Franchising Structure Options
Amongst the multitude of considerations engrossed in international franchising and one of the major issues that must be established before embarking down the road of franchising, is the franchise model. Knowing which franchise model or structure to use depends on a variety of factors that are particular to each franchisor.
There are five primary franchise models commonly used to expand internationally. They are:
Direct Franchise Agreements;
Master Franchise Agreements;
Area Development Agreements;
Area Representative Agreements; and
Joint Venture Agreements.
Determining the model most suitable to meet the expansion plans of the franchisor depends on a number of factors. These include, but are not limited to (a) financial resources available; (b) human resources available (in terms of numbers and franchising experience); (c) the amount of support /control required to ensure the integrity and quality of the franchising system is maintained; (d) amount of training and on-going support required; and (e) the availability of products required for the operation of the business from local markets versus the requirement to import products.
In terms of financial resources, international franchising can be highly capital intensive as the franchisor will need to maintain staff to support the franchisees in terms of operational development, training, ongoing support as well as inspections to ensure that franchisees arecomplying with the system. The franchisor may decide to outsource these services initially, this may reduce the costs of maintaining a large staff which may not be supported by initial franchising revenues.
The Master Franchise
The master franchise is a set up in which a person or organization is in charge of developing an entire franchise system and brand in a particular region or country. The person or organization is granted the right to open its own franchises as well as the right to sub-franchise out rights to other franchisees for individual or multiple units, or for regional franchising. The master franchise owner is essentially the franchisor in the country and takes a royalty from any sub-franchisees, which is usually shared with the franchisor.
Master Franchising is very common in practice. It allows the franchisor to expand abroadwithout the need for great resources, financial and human. This arrangement will allow for rapid market penetration, accelerated growth of the franchise system and attraction of sophisticated investors. Having a master franchisee can significantly lower the administrative costs of the franchisor since the franchisor will only have one contractual relationship which covers the entire territory. If the international franchisee is successful the financial reward to the franchisor will be significant in terms of the return on invested capital.
The franchisor grants the master franchisee the right to manage and operate the franchise system in the host country, which includes providing local support to sub-franchisees, enforcing thesystem standards and serving as the collection agent for the fees and royalty payments due thefranchisor. Selecting the appropriate international master franchise and strategy for the target country is critical and can determine the success or failure of the franchise in a particular jurisdiction.
The franchisor will usually need to provide training to the master franchisee to ensure the master franchisee understands and can implement the franchisor’s system. Once the master franchisee has been adequately trained, the master franchisee then takes on the obligation to train the sub-franchisees. In most cases, certain aspects of the business model must be refined for the target country.
The master franchisee must have sufficient resources to develop the territory. Under a master franchise, a substantial amount of control will shift from the franchisor to the master franchisee since it will be responsible to enforce standards and procedures among the sub-franchisees. The master franchisee is responsible for developing the market, selecting good operators to sub-franchise and implementing the publicity and advertising campaigns for the system. The efforts of the master franchisee are significant as they are in effect taking the role of the franchisor. The master franchisor requires substantial capital and resources to operate a master franchise. The upfront fee to become a master franchisee could be substantial ranging from several hundred thousand dollars to several million dollars. The Master Franchise Agreement is generally a long term contract, typically 10-20 years in duration.
The master franchisee should be familiar with issues relevant to the target jurisdiction, such as cultural issues, language issues, local tastes and preferences for the product or service being franchised. The master franchisee further takes on the all responsibility for compliance with applicable franchise laws, disclosure and other local laws in the target country. In coordination with the franchisor, the master franchisee produces the franchising materials, documents, disclosures, manuals, policies and procedures in the language of the target country. The role of the franchisor becomes that of supervising and managing the master franchisee – one entity- as opposed to numerous franchisees. The franchisor will further monitor compliance of the master franchisee in completing all of its obligations, developing the market and providing the assistance and guidance to the sub-franchisees.
The main risk to the franchisor in this business model, is if the master franchisee fails, the entire system in the target country may fail and will be difficult and costly to salvage the franchise system in the foreign market.
It is possible to protect or mitigate such risks by adequately addressing these issues in the master franchise agreement, however the best protection will be having an adequate team to monitor the activities of the master franchisee. The master franchisee may need to modify the franchise agreement with sub-franchisees to comply with local law as the franchise agreement should be governed by local law to allow ease of enforcement against sub-franchisees. The master franchisee will need to consult with local counsel in the target country to amend the franchise agreement, but typically, the franchisor will need to approve all changes- and may consult their own local counsel- to ensure protective provisions are still maintained in the franchise agreement to protect the interests of the franchisor, such as, the assignment of the franchise agreement in the event of termination of the master franchisee.
It is incumbent that the master franchisee selected is conversant with both sides of franchise operations- they need to know how to operate a franchised business as well as how to manage a franchised business from the standpoint of the franchisor. On the franchisee side, Franchisees need to be comfortable that the master franchisee will provide the support they need to thrive in the target country as well. If the master franchisee is not providing adequate support and training to sub-franchisees, this will not only negatively impact the franchisor, but, also, the sub-franchisee, who is a representative of the brand in the target country.
This option falls under the business model of master franchising, but instead of granting master franchisee rights for an entire country, the regional franchisee is granted the right to develop that brand in a region that is large and identifiable (such as a province or state). Regional franchise owners may own franchise units, but also have the right to sub-franchise out individual and multiple units.
Area Representative Franchising
An area representative is similar to the master franchise relationship, wherein the area representative provides the same services as a master franchisee, but rather than having a direct relationship with franchisees and area developers as a master franchisee would; the franchisor continues to have this direct relationship. The area representative provides services to the franchisor against a fee, usually a percentage of the franchise fees and royalty fees, just as a master franchisee would. The difference is that the fees are paid to the franchisor, and the franchisor pays the area representative.
This model gives the franchisor more control over the franchisees and the fees to be collected while the area representative is a service provider who can be easily terminated if not performing.
The disadvantage is that the franchisor is responsible for invoicing, collecting and following up on payments with franchisees. Furthermore, any action by a franchisee would be against the franchisor directly, rather than the master franchisee.
Area Development Franchising
Area Development Franchise may be considered as a type of a direct franchise relationship. This option is similar to regional franchising, except that it is for a city or smaller region, and the franchisee owns and operates the franchise units- no sub-franchising is permitted.
In recent years, area development franchising has become a more popular model of franchising and its popularity is steadily increasing. Offering direct franchises is impractical for the franchisor unless the target country is in proximity to the franchisor’s headquarters. The Area development model provides franchisors with the ability to expand at a faster rate in a certain region or city, but, unlike master or regional franchisees, the franchisor minimizes or spreads its risk by having multiple area developers in the country and region rather than one master franchisee.
Under the area development model, the franchisor enters into a direct contractual relationship with one or more franchisees, each of whom has the right to develop multiple units in the designated territory. Typically, there exists an Area Development Agreement which sets forth the territory covered, the projected schedule for development of units and separate Franchise Agreements for each unit opened by the franchisee. The area developer is required to develop a few to several outlets in a defined area. Under this model, the franchisor deals with a smaller number of franchisees making management and support of the franchisee more efficient and less costly.
Since a separate franchise agreement is signed for each outlet, the franchisor maintains control to enforce system standards and monitor compliance with all payment obligations, however, once the area developer has been trained, the area developer can be given the responsibility to develop and train staff for its outlets. The franchisor is responsible for all documentation including compliance with disclosure requirements and registration requirements. Under an Area Development Agreement, the franchisor does not have to share any of the royalty or service payments from the franchisees.
Direct Franchising is the grant by the franchisor directly to a franchisee the right to open one franchise unit. With this option, the franchisor basically sells franchises internationally as a per unit franchise. The franchisee buys directly from the franchisor’s headquarters or from a subsidiary office located in the target country.
A franchisee may own more than one unit, but each will be covered in a separate Franchise Agreement. Disclosure and registration requirements must be complied with separately for each contract. Direct franchising requires that the franchisor have a high degree of involvement withthe franchisees. The franchisor is required to provide all the obligations under the franchise agreement, such as training, ongoing support, marketing and advertising, inspections, collections, etc.
The franchisor may provide support remotely from its headquarters, but this can be difficult if the target country is distance. The franchisor may determine that it needs a presence in the host country to fulfill its obligations, but it must consider the other issues such as the local tax laws and any applicable Tax Treaties to determine if such activities will create a taxable presence inthe target country.
Under this franchise model, the franchisor is able to maintain great control over the franchise system since it will manage the selection of the franchisees, prove training, assist with the development of the operation of the unit, arranging for publicity of the system, as well as manage the inspections and audits. The franchisor will also incur substantial costs in providing these services, but, the franchisor will be the sole beneficiary of the royalty payments made by thefranchisees. Generally, Franchise Agreements provide for an upfront franchise fee and apercentage royalty payment of sales. Sometimes these payments may be separated to provide payments for services provided by the franchisor to the franchisee and a separate payment for the right to use the trademark and other intellectual property rights. By separating fee for services from royalties, the amount of income tax withholding applicable in a jurisdiction can be reduced.
In order to be successful, Direct Franchise Agreements should be utilized in franchise systems where the amount of training required is not significant, the location of the target country is geographically close to the franchisor and there are minimal language and cultural barriers.
Joint Venturing is a mix between master franchising and direct franchising. The franchise enters into a relationship with a business partner (preferably one with experience in the franchisor’s industry) in the target country. The business partner and the franchisor jointly finance and control the franchise’s brand and model in the target country. The parties may either develop and manage the franchises together, or sub-franchise them to others. Here, the partner to the franchisor is essentially acting as a sub-franchisor, but with the added benefit and investment of the franchisor. This model gives comfort to a business partner in that the franchisor has a vested interest in the development and success of the brand in the target country. Joint ventures are often utilized when the franchisor has sufficient resources but needs the local expertise to develop fully the market of the host country.
The form of the legal entity may vary from jurisdiction to jurisdiction, but typically it will be in the form of a corporate entity have separate legal personality from the franchisor or the business partner. The franchisor relies on the knowledge of and experience of its business partner in the local market; and the business partner relies on the franchisor to provide its knowledge of the system and training expertise. This entity may serve as a master franchisee or developer. The parties would document their rights and obligations in a shareholders agreement, operating agreement or joint venture agreement. Typically in such an arrangement the franchisor would obtain greater control over the development since it will be participating as an investor and operator. Local corporate and tax laws must be considered in this business model.
This entity would then enter into an agreement- whether a master franchise or area development agreement with the franchisor.
Prior to deciding which business model to use, the franchisor needs to objectively analyze its needs, objectives and capabilities. Franchisors will always have interested parties from various jurisdictions approaching them to buy a franchise, but it is better to proceed slowly and with caution. Proceeding without knowing which model is most suitable and possible, could negatively impact the brand in the long term and the franchisor may not be able to recover.