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Considering international franchising: how hard could it be?

Considering international franchising: how hard could it be?

Do you know your JVs from your SFDDs? If you’re planning on franchising your brand internationally, take time to understand the options at your disposal

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Most people with a basic understanding of franchising understand the three fundamental aspects of the franchise model:

1. A business owner (the franchisor) gives a person (the franchisee) the right to use the franchisor’s brand, trademarks, and system of doing business.

2. The franchisee promises to pay the franchisor a continuing fee for those rights.

3. The franchisee promises to follow the franchisor’s rules for operating the business.

The franchisor’s brand and trademarks are generally the same, whether they are in one country or across the globe. How the concept is executed and the considerations involved in setting up the brand may be modified, though, to be successful in new countries.

Most franchisors that embark on international franchising have already operated one franchise business in their home countries before they consider international franchising. For the first-time international franchisor, a strong foundation for international franchising must be established before the first international franchisee can open, and begin reaping the rewards, of an international franchise business.

Together, the international franchisor and international franchisee must work to adapt the business model to suit the cultural, business, and legal needs of the franchisee’s market.

What does that mean in terms of time and money? Because international franchise programs are rarely the same from country to country and from franchisee to franchisee, only experienced international franchisors can reasonably estimate the answers to those questions.

As international franchise lawyers, we are frequently asked these questions. Rather than give the answer lawyers are trained to recite (“It depends!”), we outline the international franchising process so that franchisors can better understand what is involved, what decisions must be made, and the documents that must be drafted, negotiated and/or filed before collecting any money from a transaction. As we outline the international franchising process, we also explain how the international expansion strategy selected may affect the cost, time, and returns associated with international franchising.

Master franchising

It is very common for burgeoning international franchisors and franchisees to insist they want to use master franchising for their first international franchise transaction. Master franchising is appealing because, within a territory, the master franchisee recruits, trains, and supports subfranchisees and opens its own franchised outlets, using the franchisors operating system and its own financial resources. Master franchisees become the defacto “franchisor” in the territory granted under the master franchise agreement (MFA). The master franchising approach allows franchisors to rely on their master franchisees to communicate directly with multiple franchisees in the foreign territory and to enforce franchise agreements. In theory, franchisors avoid the burden of becoming fully conversant with business and legal practices there, because the master franchisee takes on those duties. Master franchisees do most of the work, and the franchisor provides general support from its head office.

“The business model must suit the cultural, business, and legal needs of the franchisee’s market”

There is nothing wrong with this approach to international franchising, but before adopting a master franchising strategy, franchisors should first consider the cost.

Before granting a master franchise, a franchisor must prepare a master franchise agreement and, in over 20 countries, a master franchise disclosure document (MFDD). They must also prepare a subfranchise agreement (SFA) for the master franchisee to use, and in the countries with franchise disclosure laws, a template subfranchise disclosure document (SFDD) for use by the master franchisee.

Although some franchisors believe that they will save money by allowing their foreign master franchisees to draft the SFAs and SFDDs that they will use, the savings are illusory. Here is why: the unit franchise agreement or subfranchise agreement defines how a franchisor regulates the services provided to franchisees and their obligation, defines how customers of the franchised businesses will be served, and protects the franchisor’s intellectual property (including trademarks, trade secrets, and copyrights) that is licensed to franchisees. Experienced franchisors believe that these controls are vital to the success of their franchising programs.

If an inexperienced master franchisee uses a lawyer with limited franchising experience to prepare the SFA for the franchisor’s review and approval, it usually takes a lot of time and expense for the franchisor and its international franchise lawyer to review the master franchisee’s draft, and then negotiate the language in the SFA with the master franchisee’s lawyer. Moreover, if the franchisor uses the same approach with multiple franchisees, it will incur the same type of expense in each territory.

Subfranchise disclosure documents describe the subfranchise that is being offered and contain information about the franchisor and the subfranchise agreement. At least in the U.S., franchisors have been held liable for misrepresentations or omissions by master franchisees in their SFDDs. To deal with that risk, franchisors should retain international franchise counsel, both in their home countries and in the master franchisee’s country.

While creating a master franchising program is typically more expensive than using an area development agreement, the returns for franchisors and master franchisees are less than they would be in an area development franchise.

That is because they share the fees collected from subfranchisees. Often those shared fees are the sole source of revenue each will generate. Determining the appropriate share for any particular transaction and franchise program requires financial modeling and projecting of average unit volumes in the master franchise territory, as well as an evaluation of other sources of revenue that a master franchisee and franchisor may extract from subfranchisees.

If the fees that are charged to subfranchisees are not competitive with what other franchise systems charge their franchisees, development goals will not be satisfied. Thus, increasing subfranchisees’ royalty obligations to generate adequate revenue for a franchisor and master franchisee to share, may not be feasible. Everyone involved should understand this before signing an agreement.

The two threshold questions for every master franchise proposal, which must be answered before a master franchisor and master franchisee sign a letter of intent, are:

1. If the master franchisee is reasonably successful at fulfilling its development goals and obligations under the MFA, will the master franchisee achieve market-rate profits or better?

2. Will the franchisor generate enough revenue to justify its investment in the master franchise program?

One quick way to estimate the viability of a fee split begins with examining the financial statements of the franchisor’s operations in its home market. If it had to share a portion of its revenues with another business, how much of those revenues could it share and still be as profitable as it wants to be?

For example, if the franchisor collects a six per cent royalty fee and makes a 10 per cent return on investment, what will its master franchisee’s return be when a portion of that six per cent royalty is shared with the franchisor? Answering these questions can be difficult, but no one should enter into a master franchising program without feeling comfortable with the answers.

Area development franchising

Instead of a master franchise, the parties may consider using an area development program where 100 per cent of royalty and other fees (fewer taxes) are collected by the franchisor. In an area development program, the area developer maintains a controlling interest in each franchised unit opened in the territory. The franchisor trains the area developer’s management team to train the operators of businesses in its territory.

The franchisor’s legal investment in an area development program is considerably less than it usually is in a master franchise model. The franchisor needs to only draft and use two agreements: an area development agreement, and a unit franchise agreement. An area development agreement defines the development requirements and methods for opening, training and supporting operators of individual franchised units. A unit franchise agreement prescribes how each franchised outlet is to be operated. All agreements are signed by the franchisor.

If disclosure is required or preferred in the territory, a single franchise disclosure document can be prepared. Although an area development manual and training program are needed, the area development version of those manuals and training programs is typically a revision of similar documents used in the franchisor’s domestic franchising program, rather than entirely new documents.

Because an area development franchise is a direct franchising program, the franchisor maintains greater control over operations in the area developer’s territory than it would in a master franchise program.

All fees are paid to the franchisor and nothing is shared with a third party. Therefore, the ability to calculate the returns on this international franchise investment is much more straightforward than when using the master franchising model.

Joint ventures

Many potential parties to an international franchise investment consider a joint venture (JV) in which both the foreign (potential) franchisor and the local investor will form a company to adapt the franchisor’s brand and test it in the local investor’s territory. Even when structured as “partnerships”, in which both parties invest and risk loss, under the laws of some countries the JV structure may also be regulated as a franchise.

Although franchise agreements are prepared as “form agreements”, with the expectation that the capital investment of preparing the prototype documents will be amortized over many transactions, each JV is bespoke. The demands and needs of each party, the investment required, the conditions for buying out one partner or the other, the share of profits and losses, and other material considerations are dictated by a unique agreement.

The legal costs are typically higher than those incurred in a master franchise or area development franchise arrangement, due to the need to develop the JV entity and its corporate documents, in addition to the franchising documents. The “franchisor” entity also usually prepares a license agreement through which it grants the JV a license to use its trademarks and know-how.

JV’s are often designed so that the JV or its successor will obtain master franchise or area development franchise rights for its territory.

Because the “franchisor” invests its own capital into the JV, its investment and returns/ risks often exceed those associated with a master franchise or area development franchise investment. The returns a party to a JV will receive from a successful business depend, almost entirely, on the JV Agreement and other agreements the entity negotiates.

“Sometimes the economic structure of a business or the size of a territory will only support the grant of a unit franchise”

Franchisors need to understand both the profit potential from a JV and their exposure to operating losses. They also may incur tax and audit expenses arising from a JV that they would not incur using a standard franchising model.

Unit franchises

Sometimes the economic structure of a business or the size of a territory will only support the grant of a unit franchise, whereby the franchisee will operate a single franchised outlet.

The cost of preparing and localizing a unit franchise agreement for an international franchise transaction is usually lower than the costs of any other format discussed in this article. However, the cost of granting and negotiating an international unit franchises is much higher than comparable costs when granting an additional franchise in the franchisor’s home country. The agreement may need to be translated, filed and made the subject of a disclosure. The franchisor’s manuals and training program will require localization and, possibly, translation.

Because the transaction costs and cost of adapting the franchise to the new territory are typically so high, and the typical returns for a franchisor from a single franchised location are so relatively low, unit franchise grants in international franchising tend to be the exception rather than the rule. However, if the franchisor’s country is adjacent to the franchisee’s country and if the parties share a similar culture and legal system, or if the business is expected to generate significant revenues, a unit franchise approach should be considered.

Examples of successful international unit franchises include large, luxury hotels, car rental franchises granted for major international airports and business training programs located in business centers.

Carl E. Zwisler is an internationally acclaimed franchise lawyer. He represents franchisors and master franchisees from the Washington, D.C. office of Gray Plant Mooty

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