Franchising in the global market

Many businesses with an established home market recognise that franchising provides techniques which enable them to expand outside their home territory and so tap into the world’s vast global markets. By Chris Wormald, head of retail and, joint head of the franchise and licensing team at Fieldfisher.

Some of the world’s leading brands such as McDonald’s, Holiday Inn and Budget Rent A Car have established truly international networks building off the platform of their franchising know-how and techniques developed in their home markets. Others, including Marks & Spencer, Mothercare, Costa and River Island (all major company-run chains at home) recognise that franchising internationally offers the prospect of bringing their products and services to new consumer markets without the demands on capital, people resources, and risk which opening an owned and managed network overseas would entail.

What then are the basic keys to successful international expansion and what are the structure available? First, the structures.

The five basic structures

The basic strategies and techniques which can be used to enter a new market are: company run expansion, direct franchising, developmental franchising, master franchising, and joint venture franchising.

Company-run operations

Although the prospect of being in the position to control one’s self the establishment of the pilot outlets in a new market, and so the initial adaptation of the brand and system to local conditions is attractive, to do so oneself with a company-run operation overseas is fraught with a number of problems, particularly capital and people constraints.

It is very costly to dedicate sufficient resources to an overseas start-up, let alone tackle multiple markets. Who will staff and lead the overseas branches or subsidiary? Its business plans and budgets must be carefully considered. Organic growth using this approach will necessarily be slow – the world is a big place with many major markets to prioritise and choose between.

The locals know how to do business in their country, how much to pay for sites and construction, how to employ staff and generally get things done effectively. The learning curve for a foreign newcomer attempting to do this will be steep with many hard and expensive lessons to be learnt. Some major corporates have never recovered their enthusiasm for international expansion after disastrous and expensive initial attempts to do it themselves.

The franchising alternatives described below offer the prospect of more rapid expansion into more markets within a relatively shorter time frame, coupled with a requirement for far more limited resources and risk. The right overseas franchisee will provide both the resources and the market knowledge to drive forward and develop a new operation, insulating the home country franchisor from the risks and the mistakes which the local businessman or company will best know how to avoid.

Direct franchising

Direct franchising is really an extension of franchising in the domestic market. The UK franchisor will find and enter into franchise agreements directly with a number of individual franchisees in the overseas target market. The agreements will be very similar to those used domestically, but with a number of adjustments to deal with international issues, such as the deduction of withholding tax or service fees, currency conversion and other matters. The franchisor will need to provide the back-up and on-going support directly to its franchisees.

This technique is usually fairly limited in scope because the more overseas franchisees there are, and the further away geographically, the more difficult it is to provide the necessary support. Franchisees are consequently more likely to stray off the straight and narrow if the degree of supervision by the franchisor is reduced, as it will be, and the consistency with which the products and services, and the brand associated with them, are presented in the overseas market is likely to suffer. There is no local guiding hand on the tiller, no local country head office, and no local co-ordination of the overall country development, marketing, etc. There is a place for direct franchising, but usually on a fairly limited scale, for example perhaps for piloting in a new market relatively close to home.

Developmental franchising

Development franchising, often referred to as area development agreements, involves the franchisor granting the rights to an individual, company, or investor group to develop and operate themselves a number of outlets within a particular territory or region. A good example of this in the UK is Whitbread which was, until its recent sale of that business, a developmental franchisee of both Pizza Hut and TGI Fridays, rolling out the restaurants as company-owned and operated units, and, after many years and with the consent of its U.S. franchisor, also sub-franchising to third parties. This is the technique used by Starbucks internationally

The advantage for the franchisor is that it has only one franchisee in a region or country to liaise with, and such a franchisee is likely to be significantly resourced, experienced in operating businesses in its market, and consequently less likely to need significant support from the franchisor. Developmental franchising is typically used in the retail, hospitality and leisure sectors, where significant investment is needed to build and roll-out and run big ticket retail stores, restaurants or hotels.

The development agreement will typically require that a specific number of outlets must be opened within a prescribed period, say one store to be opened within the first 12 months, with a required openings schedule stipulated over the following years. In exchange for this level of commitment to invest in the market, the franchisee is usually granted territorial exclusivity, provided the openings schedule is met, and fairly long-term rights, typically between 10 and 25 years.

An up-front fee, sometimes significant and running into six figures, is typically paid to secure the development rights. The franchisor is after all parting with its rights to develop the territory in another way.

The operation of each unit will usually be regulated by an individual franchise agreement. There are a number of reasons for structuring arrangements in this way. An initial franchise fee will typically be paid for each new outlet which opens, as well as weekly, monthly or quarterly continuing fees based on sales. As in domestic franchising, there will inevitably be an obligation to spend a required amount on marketing and promotion, and perhaps an obligation to pay a small percentage to the franchisor for the global marketing of the brand.

Master franchising

Master franchising is most frequently seen in the service sectors, or where the nature of the business or service requires the cloning of multiple outlets, each with a hands-on owner/operator. Kall Kwik is an example in this country of a master franchisee of a U.S. franchisor.

To secure the rights to develop a territory, the master franchisee will, like the developmental franchisee, again usually have to put down a fairly significant sum up-front, with a commitment to pay to the home country franchisor both on-going percentage fees based on total network sales, and typically a slice of the initial fee charged for each outlet which opens.

The fundamental difference from the developmental franchisee is that the main business which the master franchisee, sometimes referred to as the sub franchisor, must establish and operate is the business of being the franchisor for the particular system in the territory for which rights have been granted, rather than just operating outlets itself.

Master franchising is usually done on a country basis whereas developmental agreements are just as likely to be regional within a country as for an entire country. Gowrings is an example in this country of a significant multi-unit Burger King developmental franchisee which now operates over 50 restaurants.

The master franchise agreement will, like the development agreement, inevitably impose a required schedule of numbers of outlets to be opened within a particular time frame. To fail to require this, exposes the franchisor to the risk that the target market will be under-developed and, notwithstanding the problems in restructuring the network which would ensue, the franchisor must reserve the right to terminate a master franchisee who is not adequately performing.

The parties will often agree that the master franchisee must open and operate a number of pilot operations itself to prove the system works in the culture, market and business environment of the overseas country; to allow for the almost invariable element of adaptation and tweaking of the business concept to best fit local conditions; and to provide a seedbed and training base for the franchising and support personnel which the master franchisee will need to support its network as it starts to recruit and grow local (sub)franchisees. Any company-run outlets will also provide a useful source of revenue as the business develops to the stage where its franchising operation and revenues themselves reach critical mass.

Besides the agreed fees and development schedule, other features of a master franchise agreement follow from the local franchising function which will become the primary business of the master franchisee. Issues will include the need to develop a local training function (using translations of the home country operations manuals), possibly a training centre and the need to follow the franchisor’s tried and tested methods of franchisee field support and motivation.

The franchisor will need to ensure that the form of sub franchisee agreement which the master franchisee will be entering into with its sub franchisees properly imposes the necessary controls and obligations needed to ensure that their businesses are operated in accordance with the system and the reputation of the brand maintained. The master franchisee will be contractually obliged to monitor sub franchisees’ performance and, ultimately, to enforce these sub-franchise agreements. Careful consideration needs to be given to whether the franchisor has a direct right to terminate sub-franchisees.

The term of the master franchisee’s agreement must be long enough to allow it to recoup its investment in building a proper country infrastructure, and to issue sub franchise agreements with a term long enough to attract sub franchisees and enable them to do the same, typically 25 – 50 years.

The size of the up-front and continuing fees charged by the home country franchisor for the master franchise is critical. They must be set at a level which both covers the expenses the franchisor will inevitably incur in finding, training and establishing the master franchisee in business, as well as permitting a reasonable long-term income stream to flow back to the home country. They must not, however, be set so high that the master franchisee will feel under pressure, either not to invest sufficiently in its support infrastructure – which is essential to develop and maintain the brand and the network – or to gouge its sub franchisees and charge them fees which are disproportionate to the scale of their businesses and the profits which they will need to generate to make the proposition attractive.

Generalisations are dangerous here. Each business must carefully evaluate its approach based on realistic business plans which take into account the needs of all parties, the costs of doing business in the new market and the level of profitability available, as well as the need to enhance and maintain the image of the system and the brand name.

In a master franchise arrangement it is also crucial to address carefully what will happen, as a matter of local law, if the master franchisee should fail and either want to sell its business, go bankrupt, or if the home country franchisor needs to terminate the relationship.

This is a very important subject which calls for the legal structures to be carefully planned up-front in both master franchise and developmental franchise agreements. The overseas franchisee may wish to sell its business, or bring in partners. It is crucial to the long-term focus to the local business and maintenance of the network’s image and reputation that the control and perspectives of the master franchisee, who was probably selected extremely carefully at the outset, do not change for the worse due to the influence of new shareholders.

The franchisor will therefore want a qualified right of approval of new owners, and certainly a veto over potential competitors becoming involved. It will also be sensible to include options and pre-emption rights to buy-out the master franchisee which will be triggered both by an impending sale or business failure, and on termination.

In a master franchise situation, it is also important to consider the fate of the sub franchisees if the master franchisee fails. Will the home country franchisor wish to step in? It will probably not want to be obliged to do so, but will certainly want to investigate how, as a matter of local law, the contracts should be set-up at the outset so as to have an enforceable option to do so itself, or through a replacement master franchisee, in order to protect the image and reputation of its network, and also so as not to put at risk its income stream from the country, which over time could become very substantial if a large network of sub franchisees is established.

Related to this, the franchisor will want to build in precautions to prevent the sub franchisees taking the opportunity to jump ship to a competing system, again with the risk of loss of a major income stream. Taking over in these circumstances is never easy, but the legal mechanisms usually exist, if carefully planned for in advance, to give the home country franchisor the rights and controls it needs.

Joint venture

A joint venture is created where the home country franchisor agrees to invest and become a shareholder partner in the overseas company to be established by the foreign franchisee. The joint venture company established in this way, in which the franchisor owns, say, a 50 per cent or perhaps 25 per cent share, itself then becomes the overseas country franchisee and is granted either developmental or master franchise rights for the territory by the home country franchisor.

There may be a number of reasons for doing this. The franchisor may wish to share in local profits, as well as receiving its income stream of continuing fees under the franchise agreement. Of course, there is likely to be a price to pay for investing in the capital of the overseas company with the risks which arms’ length franchising avoids, though the risk in this situation is, of course, being shared with the local partner.

Some countries’ legal environments, exchange control or foreign investment laws may make it difficult to repatriate the level of royalty fees which the franchisor would normally want. This may result in the restructuring of the arrangement into a joint venture with a right to receive dividends out of profits, as well as a reduced level of continuing fees. Developing countries’ investment approval regimes may insist on some inward investment.

Sometimes, the prospective franchisee may have all the other characteristics of the ideal local country franchisee, but insufficient funding, which may lead to the franchisor deciding to chip in.

A joint venture (or shareholders’) agreement will regulate the parties’ rights and obligations as shareholders in the new company. In addition, the new company will enter into a developmental or master franchise agreement with the franchisor. As a result, the franchisor ends up wearing two hats with different sets of rights and obligations both as franchisor, and separately as a shareholder in the franchisee company.

There are a number of issues and potential problems which can arise in joint venture company arrangements, basically flowing from the partnership relationship, such as the local partner’s authority, limits to authority, future funding, and what happens if things go wrong.

The franchisor is quite separately in the strong position of also controlling the joint venture company’s rights to operate the system through the franchise agreement which, depending on the facts, it might become entitled to terminate, enabling the franchisor to start again with another franchisee, even if the relationship in the joint venture company has broken down.

Key considerations

  • Don’t take your eye off the ball at home. Plan for, and resource, the exploratory steps sensibly. Flights, accommodation, key management time away, and finding and evaluating potential partners all have a cost. Ensure that the domestic operation can bear it and budget for it realistically.
  • Plan and implement a sensible trade mark protection programme in advance. The mark is the foundation of the rights you will be granting overseas. Even large companies have learnt to their eternal cost that (generally speaking) the first to register a particular trade mark in a country has the legal right to use it. Trade mark piracy does exist, and if you harbour international ambitions, plan to spend and budget for the fairly significant protection costs which a programme of international trade mark registrations will cost. Without the mark you may have much less to franchise! It is vital to develop a suitable strategy to do this before you attract the attention of those who might see the opportunity to steal your brand and exploit your reputation in this way. Stopping it after the event may be impossible, effectively preventing you from entering an overseas market at least under your usual brand name. At the least, conducting a fight is likely to be a protracted and very costly exercise.
  • Getting the right country partner is critical, and a far more serious problem, if you get it wrong, than an occasional badly recruited franchisee at home. Take it very carefully!
  • Spend some time analysing and prioritising overseas markets. The world is a big place and with limited resources where are you going to go in the next five years – specifically?
  • Don’t rely on unsolicited contacts from overseas. Try to be proactive rather than just reacting to the inevitable enquiries you will receive, but don’t necessarily write them off either. Someone has had the wisdom and energy to identify you, and decide that your concept will work back home. Establish sensible criteria and characteristics for the ideal country or regional franchisee. Do some background enquiring and due diligence to check out the prospective franchisee.
  • Most importantly – will your business concept actually work in your target country, or are there cultural, economic, or industry-competitive differences that are likely to present barriers? Eating habits may be significantly different; property, tax or import duty, or social costs may fatally skew the financial figures. In some cases, there may also be legal barriers. Increasingly, countries are adopting franchise-specific laws which must be addressed at a very early planning and prioritising stage, as failure to comply, for example with an obligation to provide certain information to a potential franchisee before entering into negotiations, can have serious consequences.
  • Carefully work out your package in advance. Don’t negotiate on the hoof.
  • Consider whether there are tax advantages of offshore holding structures; the use of branches and subsidiary companies overseas, or trade mark holding companies established at the right stage can result in greater after-tax resources, either to repatriate as profits, or from which to fund further international expansion.
  • Get the best advice from those who have done it successfully before, and check out the credentials of those who claim they have. This really is an area where getting the best legal advice is (almost) worth its weight in gold! Remember the ‘ticking time bombs’ of gaps or poorly drafted provisions in agreements which have been done by those with insufficient experience of international transactions. You won’t necessarily realise this until something goes wrong down the line – then it may be too late.