China: How to establish a franchise in China

  1. Introduction

Franchising is a popular business model used extensively in China as well as the rest of the world by many international retailers and brands to achieve business success. This article explores how to establish a franchise in China while highlighting the most important considerations unique to this market.

  1. Barriers to Entry

The term "franchise" in the Chinese Regulation on the Administration of Commercial Franchises refers to business operations by which an enterprise owning a registered trademark, enterprise mark, patent, know-how, or any other business resource (hereafter the "franchise resource") confers or licenses the said franchise resource to any other business operator through a contract. The franchisee undertakes business operations under a uniform business model as stipulated by the contract and pays franchising fees to the franchisor.

This definition is common and recognized worldwide; in other words, most foreign franchise models can be used in China through ways analyzed below. Nevertheless, it does not mean there are no obstacles to overcome. Chinese authorities have set preconditions on franchise businesses that apply to both foreign and domestic franchisors. In detail, the preconditions are:

  • A franchisor engaging in franchise activities shall possess a mature business model and the ability to provide long-term business guidance, technical support, business training, and other services to the franchisee.
  • A franchisor engaging in franchise activities shall have at least two direct sales stores, and shall have undertaken the business for more than a year (the so called"2+1" requirement). For a foreign franchisor, it is not required that such direct sales stores are located in China. In other words, two direct sales stores abroad qualify as well, however the franchisor has to provide a business certificate of the direct sales store (including a Chinese translation) notarized by the local agency and accredited by the local Chinese embassy or consulate.
  1. Two Common Business Models

Regarding the ways of operating a franchise business in China, there are two business models. In accordance with the Chinese WTO Schedule of Specific Commitments on Services, restrictions on franchising have been withdrawn since Dec 11, 2004. Therefore, there are currently two available models: the cross-border supply model and the commercial presence model. A foreign franchisor may directly sign a franchise contract with Chinese franchisees or set up a WFOE in China to operate the franchise business.

The foreign franchisor may choose either model based on its specific conditions and commercial strategy. Both ways have their advantages and disadvantages. Please refer to the table below:

Cross-border supply Commercial presence (WFOE)
Advantages
  • The foreign franchisor can quickly establish a franchise by directly signing a franchise contract with one or each domestic franchisee, which will limit the time and the costs.
  • The foreign franchisor can meet the "2 + 1" requirement if he has two foreign sales stores.
  • It is more convenient for the franchisor to train and supervise the franchisee, to expand business, and to protect its IP.
  • It is easier to adapt to the local cultural and trade customs.
  • According to most recent information, the WFOE does NOT have to meet the "2 + 1" requirement before it can operate a franchise business as long as its investor meets this requirement.
Disadvantages
  • This model is not suitable for rapidly expanding the market as the marketing costs are high and communication between franchisor and client is difficult.
  • It is difficult and costly to train and supervise the franchisee.
  • One cannot easily appoint one master franchisee, since he may not immediately qualify to act as franchisor (2+1).
  • Establishing and operating a WFOE requires time and investment.
  1. How to Establish a Franchise

4.1. Registration
In accordance with the Regulation on the Administration of Commercial Franchises, a franchisor shall apply for archival filling to the local commerce authority within 15 days after it signs a franchise contract with a franchisee within China for the first time.

When applying for registration, the following files shall be submitted:

  • copy of the business license and the original and photocopy of yearly check certificate, or other original subject qualification certificate with the photocopy;
  • The WFOE shall submit the original and photocopy of Approval Certificate extra. When the registered items of business license have changed, an Alteration Certificate issued by the Industrial and Commercial Bureau shall be submitted;
  • original and photocopy of registration certificate of business resources such as the trademarks, enterprise mark, patent and know-how;
  • approval of related competent department, if the franchised products or services need to be permitted according to the related laws and regulations;
  • original and photocopy of ID card of the legal representative;
  • application form;
  • contact sheet;
  • distribution of the direct sales stores;
  • distribution of the partner shops;
  • franchisor's market plan;
  • franchisor's commitment signed and sealed by the legal representative;
  • specimen of the franchise contract;
  • operation manual.

Notice:

  • In case a franchisor fails to do so, penalties will be imposed. In detail, the local commerce authority will impose a fine of at least 10,000 RMB but no more than 50,000 RMB, to be paid within a certain time limit. If the franchisor fails to do so within the time limit, it will be fined at least 50,000 RMB but no more than 100,000 RMB, and a public announcement will be made. Nevertheless, failure to meet the 2+1 requirement or complete the filing process with the commerce authority does not necessarily nullify the franchise contract. In that case a local court will judge the effectiveness of the franchise contract based on specific circumstances.
  • The franchisor shall apply for alteration to the relevant authorities within 30 days when the following information registered has changed:
    • industrial and commercial registration information;
    • franchise resource;
    • distribution of the direct sales stores run by the franchisee.

4.2. Contract requirement
A franchisor engaging in franchise activities should sign a franchise contract with the franchisee in written form. The contract shall include the following contents:

  • basic information of the franchisor and the franchisee;
  • contents and duration of the franchise;
  • type, amount and payment method of franchising fees;
  • specific contents and methods for business guidance, technical support, business training and other services to the franchisee;
  • quality, standard request and warranty measure for products or services;
  • sales promotion and advertising for products or services;
  • consumer protection and compensation for damage in the franchise business;
  • alteration, dissolution and termination of the franchise contract;
  • responsibility of default;
  • solution of the dispute;
  • other matters franchisor and franchisee agreed upon;

Notice:

  • the franchisor should offer a manual including the operation of a franchise business to the franchisee and provide business guidance, technical support, business training and other services to the franchisee continuously according to the content and manner of the franchise contract.
  • franchising products and services shall conform to the laws and regulations.
  • if a franchisee pays the fee before making a contract, an explanation about the use and the way of refunding should be stated in written form by the franchisor.
  • franchisee shall not transfer the franchise to others without permission. Disclosing and allowing others to use the franchise resource is also forbidden.
  1. Disclosure of Information Required

Chinese law states that, for the purpose of protecting the franchisee's interest, the franchisor is required to provide the following information to the franchisee at least 30 days before both parties execute the franchise contract:

  • the name, domicile, legal representative, registered capital, business scope of and basic information about the franchised operations of the franchisor;
  • the basic information about the registered trademark, enterprise mark, patent, know-how and business model of the franchisor;
  • type, amount and payment method of franchising fees (including whether and how a deposit would be charged and refunded);
  • prices and requirements for providing products, services and equipment to the franchisee;
  • specific contents, methods and implementation plans for continuously providing business guidance, technical support, business training and other services to the franchisee;
  • specific measures for guiding and supervising the business activities of the franchisee;
  • investment budget for franchise network;
  • number, distribution and business evaluation of current franchisees within the territory of China;
  • digests of the financial statements and audit reports as audited by the accountant firm for the recent two years;
  • conditions about franchise-related lawsuits and arbitration for the recent five years;
  • whether the franchisor or its legal representative has ever conducted major illegal business operations; and
  • other information prescribed by the commercial administrative department of the State Council

If a franchisor hides any of the information listed above or provides false information, the franchisee may terminate the franchise contract. If the information provided by the franchisor has undergone any major change, notification should be delivered to the franchisee.

  1. Termination Right of Franchisee

According to Chinese law, the franchisor and the franchisee shall stipulate in the franchise contract that the franchisee may unilaterally terminate the contract within a certain period after the franchise contract has been concluded.

This is the so called "free termination right" granted to a franchisee. This right gives the franchisee a cooling-down period to avoid risks such as being inexperienced or acting on impulse. There is no uniform period regulated by law, and the franchisor may set it based on the specific situation of the franchise. We advise a "free termination right" period that expires before the franchisor hands over the franchise resource.

When the franchisee terminates the franchise contract by this right, it shall be free of any liabilities based on breach of contract, and the paid fees, such as the deposit or loyalties, shall be refunded if franchisee has not used the franchise resource yet. Nevertheless, if such termination causes direct loss to the franchisor, the franchisor may claim damages against the franchisee.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Authors
Robin Tabbers
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