The Legal 500

At some stage in the development of every successful business, strategy turns towards expansion. The first option considered is usually corporate growth, making use of the resources within the company to expand. But there are other options, and this briefing explores the potential role that intellectual property can play in providing one such (popular) alternative.

Any form of expansion, like any other strategic business move, brings with it its own commercial risks. More so when that expansion is within the international market. Of all the models that might be adopted, corporate expansion offers the highest potential return but also involves the highest risk, primarily because of the enormous investment that it requires. Not only is there considerable financial commitment, but the business must also devote valuable management time to researching the new market, ensuring awareness of relevant local regulations, locating suitable properties, and recruiting local employees.

A company that operates under a strong brand with a distinctive method of operation has an alternative to the traditional corporate expansion route. By exploiting the intellectual property rights in its brand and know-how, a company can reduce the commercial risks of expanding overseas by using the tried and tested formula of franchising. In brief, the company will grant a licence enabling a third party to use its brand and know-how so that the business is replicated in the new market. Franchising is not limited to the traditional well-known brands such as McDonald's, Domino's and KFC and nor is it limited to fast-food chains. Franchising can, and is, being used as a successful model for most forms of business. All that is required is a strong brand identity and method of doing business which can be licensed. Other brands that successfully franchise include Marriott, Avis, Hilton, Laura Ashley, Monsoon and H&M. As is evident from that list, franchise businesses are found in diverse sectors.

Although reference is made to 'franchising', terminology should not be a bar to adopting a franchise model. Many companies, for a variety of reasons, shy away from the word 'franchising', perhaps due to a historic connection with fast-food concepts. If such reservations exist, there is no reason why a franchise model might still not be adopted with new nomenclature, with franchisees referred to as 'licensees' or 'partners'.

A key attraction of franchising as a route to the international market is the fact that the franchisees have a good knowledge of the local market, access to funding and are generally more committed than corporate employees. Many master franchisees are successful, well-resourced companies looking for a way to extend their current commercial interests. Together with the reduced need for capital investment and increased speed of potential growth, this makes a potentially highly successful formula for international expansion with a greatly reduced risk profile.

The key to international success through franchising is a strong business format that can be successfully adapted to the target market. However, that alone is far from sufficient to optimise a franchisor's chances of success. The overall structure must suit the franchisor's individual business.

The options

Basically, there are five options when it comes to structuring an international franchise: a direct franchise; a master franchise; a regional franchise; a developer; or a subordinated equity agreement.

Direct franchise

The franchisee is granted the right to operate one unit or outlet of the franchised business - a unit franchise. This is the simplest and most common form of franchising. A single franchisor may ultimately have several hundred different unit franchises. It is not particularly well suited to serious international expansion due to factors such as distance, language and market differences.

Master franchise

A master franchisee is granted the rights to a substantial territory - usually a whole country. It will then grant unit franchises to unit franchisees throughout the territory. The master franchisee is in many ways similar to a franchisor. The term 'sub-franchisor' is therefore sometimes used instead of master franchisee, and unit franchisees referred to as 'sub-franchisees'. This is the structure adopted by many franchisors to enter a new country. The master franchisee needs to have sufficient drive and resources to exploit the territory fully and control the unit franchisees in that territory.

Regional franchise

In a geographically large area a franchisor, or master franchisee, may decide that it is commercially appropriate to further divide the territory up with separate 'regions' and grant a master franchise for each separate region. These franchises are known as regional franchises or sometimes area franchises. This structure is common in large countries, such as the USA and China, where separate franchises for one or several of the different regions are felt to be appropriate.

Developers

Rather than be a master franchisee and sub-franchise to unit franchisees, large corporations sometimes prefer to exploit their territory by opening outlets themselves. These are known as developers. Whitbread is an example of this, holding the development rights for TGI Friday's in the UK. They have a single developer agreement which allows them to open many units. Developers therefore need to have considerable financial and other resources. Large corporations often find it culturally difficult to accept that working with franchisees means working with independent business people who cannot simply be 'hired and fired'. They are therefore more likely than anyone else to be developers.

Subordinated equity

There is no limit to the refinement that can be made to the 'classic' forms of franchising to accommodate the differing demands of potential franchisors and/or franchisees.

It is sometimes necessary or commercially desirable for the franchisor to take an equity interest in the franchisee's business. This is more common in the control of master franchisees, developers and regional franchisees. It leads to a sophisticated and finely balanced dual-level relationship between the franchisor and the franchisee. This dual-level relationship is created through there being the 'normal' franchisor/franchisee relationship in addition to the relationship of fellow shareholders. This equity-based relationship is very much subordinated to that between them as franchisor/franchisee. Thus the term 'subordinated equity arrangements'. The balance between the two relationships is delicate and needs to be carefully crafted. Further complications may include the franchisor's equity contribution in the joint venture being a waiver of the up-front franchise fee and the franchisor (or one of it officers) becoming a director of the master franchisee.

Choosing a Structure

When choosing a structure for the international market the most fundamental question that the prospective franchisor needs to ask itself is: 'What do I aim to achieve by franchising?' Is it to earn vast amounts of money by establishing the business across the nation? Is it a defensive move to keep up with key competitors? Is it to sell more products? Whatever the answer it is likely to have a significant effect upon both the wisdom of franchising and the structure to be adopted. There is no right or wrong way to structure a franchise. It will, at least in part, be determined by the franchisor's available financial and other resources, the product/service involved, and the relative importance of the project to the franchisor.

The financial strength of the franchisor or at least its access to finance from its bankers and possibly from government agencies will be one of the most important issues to consider. The cost of entering into a series of regional franchises, although not inconsiderable, is likely to be considerably less than pursuing the unit franchise approach to the market. In practice, a mixed approach is probably going to be most appropriate, with the franchisor developing those regions in which it already has a presence or which for various reasons it deems to be desirable for it to exploit, and regional franchises being granted for other areas.

Which structure is most appropriate will depend upon a number of key issues including the following:

Nature of the business

It is important to examine what the core of the business actually is. Does it rely upon the supply of goods or expert services? Is training vitally important? Is it a retail concept? Is it services based? The answers to these and similar questions will have real impact upon the structure best suited to the business.

Available resources

If the business has a large reserve of manpower that is experienced in franchising matters and plenty of cash to throw at the project, direct franchising might be safer and more cost-effective in the long run in certain jurisdictions. If resources are limited, then a master franchise or development approach might be preferred.

Nature of target market

The size and make-up of the target market is crucial in deciding the most appropriate structure. What is likely to work for a small and, in geographical terms, relatively close market like Ireland may well not be appropriate for a large, regionalised and distant market such as China.

Type of partner

If the company is aiming for a large blue-chip partner, it is likely that the development route will be most appropriate. However, if the partner is a smaller, more entrepreneurial organisation with little experience of the company's sector, a subordinated equity or master franchise approach may be more appropriate.

Financial structure of business

It is important to be very clear about how the business can make money out of international franchising. Is it related to the supply of goods? Is it linked to the ongoing supply of support services? Is it merely attached to the use of the brand and know-how? Different answers will lead to different conclusions as to the most appropriate structure and, of course, the most appropriate tax planning. Transfer pricing and withholding tax issues also need to be considered. The tax planning is essential but must not be done in isolation from the intellectual property strategy. The two must work in harmony with each other. If they clash it could have an extremely negative impact on the success of the business.

Once an appropriate structure has been determined, it must be properly reflected in legal documentation that meets the company's needs and that creates a workable commercial relationship. Cross-border franchisees can often be greedy and wholly unrealistic about their ability to make a success of the business in their market. It is quite common for them to want too much too soon. The franchisor should stand firm and ensure that the partner does not bite off more than it can chew.

Performance targets are usually an appropriate way to try to help ensure that a franchisee or developer is realistic about what it is likely to achieve and then to make sure that the market is fully exploited at a commercially appropriate rate.

Intellectual property

Before launching upon any form of international expansion strategy, particularly franchising, it is essential that companies conduct a full intellectual property audit and agree a cost-effective strategy to secure their brand and other rights in their target markets. The range of strategies is vast and must take account not only of technical issues such as the classes and specification of trade marks to be registered and which of the various international treaties they should be processed under, but also practical issues such as cost, cash flow and how it interfaces with the tax-planning issues.

Regulatory issues

Across the globe 22 countries (six of which are EU member states) have laws that specifically regulate franchising. Some countries, such as France and Belgium, require the franchisor to provide the potential franchisee with specific information a set number of days before closing. Some, such as Spain, also require the documentation to be registered on a public file before a franchisor can grant franchises. Other jurisdictions, such as the USA, combine both of these types of legislation with extensive relationship laws that regulate the termination of the agreement and the rights of the franchisee. It is therefore essential that before a business embarks upon an international franchise strategy it properly prepares itself for dealing with these regulations. If properly prepared for, these regulations do not present real barriers to the success of the franchise.

Conclusion

The financial and commercial benefits of a well-planned and well-executed international franchising strategy are clear. A large number of well-established corporates and smaller companies are successfully exploiting foreign markets through this medium. However, it requires careful planning. Once the appropriate structure has been identified, rolling out a franchise internationally can be a relatively low-risk, high-reward venture. If nothing else, franchising offers an attractive alternative to the traditional route of corporate expansion.