagreed with many of the allegations and that some were based on “incorrect facts or false assumptions.”

AAF’s Sullivan described LCA’s handling of the notice via an open letter as “inappropriate, premature and puzzling.”

Sullivan told The Age and Herald that LCA was another example of the need for reform in the $180 billion franchise sector.

Franchise reforms

Earlier this month the Morrison government lifted the maximum fine for breaching the Franchising Code from $66,100 to $10 million. but it is a small part of what is needed to fix franchising, a sector that was described in the parliamentary inquiry as operating in a regulatory environment that has “manifestly failed to deter systemic poor conduct and exploitative behaviour and has entrenched the power imbalance”.

In the past few years there have been a number of franchising scandals involving prominent chains such as 7-Eleven, Domino’s, Pizza Hut, Chatime and Retail Food Group, which had an imbalance of power between head office and the franchisees, and systemic conflicts that caused misery to thousands of gouged franchisees.

There have been 17 parliamentary inquiries into the franchise sector in the past four decades. Each failed after vested interests lobbied governments to water down recommendations. The latest inquiry was no exception.

In a statement to the Herald and The Age, LCA said in late 2020 it committed to good-faith discussions with the group and the “outstanding concerns” were subject to mediated discussions with former Federal Court Kevin Lindgren QC. “We have expressed on multiple occasions our desire to proceed these discussions, but Mr Lindgren has been waiting for further important details to be supplied by the franchisee parties before scheduling a date for mediation,” it said.

For the LCA franchisees, the hope is mediation with Mr Lindgren QC will bring them some relief.

“They sold us these businesses on the promise of a true 50/50 partnership, now we need their actions to match their words,” a franchisee who is part of the signatories of the notice of dispute said. “Many of us have put our life savings into these businesses, we cannot afford to lose them.”