Mitigating risks in international franchising

Whichever route to international franchising is chosen, be it a direct, master or area development franchise, having made a decision to franchise internationally, it is important to ensure that steps are taken to maximise success. 

Whether in a particular jurisdiction or more generally, undertaking adequate due diligence as well as considering structure and growth plans will be crucial, both initially and for the longer term of the franchise. Before starting the process, an understanding of culture and custom, together with preliminary research on how familiar or prevalent franchising is in the target country, will inform the approach and whether to proceed.

At the most basic level, franchisors need to investigate whether there a demand for the product or service, the size of the potential market, and how this can be verified, such as independent research and analysis on any competitors. Consideration will also need to be given as to whether any changes need to be made for the local market and what impact this could have on the brand. It may be appropriate to limit certain aspects of the franchise until they have been sufficiently developed in the local market, such as ecommerce, delivery, and use of technologies.

At the same time franchisors will be considering how the franchisee can be required to adapt to offer new services and products and what controls the franchisor needs to put in place to regulate their use or provision, such as maintaining third party relationships. In addition, an assessment will need to be made on whether there are any particular issues of concern such as local or regulatory hurdles and how they will be able to be overcome to fit local market needs. This includes whether there are any tariffs or tax implications which would have an impact on profitability and payment of royalties, and if necessary, specialist tax advice taken.

For retailers in particular, consideration will need to be given as to how products will be supplied to the franchisees and the structure of the franchisor's supply chain and lead in times for product ordering. Where products or food items can be sourced locally, the franchisor will need to set out the processes to put in place to check or approve suppliers and quality of product supplied. If supplies of products, equipment, or raw materials are to be made by the franchisor or its suppliers to the franchisee, the franchisor  will want to assess the ability of the franchisee to be able to pay for items supplied and consider how best to minimise risk, for example, through letters of credit, shortened payment terms, upfront payments and guarantees.

Ensuring that all relevant trademarks are registered in the target countries is often overlooked and can prevent a franchise from proceeding. Ensuring that the legal requirements for franchising in the target market can be met is an important preliminary step because if the criteria cannot be met, then the planned franchise at worst cannot proceed, or at least will need to be delayed.

The due diligence exercise on the prospective franchisee is also key. This is not just about obtaining information on ownership structures, management and financial information, but also goes to a deeper level to find out if there is a cultural fit and if the management team have the right skills and attributes as well as financial resources. The practical skills needed by a master franchisee, who will be sub-franchising and recruiting and managing sub-franchisees as well as enforcing the terms of the sub-franchise agreements, are more difficult to assess but may be already in place with multi-brand franchisees. There will also need to be an assessment of local market knowledge and, where the franchise is property based, whether it has sufficient enough covenant strength and property contacts. Assessing the suitability of a prospective franchisee will be a combination of business, financial and legal due diligence including verification against publicly available information.

An important part of the process will also include meeting the owners and operational team. It is inevitable that at this stage the franchisee will be enthusiastic but the franchisor will need to be careful not to equate enthusiasm with competence. Be wary of not getting along with or having doubts about the franchisee during this preliminary stage. Communication problems and issues with performance of international franchisees can take up an extraordinary amount of management time to resolve and overcome, as well as having an impact on the brand and plans for expansion in the region.

It is important for the franchisee to be placed under an obligation to actually establish the franchise including any pilot operations, and for appropriate criteria to be set out for achieving this. It is also important to set out in writing the requirements and expectations for expansion. Usually, the franchisor will want the franchisee to expand quickly in order to obtain a flow of continuing fees.  However, the franchisee may want to be sure of success before making a significant investment and may therefore be reluctant to agree to the setting of minimum targets until the viability of the franchise has been tested. This may be particularly an issue where the franchisor does not require one or more pilot operations and wants the franchisee to rely on the success of the franchise in other countries.  Ultimately, this will be a matter for discussion between the franchisor and franchisee as to whether it is feasible or desirable to rely on the successful roll out of operations in other countries.

The potential franchisee should be required to prepare business and marketing plans which will also give valuable insight into its aspirations and whether this aligns with the franchisor’s own views for the brand and its expansion. This will also allow further discussions to be held on the proposed franchisee’s financial strength and available capital to fund growth as well as other resources necessary to support growth plans and to put in place the necessary infrastructure. These discussions will also assist in putting together minimum performance development criteria to maximise success and any controls which might be prudent to put in place to limit expansion if things are not going to plan with appropriate milestones. Failure to meet agreed targets could allow the franchisor to remove exclusivity and/or terminate the franchise agreement. Agreed business and marketing plans will need to be updated annually and approved by the franchisor. It would be usual to assess performance against these plans and hold discussions with regard to any deviations.

A franchisor may also consider other controls to be put in place to minimise risk and exposure.  Where sub-franchises are to be granted this may be by approval of sub-franchisees prior to the grant of sub franchise agreements and the obtaining of approval prior to sub-franchise terminations.  Where the franchisee has specific requirements regarding the opening of new outlets, the franchisor may require to approve the sites before fit out and also before opening.

In the event of serious breach of the franchise agreement, the franchisor may require step-in rights allowing it to step in and operate the franchisee’s business on a temporary basis. These can be useful, but in some countries may not be a viable option where it might therefore be better to terminate the franchise agreement. The number of individual properties may also make it an unattractive right.

As with domestic franchising, the franchisor should also consider controls to be placed on the franchisee, its affiliates and potentially key individuals who will be controlling and operating the franchisee (subject to compliance with local applicable laws) to ensure that competitor concerns are addressed and that the proposed operational structure is maintained.  In addition, guarantees and performance bonds where appropriate will all assist in keeping the franchisee compliant.

If things start to go wrong, it is important that the franchisor takes action to ensure that the franchisee stays on track. Regular communication and discussing issues before they escalate out of control are essential. However, in certain situations, termination may be the only option although it is not a step to be taken lightly. The franchise agreement will therefore need to contain effective provisions to enable the franchisor to terminate the franchise agreement where it is necessary to protect the brand and to avoid the franchisor suffering significant damage. In a master franchise scenario, local advice should be taken when structuring the sub-franchise agreements to anticipate a termination of the franchise agreement with the master franchisee and the options which the franchisor would wish to put in place at that stage.

It is expensive and time consuming to terminate a franchise agreement or remove a franchisee if things start to go wrong, and the international element introduces a new level of complexity. In addition, in certain jurisdictions local laws may make it more difficult to terminate the franchise agreement and there may also be limitations on enforcement of rights under the franchise agreement including potential difficulties in the enforcement of judgments and arbitration awards. Local counsel can assist in identifying particular issues and exit strategies as well as effective dispute resolution procedures. Whilst use of local counsel may seem an unnecessary expense, costs can be managed by agreeing scope and fee budgets in advance.

For those franchisors who are already franchising, they will be well aware that there are no boundaries on the issues which can arise with franchisees. However, a planned and carefully thought out approach using experienced advisors who can help structure the arrangements and identify and mitigate potential risks plays a key part in maximising successful outcomes.

This article was first published by Global Franchise Magazine.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at January 2020. Specific advice should be sought for specific cases. For more information see our terms and conditions.