Franchising World, May 2006

By Larry Weinberg

International expansion can be extremely appealing for most franchisors. It holds both the promise of large untapped markets and the allure of the exotic. However, without careful research, planning and execution, it can also lead to dismal failure. Not only do costs rise with distance, but different legal, economic, cultural and linguistic regimes can all create dangerous pitfalls.

The structure one chooses for any expansion to a new market will be an important factor in determining its eventual success. However, no single vehicle is ideal for all international expansion. Instead, the best structure will vary according to the characteristics of the target market, the nature of the individual franchise business and the resources available to the expanding franchisor. For instance, one must generally balance desired control with available resources. The fewer resources the franchisor has to invest, the more likely that it will have to relinquish tight control of the system. To address these tensions, franchisors will frequently create hybrid arrangements that draw elements of two or more structures together.

While control and resources are perhaps the most important factors that must be addressed when choosing an expansion structure, other key considerations include the unique characteristics of the local market, local legal barriers, training, available human resources and the challenge of creating and maintaining local distribution networks. Too often franchisors are pulled into a new market because of interest expressed in that jurisdiction. While that is flattering, it often means that the franchisor’s international expansion is not well-planned or researched in advance, as the structure is chosen in response to the interest shown, as opposed to prior research and planning. Franchisors are “pulled” into a market, instead of formulating a plan to “push” into that market.   

In this article, structures are compared that have been commonly used for international expansion, an overview is provided of the business considerations that will be most relevant in deciding on a structure for franchise expansion into a new market.

Direct Franchising

In a direct franchising arrangement, frequently used in domestic markets, the franchisor contracts individually with single-unit franchisees in the target market. Direct franchising is a good way to ensure that the franchisor retains maximum control over the system. What is more, since there is no middleman, royalties and revenue streams may be higher than under other arrangements. On the other hand, the need to establish agreements with individual unit holders usually results in a slower rate of growth (but still faster than opening corporate stores). Single-unit franchisees, who tend to be smaller and less sophisticated independent owner/operators generally require greater levels of support than would a more sophisticated multiple-unit franchisee. This may also mean that the foreign franchisor will need to purchase or find local advice and contacts by itself, as well as establishing its own local distribution networks. Navigating the local market can be onerous and challenging under these conditions. Finally, under the direct franchise arrangement the franchisor generally provides all training and all advertising and promotional materials. It may also be necessary to open a local office to support the network. As a result, direct franchising can be costly in both time and money.

In general, direct franchising is no longer considered the ideal way to expand internationally. However, it may be worth considering under certain circumstances. First, it can provide a way to test the target market before expanding through a different vehicle. Second, it may be a sustainable method of expansion where the target market is located near the franchisor’s home territory or country or where there are few legal, linguistic and cultural barriers. It is particularly suitable where the expanding system’s business is not very technical and little training will be required, or where a very high level of system control is important. If contemplating this method, you should be particularly wary of any legal local ownership requirements, as well as tax and liability issues that may arise if you open a branch office.

Master Franchising

In contrast, master franchising is a popular expansion structure that resolves many of the issues that direct franchising creates. Under a master franchise agreement, the franchisor typically grants a master franchisee the right to offer units to subfranchisees. Depending on the size of territory and whether or not exclusivity is provided, the responsibility for developing the system in the new territory, including distribution networks and training programs, rests with the master franchisee, rather than the franchisor. As a result, this system requires less resources and significantly less capital investment by the franchisor. Additionally, the local master franchisee’s familiarity with its own market will allow the entire system to benefit from its knowledge and contacts. This can also help ensure compliance with local laws. Be aware that the franchise disclosure laws of some countries apply equally to the grant of a master franchise as to the grant of a single unit franchise.

Despite many advantages, master franchise arrangements are not without drawbacks. While the structure is useful for spreading costs of administration, training and support, much depends on the quality of the master franchisee. Not only does the system’s success depend upon the abilities and resources of the master franchisee, but the local knowledge and sophistication it brings to the system is a key advantage of the structure, so it is absolutely vital to choose the right person or entity. However, such experience may not be cheap - or easy to find - and the master franchisee will naturally expect to profit from its role, which will generally decrease the franchisor’s revenues from such a venture. Additionally, the existence of the master franchisor makes it much harder for the franchisor to control the system closely.

If contemplating a master franchise arrangement, you should remember that growth is essential to success, and set clear growth (and unit maintenance) targets for the master franchisee. Consider using multi-tiered growth incentives, giving rewards for good performance, while suspending certain rights (e.g. exclusivity) for failing to meet goals. In an ideal world, the franchisor might develop targets by testing the market through an initial direct franchise arrangement. However, that rarely happens, and so the franchisor is left to study the market in other ways to determine the unit levels that should be attained. Master franchisees are very often required to own and operate one or more stores themselves in order to familiarize themselves with the business.

Area Development

Area development arrangements are similar to direct franchising, except that the franchisee is permitted to develop multiple units across a designated territory. As a result, where the territory is small, such an arrangement may be very similar to direct franchising, with its associated benefits and disadvantages. Where the territory is large, the system leads to lower capital investment than direct franchising, as well as lower administration costs, less need for training and monitoring, and less need for direct franchisee contact. This structure also allows for higher revenue and greater control than most master franchising arrangements. Like master franchisees, area developers are often adept at dealing with local market issues although this too will likely depend on the size of the territory, and their own backgrounds.

As with master franchising, the success of an area development arrangement will depend on the quality of the franchisee. Franchisors are well-advised to begin by granting a small territory, with options for the area developer to acquire more territory as they meet performance goals. The higher costs of starting this way are offset by the decreased risk of depending upon an untested entity to develop a system over a large territory.

Joint Venture

Under a joint venture, the franchisor shares ownership of an operating entity with a local partner. In practice, this type of arrangement does not change the system, which will typically be direct franchising or area development. Rather, it allocates ownership and risk in a unique manner. It can be used to take advantage of the foreign partner’s local knowledge, and to gain business or tax advantages in markets where locals are accorded preferential treatment. It can also provide a source of capital, although it is more usual for the franchisor to provide the resources and its local partner to offer expertise. Because the franchisor is working on a more equal basis with its partner, it may have more control over the system than under a master franchise arrangement. However, it will likely also have more responsibility for developing distribution networks and running training programs due to its higher level of involvement.

Area Representative

Another alternative may be to enter into an area representative arrangement, under which the franchisor grants rights to a local entity, allowing it to market, offer and perhaps even train and service franchisees on behalf of the franchisor. This is more an agency or broker arrangement than a franchise structure, and if structured properly can itself avoid the application of franchise disclosure laws. However, like single unit franchising, the franchisor often ends up dealing with unit franchisees directly despite the presence of the representative. Thus, it may not offer significant advantages over other structures.

Plan, Plan, Plan

The importance of planning your expansion in order to meet recognized business issues cannot be overstressed. Due diligence and careful thought will help avoid many pitfalls. In particular, consider the following:

Taxes.  Different structures have different tax implications. It is important to first determine whether the franchisor will be a US entity or a local subsidiary or joint venture. Consider the nature of any payments being made, and how taxes will affect the revenue stream both at the target level and the home level. Be very aware of local tax laws, and consider whether it is possible or advisable to use special purpose entities. Watch for treaties that may affect withholding taxes.

Franchise, agency and other legal regulation.  Some structures may be limited by local laws, or impelled by them. For example, creating a joint venture can get around otherwise onerous local ownership requirements. Therefore, be aware of potential limits, and determine the consequences of non-compliance. Be prepared for administrative red-tape, especially in less commercially-focused markets. Trademark and other intellectual property laws can affect the franchise system and should be researched. In most cases, the franchisor’s principal trademark needs to be separately protected in the target country, and this should be done well in advance of any actual expansion. In some jurisdictions, disclosure laws can create a huge amount of paperwork when they impact area developer or master franchise arrangements.

Relationship issues.  The franchisor should determine the degree of control it will require over the system, and be realistic about what to expect under different structures. In practice, contractual arrangements can only provide a certain amount of control and are therefore a limited tool for the franchisor.  Likewise, you must know what degree of responsibility you are willing to accept in the target market, and be prepared to provide this as needed. This can extend to training, supervision, capital investment and business support, all of which can be very costly if not planned-for in advance. Finally, the right human resources are essential to the success of master franchise and area development arrangements. Search carefully for the right people, and limit risk where possible by gradually increasing the amount of responsibility given to each entity as it proves its worth. In countries with a western legal tradition, it is often stated that the contract is key. In the developing world, and while the contract is important, the human factor is key to the local developer’s or master’s success.

Resource issues.  Ultimately, resource issues often determine structure. These include the capital resources available for expansion. Where these are limited, a master franchise arrangement may be the only practical possibility. Likewise, consider what it will take to deal with the physical distance between markets. The costs of travel, sending corporate materials, translation and possibly a branch office can be extremely high. Consider also the availability and quality of communication systems, which may or may not meet North American standards.

While issues that affect each country, and each franchise, are unique, the above list should provide a starting point for planning an international expansion. The franchisor should evaluate its business, its resources, and its goals with care. It should also diligently examine the conditions of the target market. With this information at your fingertips, you will be in the best possible position to determine which structure makes the most sense for your expansion. 

Larry Weinberg is a partner of Toronto-based law firm Cassels Brock & Blackwell LLP.  He can be reached at  lweinberg@casselsbrock.com .