The different choices in structuring the franchise

Transcription

1 The different choices in structuring the franchise By Nicola Broadhurst Nicola Broadhurst is a partner at the Surrey law firm, Stevens & Bolton, where she is head of franchising. She is ranked in the top tier for franchise advice in the legal directory, Chambers UK A former member of the BFA legal committee, she assists the association in reviewing the franchise agreements of applicants. She advises potential and practising franchisors, both domestically and internationally, as well as franchisees. stevens-bolton.com BEFORE deciding on the most appropriate franchise structure for your business, it is essential to establish that it is franchiseable in the first place. Franchising is a term that is widely used and, often misused to describe varying forms of licensing arrangements. This article, however, concentrates solely on business-format franchising. In order for a business to be franchiseable, there must exist valuable know-how which is unique in some aspect to the business, and which, together with the brand name, forms a distinct business system. It is this system that a franchisee buys into and by paying an initial fee and continuing fees acquires the rights to operate for a limited period. The system should allow the franchisee to replicate the franchisor s business under the relevant controls and with the latter s assistance. A successful business-format franchise is one where members of the public can perceive little or no difference between each of the franchise outlets and the franchisor s own outlets and in some cases is not even aware it is a franchise due to the uniformity of its image and standards of service. Having established that a business is suitable British Franchise Directory & Guide 51

2 for business-format franchising, then the franchising structure that most appropriately meets the demands of the franchisor and its long-term goals must be chosen. The main types of structure are as follows. Unit franchises This is the most common form of franchising. Under this arrangement, the franchisee is granted the right to operate a single unit or outlet of the franchised business, subject to a franchise agreement. These rights may be exclusive and the franchisee may be allocated a trading territory, depending on the nature and demands of the business. Using this method of franchising, the franchisor may end up with an extensive network of individual franchisees spread across a large geographical area. Therefore, it is essential that the franchisor has a suitable infrastructure in place to provide the necessary support to the ever-increasing number of its franchisees. In such operations it is common for the franchisor to employ area franchise managers who each look after an area consisting of several franchisees, thereby providing the support on behalf of the franchisor. Problems arise where the franchisor does not have the financial or human resources to adequately support its franchise network and it is easy to see how, without the necessary quality checks and assistance from the franchisor, standards can slip and customer service is adversely affected. This impacts on the brand image and, therefore, the network as a whole. Lack of support is one of the most common complaints by franchisees. Multiple franchises This term is used to describe franchisees that operate more than one unit, usually under separate franchise agreements. This is often encouraged within franchise networks as a means of incentivising its successful unit franchisees and allowing them to expand at a more controlled pace. Obviously much will depend upon the nature of the business as some lend themselves more readily to being run at a distance with effective management in place. This method would obviously not be suitable where the franchisee s full time and attention is required for each franchise. It can, however, be potentially dangerous for a franchisor to allow a multiple franchisee to become too large. This can result in an imbalance of power within the network and should be avoided. Master franchises A perhaps less costly route of expanding a franchise network is to grant a master franchise. Under this arrangement, a master franchisee is granted the franchising rights to a substantial territory, often a country. The master franchisee has the rights to sub-franchise within the territory and grant individual franchises to prospective franchisees. Occasionally, the master franchisee will also have the right to enter into franchises itself, and it is a good idea for the master franchisee to initially run at least one pilot operation within the territory for a period of time before sub-franchising to establish the commercial viability of the business and its credibility when it comes to selling franchises itself. The master franchisee to all intents and purposes steps into the shoes of the franchisor for his territory and it is a useful way of expanding into new countries and exporting a business concept. 52 British Franchise Directory & Guide

3 In such cases the franchisor will rely on the master franchisee s local knowledge and contacts. The master franchise agreement usually recognises this fact by permitting the master franchisee to make necessary adaptations to the system to take into account cultural differences and jurisdictional issues once these have been agreed. A clear agreement should be drawn up at the outset, detailing the respective rights and obligations of both parties. Where the area concerned is another country then relevant local advice should be sought to ensure that the agreement is enforceable and whether there are any tax issues that need to be considered. This method can be an extremely effective way of expanding quickly into an area where the franchisor lacks the resources and capabilities to develop it directly itself and it is a way of sharing the costs. The master franchisee will usually pay to the franchisor an increased initial fee to reflect the business potential of the territory and rights being granted, and also a percentage of the income generated from its franchisees. In order to ensure that the master franchisee is exploiting the territory, effectively the master franchise agreement often contains performance targets linked to the number of franchisees to be granted at each anniversary of the agreement. Having some form of performance targets is important as a master franchisee is invariably being given the exclusive right to grant franchises in his territory over a longer period of time than would usually be granted to an individual franchisee, but these targets must be realistic. An overambitious target may cause the master franchisee to focus on selling too many franchises too quickly without having the ability to support them, resulting in inevitable failures. The success of this method of franchising will, of course, depend upon the choice of the master franchisee. The individual chosen must have the resources, drive and wherewithal to be able to exploit the territory to its full potential and to support its franchisees. Problems can obviously arise where the relationship breaks down between the master franchisee and the franchisor. Where the franchisor is based in another country, this can often leave the franchisees without any real support should the master franchisee drop out of the picture. Even where the franchise agreement states that the franchisees within the territory are transferred back to the franchisor, this is of little help where the franchisor has no other representatives within the territory. Prospective franchisees must, therefore, be aware of the possible consequences of contracting with master franchisees. Regional franchises This is similar to the master franchise arrangement, except that a large territory is divided into several areas and a master franchisee appointed for each area. This is particularly suitable for large geographical areas, such as U.S. or India. In such cases, a single master franchise for the whole country would not be ideal as it is too large an area. A single master franchisee would tend to concentrate on one area rather than the whole country. It is, therefore, British Franchise Directory & Guide 53

4 better to divide the task. Again, each regional franchisee would pay an increased initial fee and usually a percentage of the income generated by the franchisees. The attraction of receiving the increased upfront fees, can, however, lead franchisors to choose this method of franchising when it is not really suitable, for instance where the territory being divided cannot support the number of franchisees which the franchisor anticipates. The result is the regional franchisee parts with a significant sum without any means of recouping its investment and making a profit. Careful research into such a business proposition needs to be carried out by a prospective regional franchisee before any commitment is made in order to establish its commercial viability. Another inherent problem of regional franchises is that comparisons can often be easily made within the network between the various regional franchisees and their respective abilities. Where there is disparity this can cause considerable discontent. Again, the care and consideration taken in choosing the appropriate regional franchisees cannot be overestimated. Much will depend upon the interpersonal skills, business acumen and resources of each regional franchisee. This is often overlooked by franchisors keen to obtain substantial upfront fees. Area developers This is similar in some respects to multiple franchises, but is less of a piecemeal approach and more focused at the outset. A developer is usually granted the rights to develop a large area directly, but without the ability to sub-franchise. An area development agreement is entered into governing the relationship and setting out the agreed schedule of development, some times with a separate form of franchise agreement attached to be signed each time an outlet is opened. The agreement is often the subject of much negotiation as a developer will want to ensure that the targets are achievable, whilst the franchisor will want to exploit the area fully and receive its fees. This method can be more attractive to a franchisor as it involves dealing with one person rather than many, but it can be a slower way of expansion as individuals or companies are not always easy to find who have sufficiently large resources to be able to finance the opening of a number of units themselves. Joint ventures Occasionally, a franchisor will wish to become more closely involved in the investment made by a franchisee and will acquire shares in the company being established by the franchisee. The franchisor may take a different class of shares, which may have no voting rights. A joint venture can be attractive to a franchisee who perceives the franchisor s keenness to participate as an indication of a greater level of commitment from the latter. The arrangement can, however, turn out to be more risky for the franchisor, who will be exposed to a greater degree of liability as a shareholder. A shareholders agreement should be drawn up to clearly delineate each party s rights and obligations, together with supporting articles of association. Unwinding a joint venture, however, can be fraught with difficulty and this method of expansion has not been as popular as others. Choosing the structure The arrangements we have looked at 54 British Franchise Directory & Guide

5 are not mutually exclusive and often franchisors use a mixture to expand their franchise network. The prospective franchisor must ask itself what it wishes to achieve by franchising. In some cases, it will be a desire to increase revenues by establishing a nationwide or even an international business, whilst in other cases it maybe in an effort to protect its market position, or to exploit its products more effectively. If the franchisor wishes to expand internationally it should first establish what local laws govern franchising. Certain countries have franchise specific laws which may impose disclosure and registration formalities This adds to the costs. The answers will largely determine which structure is chosen. Much will depend on the financial resources of the franchisor or the availability of additional funding. It can be more expensive to establish unit franchisees across the country and support them in an effective manner than it is to grant a regional franchise or a master franchise. A master franchise can also be a relatively cheaper way of expanding very quickly into other countries, although obviously as trust is being placed in one individual, this can be very risky. It is essential that prospective franchisors seek appropriate advice at the outset to ensure their long-term goals are taken into account when developing the franchise model and that it is commercially viable. Within the UK the structure adopted must not infringe the pyramid selling regulations and there may well be tax considerations to be taken into account. Franchisors need to avoid falling into the trap of making a quick profit from a venture that turns out to be in the long-term a costly mistake. It is essential that prospective franchisors seek appropriate advice at the outset to ensure their long-term goals are taken into account when developing the franchise model and that it is commercially viable. British Franchise Directory & Guide 55