Water Street Optical

In January 2019, Mike Pritchard and Paul Smith were employed by Regency Optical Inc. Mike

was an optician and Paul was the manager of a Regency Optical retail store located on Water

Street in Toronto.

Regency Optical Inc. operated a number of retail optical dispensaries that sold fashion

prescription eyewear, fashion sunglasses and contact lenses. All of the company's retail outlets

were leased; the leases, while long-term, were operating leases. Of the three outlets that

Regency operated, the Water Street location ranked lowest in terms of volume sales.

The optical industry is a relatively close-knit group in which the main participants are well known

among themselves. Most of the opticians in Toronto know each other; most of the dispensing

optical outlet managers and employees know each other; most of the optical retail stores use

the same suppliers. In this extremely aggressive competitive environment, the cost of inventory

is usually differentiated only by volume discounts on inventory order. Personal customer service

is very important because the selling price of eyewear is generally the same from one retail

outlet to another. Success in this industry also depends on customer repeat business and a

wide selection of inventory. Another factor of significance is the relatively low cost of purchasing

inventory. Notwithstanding the Research and Development costs, depending on volume and the

complexity of the prescription, contact lenses may cost the retailer $7 to $28, while eyeglass

frames can range from $15 to over $100.

The president of Regency Optical Inc., Marcel Provost, was an aggressive "marketeer'' who

opted for increasing volume sales; in exchange, he settled for a lower profit margin on sales.

The idea was to generate volume sales and use the cash profits as reinvestment funds to

acquire more retail outlets. Advertising was aggressive and was undertaken centrally for all

Regency's retail outlets. The longer-term plan was to develop scale economies such that

Regency, because of volume alone, could offer to the public the most inexpensive frames at the

highest possible quality. This strategy would perpetuate itself only if each Regency retail outlet

experienced a certain threshold sales amount as determined by the management at Regency

Optical Inc. For the Water Street location, this level of sales was established at $35,000 per

month. Sales below this amount were not compatible with Regency Optical's overall plan.

In the first four months of operation, the Water Street location averaged $23,500 per month in

sales, with its best month at $28,000. Because these results were well below the established

sales threshold, the president of Regency decided to close Water Street and try a different

location.

Paul Smith felt strongly that the Water Street location, if it were to cater more to customer

service and offer the services of a stellar optician, could be made to meet the $35,000 per

month threshold. The management at Regency Optical Inc. disagreed; they pointed out that

despite its downtown location, Water Street did not attract a large enough client base.

Smith responded that perhaps the $35,000 threshold was only a theoretical amount; just

because Water Street's performance was below this threshold did not necessarily mean that it

was unprofitable. Regency management agreed that Water Street could be mathematically

profitable, but its performance was not consistent with Regency's business plan.

Smith continued to feel strongly about the potential success of the Water Street location.

Eventually, Regency agreed to sell the Water Street location to Smith for $160,000. Dewar

would pay $60,000 cash and Regency would finance the remaining $100,000 over the next 5

years charging no interest. The price would include all inventory on hand at the time, and

Smith's new business would assume responsibility for all outstanding Water Street liabilities.

The agreement was finalized, and on April 1, 2019, Water Street Optical (WSO) was born.

Smith immediately launched his new business endeavor. As it already physically existed, he

went to work the next morning as always, but now as an owner. Paying very little attention to the

optimal type of business ownership, his first action was to register the business as a sole

proprietorship - this was the most inexpensive option, and the simplest. He next opened new

bank accounts, changed the store signs and started a rigorous advertising campaign. Mindful of

the regulations governing optical dispensing, Smith then undertook an intensive campaign to

hire an optician. During the search period, he made extensive use of optical laboratory services

to fill the numerous orders that had resulted from his advertising efforts. Laboratory services,

while offering timely and high-quality work, are relatively expensive, considerable savings can

be had if the retail outlet can cut its own lenses.

In May 2019, Mike Pritchard left Regency Optical Inc and joined WSO. A seasoned professional

optician with a wide client base, Pritchard was well regarded as one of Canada's finest contact

lens fitters. He was also certified as a laboratory technician and could, therefore, cut lenses on

site for WSO, avoiding the high laboratory costs. Pritchard offered his services for the going

market rate - $60,000 per year -- plus a 50% ownership in Water Street Optical. Smith accepted

the offer. An effective retail manager, with skills in merchandising and advertising. and a certified

optician appeared to be a winning combination.

Instead of changing the provincial business registry, Pritchard and Smith prepared a contract

that, among other things, described Mike as a partner and formalized the partners' respective

salaries at $60,000 and $35,000.

As WSO began to enjoy steadily increasing sales and establish itself as a serious contender in

the Toronto optical market, the president of Regency Optical had second thoughts about his

decision to sell the outlet to Smith.

In July 2019, Marcel Provost paid a surprise visit to WSO. He was impressed with the store's

look: a good mixture of high quality frames and premium contact lenses, among other things. A

steady stream of customers came through the door while he was there. In fact, he thought he

recognized a few of his own customers!

Provost was indeed surprised to learn that WSO was averaging $46,000 per month in gross

sales since they started the business April 1". In view of the deep discounts WSO was offering

its customers, had the goods been sold at full retail price, gross sales would have been double

the amount reported. But Provost knew very well that no one ever paid the full retail price for

eyewear. Even so, using the discount scheme offered by Regency Optical Inc. (which was not

quite as deep as the one offered by WSO), the level of sales under the Regency scheme could

be expected to gross at least $48,000 in monthly sales for WSO.

Provost suggested that Smith and Pritchard could benefit considerably by participating in the

volume discounts available to Regency Optical Inc. He offered to take back 51% ownership of

WSO, canceling the remaining debt owed WSO for the purchase agreement and refunding the

$30,000 paid to Regency to date. In return, 51% of all profits from WSO would go to Regency

Optical Inc. and the remaining 49% would be split between Smith and Pritchard. Furthermore,

Provost would pay Pritchard a salary of $90,000 per year if he agreed to provide services to

Regency's four existing locations. WSO would change its name to Regency Optical, but the

partners could run the Water Street operation without interference from Provost.

Ever the pragmatic conceptual manager, Smith asked Provost to describe how his company

was now organized. Provost described the organization of Regency Optical Inc. as follows:

"Reporting to the president (Provost) are the managers from each of the Regency Optical retail

outlets, the central laboratory, and the corporate managers of administration, finance and

accounting, marketing, and the external accountant (under contract as advisor and auditor).

Reporting to each retail outlet manager is the optician(s). We also employ two physicians whose

practices are limited to treatments of the eye. While operating as separate business entities,

these practices report to the president of Regency. The doctors' receptionists report directly to

the respective physicians. There is also an eye examination center operated by an optometrist

who reports directly to the president of Regency. Two of the four retail outlets are being

restructured so that the manager will own 49% of the retail outlet. All stock orders, bills and

leasing matters are dealt with centrally and administered by Regency Optical's corporate

downtown location.

The central optical laboratory is located in the retail outlet in the east end of the city. Regency

employs at least two opticians per location, and at least five full-time and four part- time sales

clerks. There is also a delivery person who delivers stock orders to the respective locations.

This delivery person reports to the president. All capital equipment is centrally leased and

dispersed to each location. In addition, the opticians can work in any of the locations with the

approval of the president. The marketing manager handles all leasehold details and all

advertisements on behalf of all locations. All accounting functions are centralized at the

downtown location. The profit structure is different for each store depending on each manager's

personal investment in his or her retail outlet, and none of the proposed 51% - 49% ownership

splits have been legally established. This structure provides for maximum flexibility and

maximum growth potential."

After Provost left, Smith and Pritchard called their consultant and relayed the above information

and "offer", seeking her advice on whether the offer was a good one or not.

What is the primary and secondary problem in this case?