Franchising – The route to international expansion?

by Dentons
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Franchising is a proven route to the successful international expansion of businesses in various sectors from fitness studios and restaurants to high end fashion and beauty.  Annually it accounts for turnover of USD$300 billion in Europe, USD$850 billion in America and USD$130 billion in Australia. In the restaurant and leisure sector global brands such as Jamie's Italian, and Wagamama have used franchising successfully to grow in both traditional economies and emerging markets.  US restaurant companies such as Domino's Pizza, IHOP and Dine Equity have long been at the forefront of international franchising.

However, franchising is not the exclusive preserve of US franchise brands. A franchise strategy can also work for companies that have never franchised before. For example, some hospitality and leisure companies use franchising as an alternative to direct investment when it comes to expansion in the lucrative but high risk emerging markets of South- East Asia, Eastern Europe, the Middle East and Africa.

Benefits for all concerned

Franchising works because it offers real benefits, not only to the brand owner but also to its franchisees. It offers a number of clear advantages to companies looking at global markets. For the restaurateur, it removes the need to invest capital and other substantial resources in the venture. It uses the local know how and connections of the franchisee to secure good sites and overcome obstacles with local products registrations and permits. A franchise strategy will see the local partner make the bulk of the investment whilst benefiting from the know-how, good name and quality assurance program of the company acting as franchisor. Franchising enables restaurant and leisure companies to access the required capital and grow the business internationally without significant expenditure or external funding. Franchising also allows companies to attract high quality local investors. These investors are highly sophisticated and have a great incentive to make the project a success in their local market. They also have a strong understanding of the local market. So franchising not only enables you to grow your business internationally by taking advantage of the capital and resources of local investors, but also enables the local investor to have access to the blueprint of a strong proven concept with a known reputation. Few local investors have the resource and time to research their own specialist know how to put together an innovative and successful concept for the local market that would generate attractive levels of income without the trial and error that goes into building a successful business.

Selecting the right partner

However, in order to take advantage of the potential that franchising offers, one needs to plan the approach carefully. Successful businesses often receive a multitude of offers from foreign real estate developers interested in taking a franchise for Russia or China or the Middle East. Whilst this may be very flattering, it is important to be discerning as many of these would be franchisees will not have the required operating experience in the sector. A franchise which has been well planned, structured and executed can have a substantial positive impact on a business but one that has been done as a response to an opportunistic approach from a foreign developer can be catastrophic. The reality is that on those relatively rare occasions where international franchises fail, this is usually due to lack of due diligence regarding local partners.

Protect your brand

Before entering into an arrangement with a local partner you need to ensure that your brand is fully protected by way of trademark registrations in the target market and that any franchise fees or royalties are structured tax efficiently so as to avoid withholding taxes. That requires some expert professional advice before negotiations start. There are countries where the registration of a trademark can take between two and four years. This can result in promising negotiations aborting because the trademark situation is unclear until registration has been achieved. Early planning is therefore key.

Popular Franchise Structures

The basic structure for international franchises is straightforward. The franchisor grants the local owner the right to operate in given location for a set number of years. A franchise agreement will usually be for between 5 and 10 years.  In certain sectors such as hotel and leisure it is common for a  management company to operate the property, where the local partner does not have operating expertise. This very much depends upon the sector and the expertise of the franchisor.  However, it is usual to have some input on the choice of senior personnel that are put into place by way of interview or approval rights. This can extend to Brand Manager, Head Chef and Restaurant Manager.

In addition to the plain vanilla unit franchise for a single property, more sophisticated structures are also available and should be considered. Whilst brands with limited equipment costs may be suited to direct franchising, the investment required for most established F&B brands, will exceed the resources of the typical unit franchisee.  Instead companies should partner with an established player that has the resource available to it to construct multiple units over an agreed period of time. This is known as area development franchising. In an area development franchise the local franchisee or "area developer" is a large company that has the finance and resources to open multiple units. The area developer commits to a development schedule whereby it agrees to develop an agreed number of restaurant units over an agreed time period. It is granted exclusivity over a certain territory. Area development agreements are long-term contracts requiring significant investment. A duration of 10 to 15 years is usually appropriate. In order to avoid being locked into the wrong relationship for a substantial period of time it is however important to agree minimum performance targets.

Financial Models

The financial model needs to be carefully considered. In the restaurant sector, the amount of product that can be supplied by the franchisor at a margin is limited. As a result royalty fees are customary. In addition major brands often command an exclusivity fee. Where the restaurant franchisor provides restaurant opening services, a charge may also be justified. For some famous brands fees of USD$1 million are not unheard of whilst smaller restaurateurs may be unable to secure any upfront fees.  Specialist advice should be taken to ensure the financial model enables both parties to make a fair return on their investment.

Practical Issues

Practical matters such as importation of specialist equipment and ingredients, local health and safety rules and taxation issues require a risk analysis for each market. If the importation of the equipment or products requires additional expensive testing or certification, a market may not be suitable for franchise or it may be a case of investigating local suppliers. It is therefore vital to undertake market research into the regulatory environment before pushing ahead.

How about joint ventures?

Local partners will often suggest a joint venture. Typically, this involves taking an equity stake in the local business and a profit and loss participation. The obvious attraction would be a profit share. But, these structures are high risk and should only be attempted by experienced global organisations with access to funding and a large budget for legal and consultancy fees. Joint ventures can result in the total loss of investment and significant management time being diverted from the UK operations without any immediate financial reward. Where a joint venture is the way forward, brand owners should not compromise on brand values. These should not become a matter of debate and voting at board level but should instead be controlled by the UK brand via a franchise or license agreement.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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