Why choose franchising?

Markets for goods and services have become increasingly globalised and for many successful businesses, there comes a point in their growth cycle when demand for their products and services outstrips their ability to meet that demand from their own capital and human resources.

Franchising provides a tried and tested means of extending a business's reach into new markets, allowing rapid expansion and the generation of new income streams and relationships with new customers without the need for significant capital investment and an extensive management infrastructure.

Why go international?

Executed in the right way, a business's international franchising strategy can become a core asset of the business, helping to secure the long-term future of the business as a global brand and hedging the impact of economic risks in the domestic market. Many established brands increasingly rely on international business to drive growth, given the low rates of growth seen in many saturated, expensive and competitive domestic markets.

How to structure an international franchise

The key to success is a strong business concept, which can be operated as a franchise system and successfully adapted to the target market. However, that alone is far from sufficient to optimise a business's chances of success. It is necessary to ensure that the overall structure adopted suits the individual business. From a legal point of view, there are five options when it comes to structuring an international franchise.

Master franchising The franchisor grants a third party the right to operate the business itself and/or grant sub-franchises to third parties within a substantial territory. The master franchisee effectively becomes the franchisor for that territory, operating the business and recruiting, training and managing a network of sub-franchisees. This may be appropriate where the concept is suited to multiple units and low levels of entry cost.

Direct franchising The franchisor grants a third party the right to operate a single-site business itself. This may be appropriate where the concept is not suited to multiple units (eg, international schools, luxury retail or fine dining restaurants), or where a franchisor prefers to have a direct relationship with multiple operators in a single territory.

Multi-unit developer franchising The franchisor grants a third party the right to exploit a designated territory by opening outlets or providing services itself. The developer therefore needs to have considerable financial and other resources. This structure is commonly used in retail franchising.

Subordinated equity or joint venture franchising This is often used together with a multi-unit developer structure where the franchisor wishes to own a shareholding in the developer. This may be for a number of reasons, including where there is a need to obtain third-party investment. To facilitate this structure, the franchisor and a third party create a special purpose vehicle (SPV) and enter into a joint venture agreement or subordinated equity agreement. The new SPV acts as the developer and the franchisor grants the developer the right to exploit a designated territory by opening outlets or providing services itself. The key difference between a joint venture and a subordinated equity structure is the level of control and day-to-day involvement of the franchisor in the management of the SPV/developer. Joint ventures tend to require more involvement of the franchisor, whereas subordinated equity structures are designed for minimal franchisor involvement (save over a few key brand protection and standards issues), but with an option for the franchisor to buy back the entire issued share capital of the SPV at a later point in time.

Management franchising The franchisor grants the property owner the right to operate an outlet at a given location. Generally, the property owner will engage a management company to operate the business on its behalf, which could be a local company or an affiliate of the franchisor. This structure is very common in the hotel and leisure sector.

How to choose the right structure

Certain types of business are suited to certain types of structure, as indicated above; but there are a few other points to consider which can guide the decision-making process.

What resources do you have? If your business has a large reserve of manpower that is experienced in franchising matters and plenty of cash to throw at the project, direct franchising might be safer and more cost effective in the long run in certain jurisdictions. If you have much more slender resources, then a master franchise or multi-unit developer approach may suit you best.

What is the target market? Understanding the size and make-up of the target market is crucial. What is likely to work for a small and geographically close market may well not be appropriate for a large regionalised and distant market. It is vital to prioritise target countries realistically, in terms of potential scale of the market, balanced by ease or difficulty of market entry and support.

Who is your ideal partner? If you are aiming for a large blue-chip partner, it is likely that the multi-unit developer or subordinated equity/joint venture route will be most appropriate. However, if the partner is a smaller, more entrepreneurial organisation, a master franchise approach may be more appropriate. It is vital to establish a partner recruitment process which selects the right candidate for the business. The first few international franchisees will be ambassadors for those that follow – for better or for worse.

Is there enough of a margin for you and the partner? It is important to understand how your business can make money out of international franchising. Is it related to the supply of goods? Is it linked to the ongoing supply of support/central services? Is it merely attached to the use of the brand and know-how? Different answers will lead to different conclusions as to the most appropriate structure.

Legal challenges of going global

Whatever structure is adopted, the international strategy must be designed to identify the regulatory and legal hurdles at any early stage.

Brand protection Businesses should invest prudently to ensure that each target market will be underpinned by registered trademarks, design rights (if appropriate) and domain name registrations. This is a costly exercise, but the costs (financial and loss and opportunity) of dealing with pirates and cybersquatters or claims from local third parties with prior rights far outweigh the upfront protection costs.

Pre-contractual protection Before the parties sign the franchise agreement, they will inevitably exchange sensitive information. Businesses should disclose this information only under the protection of a robust confidentiality agreement. However, the best way to protect confidential information is to keep disclosure to a minimum until the parties have entered into the franchise agreement. The franchising manual is the bible of any franchised brand and should not be disclosed until the franchise has been signed. In addition, it is the franchisor which will incur legal costs leading up to signing the franchise agreement, so at the stage of either signing the confidentiality agreement or agreeing heads of terms, the franchisor should request a deposit, which will deducted for any upfront fee under the agreement; in the absence of an agreement, it will be refunded less the franchisor's costs.

International regulation Franchising is regulated in a significant number of countries that have franchise-specific laws, while others impose a complex and challenging regulatory environment through more general commercial laws. These laws regulate the franchise sales process and the content of the franchise agreement; some also require that the documentation be filed in a public register.

These compliance issues can affect commercial timelines for doing deals and opening sites should be identified at the planning stage.

Regulation of sales process Countries such as the United States, Canada, Australia and China require set-form pre-contractual disclosure. Key disclosure issues include how and when the disclosure must be made, mandatory cooling-off periods before the deal can be finalised and the scope of the content of the sales and disclosure documentation. The consequences of a failure to comply with disclosure requirements vary. Non-compliance generally entitles the franchisee to walk away from the agreement without restrictions, provided that it acts within a reasonable period of entering into the agreement. The franchisee can also sue the franchisor for damages. Some jurisdictions also impose fines for failure to comply.

Regulation of contractual terms Franchise-specific laws in certain countries impose mandatory contractual terms in the franchise agreement. These often include a minimum term, a duty of good faith, restrictions on termination, restrictions on post-termination non-compete clauses and so on. These mandatory provisions may affect the proposed business model and change the terms of the commercial deal on offer.

Registration requirements Some jurisdictions require the franchisor to register only relevant details, while others require registration of all documentation. In developing markets, this is to enable the government to monitor franchisors doing business in the market; while in more developed economies (eg, the United States and Spain), it is to ensure transparency and maintain a certain level of quality. In some countries, there are multiple registration requirements. For example, franchisors in China which sell franchises in just one province must file the information at the local office of the Ministry of Commerce of that province, whereas for cross-province franchising the papers must be filed with the Ministry of Commerce itself. Franchising is also regulated by a variety of general laws which must be taken into account, such as the duty of good faith, antitrust law, unfair competition law, agency law and consumer law.

Comment

There is no one-size-fits-all solution to international expansion. Such ventures must be carefully structured to reflect the needs of the business, the target market and the franchise partner. The most appropriate structure needs to be determined at the outset, as restructuring an international franchise is a complex, costly and time-consuming exercise. Choosing to work with an experienced legal counsel who has walked down this path before and can manage the international compliance on your behalf can be the difference between success and failure. It is also crucial that the business has 'bought into' franchising at the board level. Once the strategy and structure are in place, rolling out a franchise internationally can be a relatively low-risk/high-reward venture, and one which over time will generate significant income and ultimately a paradigm shift in the way the business operates, evolving from a domestically focused business with an international presence into a truly global brand.

For further information on this topic please contact Gordon Drakes at Fieldfisher by telephone (+44 20 7861 4000) or email (gordon.drakes@fieldfisher.com). The Fieldfisher website can be accessed at www.fieldfisher.com.

An earlier version of this update was first published in Global Franchise magazine.

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.