The popularity of franchising as a business model continues to grow. According to the British Franchise Association (“BFA”) the industry annual turnover is currently £13.4 billion with about 930 franchisor brands and businesses operating in the UK. In this article, we look at some of the recent trends in the franchising market and consider the key legal issues relating to setting up a franchising business.
Why are more businesses adopting a franchise model?
Franchising as a business model offers companies a means to expand their territorial footprint (whether in the UK or internationally) without over-leveraging their business financially or administratively, and without diluting their brand identity and business values. A franchise model has the attraction of apportioning both finance and risk between the franchisor and a franchisee and can assist the franchisors to expand into a new market or sector.
Who is going in for franchising?
In the United Kingdom, the best known industries using franchising models for their businesses include coffee shops, restaurants and Fast food outlets, pubs and bars and petrol stations. The franchising movement continues to expand into new fields, prominent examples being the retail sector, hotels and catering, postal services, health clubs, personal services and business and communications services, which have all shown growth since 2008.
In a recent NatWest sponsored BFA Franchise Survey, more than four fifths (81%) of franchisees surveyed said they believe franchising gives a competitive edge – and nearly half cited a “big competitive advantage” – when compared with non-franchise small businesses. Banks (notably NatWest) are also reported to be increasingly keen to back franchising as a model for new businesses.
The franchising market is now considerably more developed in many industries
Historically, franchisors have been larger companies (including market leaders such as McDonald’s, 7-Eleven, Subway, KFC, Avis and the Carphone Warehouse) with franchisees being small – often sole traders. Nowadays medium sized organisations are increasingly adopting the franchise model, particularly those specialising in operating these particular business formats: such as smaller breweries, fashion retailers and clothing stores, convenience stores and motorway service station businesses. At the same time, the number of large systems (100+ franchised units) is also growing as the industry structurally matures, and there are increasing numbers of larger franchised units, employing more people and with higher turnover (see figure below).
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Source: BFA/NatWest Franchise Survey 2012
There have been changes in the profile of franchisors and franchisees, and there has also been an increase in the use of different business models within franchising – including multi-unit and multi-brand franchising. Multi-unit franchising is where a franchisor appoints one franchisee to operate many outlets on a regional or nationwide scale. Multi-brand franchising involves franchisors and franchisees looking to diversify so that they are no longer reliant on a single brand. A recent example of this is the Whitbread Group, which now owns the Premier Inn and Costa Coffee businesses.
Both these trends illustrate the increasing maturity and complexity of the franchising market, and there is now an increasing level of choice for potential new franchisors.
Cross-jurisdictional franchising – the regulatory issues
Franchising is an increasingly popular method of international expansion for businesses. Methods of international franchising include:
- direct territorial franchising – where a business grants exclusive territorial franchises to franchisees in another jurisdiction;
- establishing a subsidiary or branch in another jurisdiction which then grants franchises to franchisees in that country;
- establishing a joint venture with a local jurisdictional business partner to grant franchises; and
- entering into a master development or master franchise agreement, under which the master franchisee undertakes to grant sub-franchises to third parties.
When contemplating an international franchise arrangement, it is vital for a business to obtain advice regarding local franchise regulations and legislation before making any significant expansion overseas. Many jurisdictions have franchise-specific laws, creating significant challenges. Types of franchise legislation include:
- anti-trust regulations (principally to prevent restraint of trade);
- foreign trade and investment regulations which regulate the entry of foreign businesses into a domestic market (note particularly China, countries of the former USSR and Vietnam), some of which have complex rules and require the registration of individual franchise arrangements;
- regulations covering technology licensing agreements;
- registration for the purposes of securing double taxation relief; and
- specific local regulations dictating the franchisor/franchisee relationship (e.g. USA, Australia, Canada, Brazil, Georgia and Mexico) which often share characteristics of franchise laws of countries like France, Spain, Italy and Sweden. Local legislation may give franchisees rights (for example regarding the availability of compensation to the franchisee on termination of a franchise arrangement) and can override the terms of the franchise agreement.
The United Kingdom remains one of the few remaining jurisdictions which does not regulate the franchise industry, permitting self regulation by the BFA.
Protecting the franchisor’s IP
While adopting franchising as a business model carries many perceived benefits, it also carries inherent risks. Franchising requires the transfer of a degree of control over a company’s brand (and accordingly the core intellectual property of its business), including the right to use business names, brand names, trade marks, images, font and formatting styles, inventions, designs and essential products which have been developed by a franchisor. It is vital that this valuable intellectual property is protected in any franchise arrangement, both in the initial franchising agreement and any associated licences or assignments of rights, and also by the appropriate registration of the franchisor’s intellectual property (including trade marks, patents and registered design rights). Usually it is necessary for a formal trade licence to be registered in the local territory, and in some territories the franchise agreement itself will have to be translated into the local language and registered. Since this often has benefits for both parties, costs for such registrations may be shared.
Franchisors will often have a considerable amount of “know-how” and expertise which they pass to franchisees. It is therefore important to ensure that a franchise agreement contains provisions which limit access to only the background know-how agreed between the parties and helps prevent a franchisee from setting up a "copycat” business following termination. It may well be possible to achieve some contractual protection by having a post termination non-compete provision in an agreement. However, in order for such a provision to be enforceable, it will commonly need to be for a relatively limited duration and appropriately limited in geographic application.
One of the chief ways in which know how is transmitted is by developing a comprehensive Operational Manual, the preparation of which can take a considerable time.
Competition Law Issues
Small to medium sized businesses with a relatively low market share which are looking to operate as franchisors are generally unlikely to run into significant problems with competition legislation (for example in relation to exclusivity).
However, regardless of a potential franchisor’s market share, certain so-called "hard-core restrictions" in franchise arrangements can nonetheless amount to infringements of competition law. The principal hard-core restrictions in the context of a franchising arrangement to be aware of include:
- fixing re-sale prices or setting minimum pricing; and
- preventing a franchisee from making so called “passive sales” outside of the franchisee’s exclusive territory or designated sector.
Price fixing is not permitted under EU law and there is a common thread of case law available to support this. The issue of passive sales is becoming increasingly relevant in the context of the development of the internet and e-commerce within the EU, a franchisor can legally prevent a franchisee from actively marketing outside of the agreed territory but only into territories exclusively reserved for the franchisor or other franchisee. Passive sales occur when a customer from a territory outside that granted to a franchisee wishes to make a purchase from the franchisee’s business. This cannot be restricted by a franchise agreement. In addition, so long as a franchisee operates from one or more “brick and mortar” establishments, it is not possible to prevent them selling on the internet, although this can be regulated.
Termination of a franchise arrangement
When a franchise arrangement comes to an end for whatever reason, it is important to ensure that the agreement is terminated lawfully in accordance with its terms. This can include ensuring that the correct period of notice is given by an applicable party to the other, and by conducting a full analysis of any potential breach of contract to ensure that it is a true breach situation and cannot be remedied within any established timeframes. Failure to do so may leave the relevant party vulnerable to a claim for damages, or unable to enforce the post termination non-compete provisions considered above. While the principles are no different from most other commercial contracts, the stakes for the franchisor and franchisee, both reputational and financial, are often higher.
Clearly, this article cannot cover all the issues to be taken into account when contemplating franchising. These can include the staffing and training of the franchisee’s nominated figureheads and its employees. Tax considerations may influence decisions such as whether to set up a representative office, a branch or a subsidiary company, and there are company registration and corporate compliance issues relating to each of these. Decisions must also be made regarding whether and how to acquire commercial property and store dressing for retail outlets, and the legal implications of transferring products or assets from the franchisor to the franchisee.
Franchising is increasing, the models adopted are becoming more varied, and the range of sectors in which franchising is regularly used is widening. Right from the outset of any discussions, getting things right in terms of the legal relationship between franchisor and franchisee is vital if both are to benefit to the greatest possible extent.