How to Enjoy A Masterly Expansion

 How to Enjoy A Masterly Expansion

At the International Franchise Expo in New York, my partner Tao Xu and I presented a program entitled ‘International Expansion – Master Franchising and Other Structures’ with Bill Schreiber, Vice President of International Development for Little Cesar’s Pizza. The presentation focused on the benefits and downsides of each of the various methods of international expansion – unit franchising, area franchising/multi-unit franchising, area director/area representative, master franchising, joint venture and direct investment. The program highlighted the master franchise structure, describing both the benefits and downsides of this structure and the factors that contribute to successful brand development through master franchising.

Many smaller brands that are new to international development gravitate to the master franchise model for four key reasons

First, master franchising can be one of the fastest means of growing the brand because it leverages the resources of not only the local master franchisee, but also the subfranchisees who will build and operate the outlets. 

Second, leveraging these resources means that, as compared to other expansion models, master franchising requires fewer resources from the brand owner in terms of time and money.
 
Third, master franchising typically involves a lower degree of legal risk/exposure for the brand owner.
 
Finally, there is less required of the brand owner in a master franchise model in terms of international franchising expertise and local resources, as once again the brand owner is relying on the master franchisee to supply some of these resources.

These factors can encourage a smaller brand owner, with less time and money to devote to international expansion, to choose master franchising as a model to begin its international expansion.

There are, however, some downsides for newer brands who choose master franchising. Because more is asked of the master franchisee than of a local area developer, strong master franchisee candidates can be difficult to find. The master franchise model also inherently provides less control to the brand owner due to the three-party structure and the lack of a significant direct contractual and operational relationship between the master franchisor/brand owner and subfranchisee/unit operator.

Because there are three parties involved in the relationship, there are three parties that need to share in the profits, which means that a master franchise relationship typically will result in a lower revenue stream to the master franchisor – but, in some cases, an increased return on investment – when compared to other distribution methods. Also, while master franchising can be a relatively easy structure to implement, it is an exceedingly difficult structure to unwind if the relationship is unsuccessful.

Several program participants questioned Bill Schreiber about the best ways to locate potential master franchise candidates. Like many experienced development professionals, Bill endorsed the use of franchise brokers, particularly the sophisticated consultants with many contacts developed through years of helping numerous brands grow through master franchising.

Trade shows

Trade shows also are great ways for new brands to meet qualified candidates looking to add new brands to their portfolios. But if a brand knows the region in which it wants to expand, attending a U.S. government-sponsored trade mission to that region can be an ideal way to meet prospective master franchisees and gain valuable insight as to the local market conditions.

A key step is establishing the process for screening and evaluating prospects.  After sending out initial inquiries, conducting preliminary discussions, and getting signed confidentiality agreements, Bill recommends providing prospects with more detailed information about the master franchise opportunity (including a franchise disclosure document, if applicable) and requesting a detailed business plan.

As long as the prospective master franchisee does not have any connections to any state with a franchise registration/disclosure law, the U.S. franchise law restrictions on providing financial performance representations (FPRs) do not apply to operations outside the U.S. So even franchisors that do not review business plans for prospective U.S. franchisees due to the FPR risk often will review business plans for prospective international master franchisees. A discovery day often is a last step in the evaluation process. 

Bill led a detailed discussion about his method of choosing the best candidate. The first step is to identify a number of factors that describe both the minimum criteria and the ideal characteristics for the candidate and transaction. Some of these factors will be the same for most, if not all, brand owners, such as meeting the minimum capital requirements and passing background checks.

Other factors will vary depending on the brand, such as cultural fit, industry experience, operations infrastructure, real estate development experience, local supply chain contacts, and potential competing interests for the candidate’s attention and capital. Once those factors are identified – Bill’s model had 20 factors – each master franchisee candidate receives a score on each factor.

To keep the model simple, Bill uses green (or 5 points) for factors that are fully satisfied, yellow (or 3 points) for factors that are neutral, and red (or 1 point) for factors that are not satisfied. Each candidate then receives a cumulative score showing its relative qualifications as compared to the other candidates. To interpret the scores, Bill emphasized that while there is a minimum threshold (for example, 80 points) for viable candidates to proceed to the next round, the candidate with the highest score is not necessarily the one who should be offered the master franchise rights. The scores and table are important to compare and contrast the candidates, but there are other qualitative factors that play into the decision.

Maximising success

When determining the key business details of the master franchise arrangement, the discussion emphasized taking a long-term view to maximize the success of all parties involved. Master franchisees usually seek a large development area, but Bill recommended a more staged approach, where master franchisees receive a smaller initial development area initially with a right of first offer or similar rights to add territory later if the brand is successful in the initial area. Bill also recommends setting the development schedule conservatively.

Studies have shown that a large percentage of international development schedules are breached, often early in the term. While it is common at the outset for both franchisor and master franchisee to be optimistic in their assessments of a market’s potential, setting an aggressive development schedule often leads to tension in the relationship when the development moves more slowly than anticipated.

It was also recommended that the master franchisee organization be required to develop at least one or a few outlets itself, often though an affiliate of the master franchisee entity. These “company-owned” outlets will educate the master franchisee about market challenges, provide facilities for training subfranchisees, and enable the master franchisee to test and perfect new products and system changes.

For franchisors who are new to master franchising, determining the right fees to charge to the master franchisee – and, subject to local law considerations, to permit the master franchisee to charge to the subfranchisee – can be challenging. Franchisors obviously want to maximize their own revenue from the arrangement, but not to the extent that doing so would jeopardize the viability of the master franchisee or its subfranchisees or the pace of unit development.

A number of factors impact fee amounts, including the brand’s potential in the territory, the level of services and assistance that the master franchisor will provide (and its marginal cost of providing them), and the likely unit-level profitability.

Many brands just starting international development require significant upfront investment by the master franchisor (for tasks such as drafting the agreements and developing the training and supply chain functions) and have a greater uncertainty as to whether the brand will be successful internationally. These franchisors often seek increased initial fees and permit lower ongoing fees or royalties.

Many experienced master franchisees are willing to assume the risks associated with a higher initial fee and uncertainty associated with a newer brand, as long as the lower ongoing fees mean that the master franchisees can realize a greater profit if the brand is indeed successful. 

The program ended with a number of lessons learned over many years of experience with master franchising

First, newer brands ideally would undertake international expansion in a planned, proactive manner, rather than as a reaction to an inquiry from a local master franchisee of a number of U.S.-based brands. Careful planning and adequate funding from the brand owner are essential to a successful international brand launch.

Second, it is critical for the brand to have a strong foundation in the U.S., with profitable franchised and company-owned outlets that have perfected the concept in the U.S. market.

Third, the executive team must have the necessary commitment to and patience with the international program, as it can often take a great deal of time and resources before the program becomes profitable for the brand owner.

Fourth
, careful planning requires not only choosing the right master franchisee, but also having a contingency plan in place if the brand is unsuccessful in the market. While no brand has a perfect record in developing markets overseas, an early loss in a strategic market can significantly hinder future international expansion opportunities for many years to come.

International development through master franchising is a significant step in a brand’s development. By planning carefully, devoting sufficient financial resources, and obtaining the right expertise, master franchising can contribute to a brand’s explosive growth.


ABOUT THE AUTHORS:

Richard Morey’s franchise and distribution practice is focused on working with both experienced and startup franchise companies. He also works extensively on international franchising and licensing transactions, including master franchise, area development and single-unit licensing deals in Asia, Europe, Central America, the Middle East and the Caribbean.  https://www.dlapiper.com/en/us/people/m/morey-richard-j/  Tao Xu devotes his practice to franchising and distribution matters, especially international franchising, licensing and distribution transactions. Tao counsels a broad range of clients in their international expansions, including master franchising, multi-unit licensing, area development, single-unit licensing and direct investment.Tao is deeply involved in franchising activities in China. https://www.dlapiper.com/en/us/people/x/xu-tao/

 

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