I SUBSTANCE NOT FORM
Franchising offers a range of exciting strategic possibilities to businesses looking to expand internationally, but its full potential is often not appreciated. To some it is an obvious and ready-made way of internationalising their businesses; others associate it with hamburgers and pizzas, and discount it as an option. Both groups have become too focused on the label they put on the international structure they adopt at the cost of objectively analysing the substance of a particular structure and how it can support and promote their business objectives. When considering how to develop an international business structure involving third parties, it is worth forgetting the form and focusing on the substantive needs of the business and how they can best be met.
Although franchising offers businesses an adaptable mechanism for expanding domestically and internationally, it often comprises one element of a broader multichannel market strategy. As a result, ‘vanilla’ franchising is increasingly less common than hybrid adaptations tailored to the precise needs of each business. Franchising may or may not be the best word to describe some of these structures, but it is essential that any existing prejudices or misunderstandings about the term do not deflect a business from developing an appropriate structure or misdirect its legal advisers as to how a particular legal structure will be regulated. How a structure is labelled will have no bearing on whether it is regulated by franchise rules or other regulations.
A range of third-party channel and relationship structures are available to companies that wish to re-engineer their approach to their target market. These include corporate or contractual joint ventures, business format franchises, a host of licensing arrangements, exclusive and non-exclusive distribution and agency agreements, and more complex ‘hybrid’ structures, such as subordinated equity arrangements.
All these third-party channel structures share four common features. To a greater or lesser extent they all involve:
- a profit sharing;
- b investment by a third party;
- c a divestiture of some degree of operational control; and
- d risk sharing.
The structures listed above all present different risk profiles for both parties involved. Franchising and its related hybrid structures present business with a versatile, effective and road-tested route to both domestic and international growth.
II WHY IS FRANCHISING SO POPULAR?
John Y Brown, the former president of KFC, identified one substantial attraction of franchising when he stated that the only way he could access the US$450 million he needed to establish KFC’s first 2,700 stores was through franchising.2 Franchising can also provide the management expertise necessary to expand the business. It solves the problems concerning capital and management that often face growing businesses (resource society theory). Franchising also helps to improve managerial performance by establishing a community of interest that incentivises managers to work hard (agency theory).
Aliouche and Schlentrich3 suggest that franchising offers business an efficient way of increasing its value. This ‘value creation’ or ‘transaction cost theory’ is demonstrated by their survey of the US restaurant sector during the 10 years from 1993 to 2002. It suggests that franchised businesses create more value than their non-franchising competitors because they have a higher prospect of creating market value and economic value than non-franchisors and generate on average higher added value than non-franchisors.
Economies of scale lead to cost savings, and increased brand recognition is created more cost-effectively.
III INTEGRATED CORPORATE OR FRANCHISE STRUCTURES
Companies such as McDonald’s have successfully developed a strategy of operating both company-owned outlets and franchised outlets. Costa Coffee is another example of a franchisor that has very effectively developed a split model of company-owned outlets in major towns and markets, and a ‘hub’ franchise model enabling it to operate effectively and bring its brand to consumers in smaller regional markets that are operated by franchisees.
This combined approach ensures that the franchisor has continual access to the operational realities of its format and is able to review and develop it on an ongoing basis. Corporate outlets generally yield higher profits for the brand owner than franchised outlets. However, the more rapid rate of growth and need for lower investment per unit gives rise to a ‘multiplier effect’, which leads to a higher return investment, greater market share and ultimately higher gross earnings for the brand owner.
IV FRANCHISING AS A PART OF WIDER-RANGING MULTICHANNEL STRATEGIES
There is nothing particularly new about the concept of businesses having a multichannel retail strategy. As noted by the authors of a 2009 Harvard Business School working paper,4 retailers have for some time started their businesses by exploiting one particular channel and then expanding it into others. In 1925, the US retailer Sears opened its first store as a way of complementing its existing catalogue business, which had been around since the early 1880s; Eddie Bauer and Spiegel’s followed the same path, and more recently, we have seen television retailers HSN and QVC moving into the internet space.5 The advent of integrated multichannel retailing is due to the rapid development of the internet as a new selling channel since the dot-com boom in the mid 1990s, when many envisioned consumers abandoning ‘bricks’ for ‘clicks’ and buying most products and services over the internet. However, the internet has become a facilitating technology, which enables traditional bricks-and-mortar retailers to broaden their offering by establishing websites and riding the wave of online shopping. This not only gives them access to more customers but also improves operational efficiency. However, the internet does not meet all of every brand’s marketing and sales needs, and franchising has evolved to further facilitate growth and development in the way that brands access potential clients, as both retailers and service providers face many new challenges and opportunities in the multichannel retailing environment: in developing international multichannel strategies; in creating synergies across channels; in deciding how to decide product mix; and in understanding how multichannel retailing will evolve over time in different geographic markets.
Perhaps the certainties are that improved financial performance will require continuing flexibility and that cannibalisation between channels and differences in prices and margins across channels will always be a risk. Multichannel retailing is continually developing as new channels, such as m-commerce, evolve into still newer channels. The legal documentation structuring these multichannel approaches to the market needs to provide for these certainties; this presents the draftsman with substantial technical challenges.
Brands generally develop their multichannel strategies by opportunistically adding new channels to existing ways to market. As a result of this fast-changing environment, and although historically it has been used in one of three ‘vanilla’ forms (namely unit franchising, master franchising and development agreements), over the past few years franchising has increasingly been used as one element in a variety of more complex and sophisticated structures developed in a bespoke manner to meet the exact multichannel, and other, needs of brand owners. These more sophisticated hybrid structures deliver not only an increased range of flexibility for customisation to businesses’ individual needs, but also more complex challenges for their lawyers.
V VANILLA FRANCHISING
i Unit franchising
This is the most basic form of franchising. It is most often used in domestic franchises. The franchisor directly grants the franchisee a right to operate one unit or a number of units. The burden it places on the franchisor means that it is rarely used internationally.
ii Master franchise agreements
In this relationship the franchisor grants to another party, described as a master franchise (or sometimes a ‘sub-franchisor’), the right to open franchise outlets itself, and to franchise third parties, described as ‘sub-franchisees’, to open franchise outlets within a specified or exclusive territory.
iii Development agreements
In this relationship, the franchisor grants exclusive rights to a party described as the ‘developer’ to develop a territory by opening a number of franchise outlets itself. Developers must have substantial capital and managerial resources and are usually experienced operators.
VI HYBRID STRUCTURES
i Subordinated equity agreements
Companies are increasingly finding that their longer-term international strategic aims are not always met by vanilla franchising. Their commercial aims require more sophisticated, hybrid structures, often involving taking equity in the corporate vehicle that the franchisee has created to develop the brand in the territory. There is a wide range of such subordinated equity structures available, the appropriateness of which will depend upon the franchisor’s commercial priorities, their longer-term market-entry strategy, the franchisor’s shareholders’ ultimate exit strategy, tax planning and so on.
Joint ventures are sometimes used to try to add further flexibility to traditional franchising structures, but more often than not these result in a head-on clash between the control dynamics present in a traditional shareholders’ agreement and the brand owner’s need to have unfettered control of the brand. Subordinated equity agreements enable the parties to circumvent these inherent tensions and equity interests to become a part of the brand owner’s overall strategy.
In many jurisdictions these can have a substantial impact on the regulatory and tax issues that the franchisor has to deal with. As a result subordinated equity arrangements tend to be tailored to each market, while at the same time not compromising the integral homogeneity of the overall international structure.
Subordinated equity structures are sometimes used in conjunction with other ‘extra-franchise’ structures, such as management agreements of various types.
Management agreements tend to be used when the foreign developer has sufficient capital to invest in establishing the brand in the target market, but does not have access to the level and depth of operational expertise and resources required to help ensure its success in that market. It also offers the franchisor a further income stream, allied to, but distinct from, that which it receives by way of the franchise agreement. Historically, these have been most common in the hotel sector, but more recently they have become part of hybrid franchise structures in a range of sectors, including the retail and restaurant sectors.
There are two basic barriers to a brand using franchising as a way of growing its profits and market share. One is a lack of talented individuals to become franchisees. The other is a lack of individuals with the capital required to invest in a franchise. Access to an appropriate talent pool is an issue beyond the skills of legal advisers; however, providing undercapitalised potential franchisees with a soft entry to becoming a franchisee is not. A variety of structures ‘incubate’ talented individuals by allowing them to purchase their franchise from the income they generate as a manager of a corporate store.
The stereotypical view of franchising as a way of cloning fast food outlets is outdated and reflects the realities of the 1980s far more than those of the current decade.
It is now more often than not just one part of a more sophisticated multichannel approach to the international market. This increases the complexity of the regulatory environment in which franchising operates and raises greater challenges for lawyers practising in the field.
1 Mark Abell is a partner at Bird & Bird LLP.
2 See C Wormald and M Abell, ‘Introduction – Alternative strategic techniques for the board agenda’, in C Wormald (ed.), Alternative Corporate Re-engineering (The European Lawyer Ltd., 2011), p. 9.
3 E Hachemi Aliouche and Udo Schlentrich, 2005. ‘Does Franchising Create Value? An Analysis of the Financial Performance of US Public Restaurant Firms.’ Manchester, NH: Southern New Hampshire University Working Paper Series, 2005-02, cited in Wormald and Abell, ‘Introduction – Alternative strategic techniques for the board agenda’, Ibid., p. 9.
4 Jie Zhang, Paul W Farris, John W Irvin, Tarun Kushwaha, Thomas J Steenburgh and Barton A Weitz, ‘Crafting Integrated Multichannel Retailing Strategies’, Working Paper 09-125 (Harvard Business School, 2009).