Franchising provides a flexible model for growth or re-engineering, with a variety of structures to meet different needs. Of all of the structures, the joint venture franchise is the least understood and most likely to cause difficulties if not structured correctly. In order to understand why this is so, it is necessary to consider the rationale for using the joint venture model and the manner in which such a relationship should be structured.
From the outset, the name itself is misleading. It implies that a joint venture and a franchise are one and the same, often documented within one legal contract – a joint venture franchise agreement. This perception is the root cause of many problems encountered with this model. A 'joint venture franchise' is shorthand for the grant of a franchise to a joint venture party.
There are many reasons why a franchisor might consider adopting a joint venture structure, but they often involve two, diametrically opposed, objectives. Usually, the franchisor wishes to either exert greater control over or show greater commitment to the franchisee by committing its own resources to the franchise.
The controlling franchisor In a traditional franchise model, the franchisor relies on the contractual terms within the franchise agreement to control the franchisee. This control often extends beyond the manner in which the franchisee operates the franchise business and touches on the franchisee's access to working capital and the identity of directors or shareholders and their other business interests, which typically have consequences if there is an unapproved transfer of shares in the franchisee. This level of control is often sufficient for franchisors, representing the right spot on the risk/reward graph.
However, for some franchisors, this contractual control is not enough and they want the added influence provided by a joint venture. With a joint venture franchise, the franchisor maintains its contractual control through the terms of the franchise agreement, but this is underpinned by a further layer of control at the corporate level through the joint venture or shareholder arrangement. By taking an equity interest in and possibly a seat on the board of the franchisee company, the franchisor can influence, and potentially direct, the franchisee business's conduct. This influence can extend to all aspects of the franchisee's internal operations, including recruitment, site selection, business planning and pricing.
The nurturing franchisor In contrast, franchisors may adopt the joint venture model simply to provide greater assistance to a franchisee. This assistance can take a number of guises, but is typically the injection of capital in return for an equity stake. The capital might be paid in cash or simply be a waiver of the initial franchise fee, allowing the recruitment of young, enthusiastic franchisees who might otherwise struggle to raise the necessary capital to invest in the start-up of the franchise. By taking an equity stake, the franchisor shows its commitment to the franchisee's business (ie, it has 'skin in the game').
Other reasons behind joint ventures The following factors may also influence the decision to adopt a joint venture model:
- Legal necessity – there are certain jurisdictions that require a franchisor to open and operate its own corporate units before it can set up a pure franchise network. Setting up a joint venture with a potential franchise partner can allow the franchisor to comply with this requirement but still press ahead with an entry into the market.
- Testing a market – from a franchisor's perspective, there is a strong temptation to convince potential international franchise partners that the franchisor's domestic concept is immediately transferable to another country without the need to set up a pilot or group of pilot locations. A joint venture can be used to test the concept in a new market before employing a pure franchise model.
However, perhaps the most common reason in current times to use a joint venture model is for the purposes of a future strategic buy-out.
A strategic joint venture can be used as a sequenced market entry strategy by which the franchisor agrees that together with a franchise partner it will establish a special purpose vehicle to act as the franchisee to establish the franchise business (under the terms of the franchise agreement granted by the franchisor) with the aim that the franchise partner will transfer its interest in the special purpose vehicle to the franchisor in due course at a pre-agreed formula-based price.
In return for the franchise partner making the requisite investment in the franchisee business, the franchisor allows it to participate in the generation of a strong income stream with a predetermined fixed-term exit strategy on an agreed valuation coupled with a release of its written down capital investment.
This buy-out structure can, of course, be attempted by way of a contractual provision in the franchise agreement. However, this often causes confusion in the negotiations and a lack of clarity on the final agreement. It also results in the acquisition of a company that has not been operated with the franchisor's input and therefore is not culturally attuned to the franchisor's expectations, and so becomes difficult to integrate into the group.
The key difference between a strategic joint venture and the many other types of joint venture franchise is the franchisor's level of control and day-to-day involvement in the management of the franchisee. Strategic joint ventures tend to require more franchisor involvement, whereas other structures are designed for minimal day-to-day involvement from the franchisor.
No matter what the purpose behind adopting a joint venture model, the structure should be broadly the same. There should be a two-layered relationship between the franchisor and its franchisee.
The first layer is the contractual franchise relationship, under which the franchisor grants the franchisee the right to operate the franchised business. The terms of this relationship are governed by the franchise agreement.
The second layer is the equity relationship, under which the franchisor takes an equity stake in the franchisee in return for giving some value to the franchisee (eg, the waiver of initial fees of a capital investment). The terms of this equity relationship are governed by the shareholders' agreement, often referred to as a joint venture agreement or a subordinated equity agreement, because the equity control is subordinate to the primary contractual control.
The following diagram illustrates a typical joint venture structure.
When embarking on a joint venture, it is best to keep the following best practice tips in mind.
Avoid conflicts of interest Above all, the franchisor must distinguish between its role as a franchisor and a shareholder in the franchisee. There is an inherent conflict of interest between the two roles and a failure to separate those interests brings significant risks. This is particularly true within a strategic joint venture where the franchisor is likely to have a representative on the franchisee's board.
It is not hard to imagine situations where a franchisor can be exposed to unacceptable levels of risk through its exercise of shareholder or board influence over the franchisee. Examples include making decisions on employee recruitment and dismissals within the franchisee (raising fears of the franchisor being a joint employer) or pushing through system-wide changes at the franchisor's behest without due regard to their impact on the franchisee.
One of the most effective ways to maintain a separation of interests is to ensure that the two layers of the relationship are maintained – the franchise agreement and the joint venture agreement.
Duty of good faith A growing line of authorities have held that a duty of good faith could be implied in ordinary commercial contracts and whilst it should not be implied by default, it is more likely to be implied in 'relational' contracts (ie, long term commercial relationships which require a high degree of trust and cooperation, such as franchise agreements and joint ventures).
In the recent case of Nehayan v Kent, Lord Justice Leggatt noted that whilst:
The parties to the joint venture were generally free to pursue their own interests and did not own an obligation of loyalty to the other, it would be contrary to the obligation to act in good faith for either party to use his position as a shareholder of the companies to obtain a financial benefit for himself at the expense of the other.(1)
Whilst this ruling by no means provides that all joint ventures will contain an implied duty of good faith, when entering into any form of joint venture, the franchisor should be careful that its actions are not contrary to the principles of good faith. The franchisor should control and reduce this risk through careful contractual drafting.
Maintain separate agreements All operational controls should be maintained through the franchise agreement. Duplicating or repeating similar or related items in the joint venture agreement should be avoided. In fact, a franchise agreement used with a joint venture franchisee should really be no different from a franchisor's standard document.
Cross default Termination of the franchise agreement should automatically lead to the winding up of the special venture vehicle. The opposite is also true – if a deadlock arises within the special purpose vehicle, then most likely the franchisee will be unable to operate. Undoubtedly, relations between the franchisor and franchise partner will mean that it would be preferable if the franchise partner was not involved in the franchise network.
Foreign direct investment In some countries, a franchisor cannot own more than 50% of the shares in the franchisee company. In such cases, ensuring that the franchisor has control under the franchise agreement is even more essential.
Joint venture franchising is a dynamic but complex commercial model that can be used to achieve a variety of strategic purposes. It is important that both the franchisor and the franchise partner understand each other's objectives and devise a version of the model which is aligned with those objectives. The more the parties invest in the planning and structuring stage, the more likely that the joint venture will deliver long-term success for both the franchisor and the franchise partner. Above all, it is crucial that the franchisor's roles are clearly delineated and that the two layers of the relationship – the franchise and the joint venture – are kept distinct.
For further information on this topic please contact Gordon Drakes or David Bond at Fieldfisher by telephone (+44 20 7861 4000) or email (email@example.com or firstname.lastname@example.org). The Fieldfisher website can be accessed at www.fieldfisher.com.
This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.