United States: International Franchise Expansions: Master Franchising - Facts And Fiction

Last Updated: May 6 2014
Article by Ned Levitt

In the world of franchising, as in business generally, there is no lack of good ideas. However, what contributes to failure more often than the quality of the idea is poor implementation. Nowhere is this truer than in international franchise expansions.

Like the siren's song, many a franchisor has become intoxicated with the idea of expanding internationally, only to end up crushed on rocky foreign shores, with little to show for the experience but a new found wisdom. International franchising has become all the rage in recent years. More and more franchisors are jumping in, some with great success and many more have been sent packing with little ceremony and little fanfare.

While there is no magic formula to follow to assure success in any business endeavour - and certainly not for international franchising – there are tried and true methods of approaching an international franchise expansion that can maximize the franchisor's chances for success and avoid predictable disasters. The best part of all is that it is not rocket science or a mystery. Rather, it requires careful thought and planning, reasonable expectations, measured growth and solid business practices.

Am I Ready?

This may seem like a trite question, but there have been countless examples of a disastrous international franchise expansion of a good concept and system, simply because it was too early in the development cycle of the franchise system at home. When are you ready? Do you have to have saturated your home market first? Do you have to be hugely profitable? Does the world have to be demanding your products or services or starved for them?

On this question, the starting point is to examine the goals that are in mind in deciding to expand internationally. Some goals call for greater domestic development first, than other goals. For example, if the franchisor is interested merely in the prestige of being international or is concerned that competitors are gaining more credibility because of their international programs, there is less pressure to be sufficiently strong at home. Once it is clear what the desired goals are, a proper analysis of readiness can be done.

Saturation of the Home Market

Classically, international expansion has been undertaken only after the franchise system has achieved near saturation in the home country. Modern thinking, however, is that system maturity and depth of resources are more important indicators than saturation. More and more franchisors are able to develop, with modern technologies and methods, solid domestic programs along with profitable international programs. In fact, some franchisors find that many of the skills and resources necessary for international expansion are similar to and enhance the domestic expansion of their systems.

Is Expertise in the Underlying Business Enough?

You cannot franchise mediocrity domestically and you certainly cannot franchise it internationally. So expertise in the business being franchised is absolutely crucial. However, master franchising, the international expansion vehicle of choice for most franchisors, often requires the franchisor to export expert knowledge about the process of franchising and how to adapt it to local conditions as well. If the franchisor has not honed its ability, strength and depth of knowledge about franchising, then international franchising maybe should wait. This franchise expertise is not just about generally known and applied franchise methods, but also about the nuances of franchising in the particular industry or type of business. For example, franchise techniques are different in a service franchise than in a product franchise or in a retail franchise than a business to business franchise.

Capital Resources

There is no arguing with the idea that franchising is an alternative method of financing the growth of a business, as the franchisee's capital is employed in the expansion rather the franchisor having to tap its own financial resources. However, that truth is moderated by the fact that the "pump has to be primed". As is the case in an early stage domestic franchise program, the franchisor has to invest capital before sustainable franchisee capital can be relied upon. International master franchise expansions are no exception, even if the categories of investment are different.

Internationally, the franchisor will encounter greater travel costs, costs in establishing solid supply chains locally or across borders, greater franchise marketing costs, costs for foreign market research for adaptation issues, translation costs for agreements and manuals, legal costs to protect trademarks and comply with local laws, etc., etc., etc. While master franchising typically allows the franchisor to download a significant portion of the foreign development costs onto the shoulders of the master franchisee, if the franchisor is not prepared or able to invest sufficiently in the expansion, disaster is lurking around the corner.

Human Resources

People run businesses, not machines. Having the right people to do the required jobs is critical in any business and in any type of franchise activity, whether domestic or foreign. However, the skill sets for international franchising, in many ways, are different than the skill sets for purely domestic franchising. One reason for this is that the international franchisor is dealing with cultural and possibly linguistic differences that are sometimes deep and complex. If the franchisor's people do not understand the nuances of the foreign market, the chances for disappointment are that much greater.

Another danger exists in underestimating the amount of time and the cost required to sell and service foreign master franchisees. Usually, the cost of master franchise sales is many times greater than the sale of unit or area franchises and certainly more than domestic sales and the time it takes is significantly longer. In franchise mythology, master franchisees need little support after the sale; reality is something else and the cost of that support is much greater in foreign markets initially, until the system matures in that market.

Which Countries When?

All too often, a franchisor begins an international franchise expansion or jumps into another foreign jurisdiction because some eager prospect approaches them with a financial enticement. Sometimes, such a move by a too early stage franchisor is justified by arguments like "well if it fails over there it won't affect the system at home", "it is easy money that is much needed and we are not investing in this, there will be no cost", "our competition is over there already" or "it will enhance our image and make domestic sales easier when everyone sees we have 'gone global'". In reality, an international master franchise expansion has to be "pushed" by solid planning and the establishment of a sound foundation, not "pulled" by a chance encounter with an eager prospect. The drain on resources, the loss of future possibilities and the potential for bad publicity, in this electronic and 'global' age, of a failed international expansion may outweigh any perceived advantage.

The choice of which foreign markets and in what order is absolutely critical in succeeding in an international franchise expansion. Some obvious factors are proximity geographically to the home market and linguistic and cultural similarities. Grouping countries in natural blocks, i.e. the Middle East, Eastern Europe, South America, may also prove to be more efficient than to direct limited resources to more wide ranging markets.

Acceptance/demand for the products and services of the franchise system should also be an important factor. This is a point not lost on the Wal-Mart company, when it closed its operations in Germany.

Also, there can be dramatic differences, one country to the next, as to the number of business people who will be accepting of the franchisor's terms and financial proposition for the master franchise rights. To put it more directly, on average, prospects in countries like Canada and England, for example, are more likely to negotiate strenuously and over longer periods of time, than would typically be the case in say Mexico or Bahrain.

Why Choose Master Franchising?

The franchisor has a number of choices of vehicles for international expansion. Each one carries with it its own set of issues, challenges and advantages. Within each vehicle type there are different approaches that can be taken and hybrids can be constructed to suit the particular needs of the franchisor.

Direct Unit Franchising

Granting unit franchises directly to foreign franchisees will be the slowest, most expensive and, in some ways, riskiest expansion method. In direct unit franchising, the franchisor shoulders the entire burden of selling franchises and supporting the franchisees. In foreign markets, the franchisor also has to figure out what adaptations would be required to be made to the business model. However, if the franchisor has a reasonable level of knowledge of the foreign market and sufficient resources, establishing a few unit franchises directly first may prove to be an invaluable learning experience for the franchisor before granting the more substantial master rights.

Development Arrangements

Multi-unit franchises, area development arrangements and territorial development arrangements are some of the names applied to situations where a single franchisee is given the right to open up two or more franchises in a given territory. Sometimes a franchisee will acquire multiple units by evolution, as the franchisee grows and prospers. Sometimes franchisees acquire multiple units by operation of rights of first refusal originally granted to the franchisee for additional units within areas contiguous to the franchisees original territory. Often, rights of first refusal are granted by the franchisor as inducements to sell franchises. However, there is one school of thought that it is dangerous to grant rights of first refusal, until the franchisee has proven himself to be capable and trustworthy. Otherwise, the franchisor is permitting the unit franchisee to become a multi-unit franchisee solely because of the interest of another party in purchasing a franchise.

A cautious approach should always be taken when considering granting to one franchisee the right to open multiple franchise units in a system. Multi-unit franchisees are usually financially stronger and more sophisticated business people. This can be an advantage in good times and a disadvantage when trouble arises, as such a franchisee will be a more formidable adversary and a more demanding "customer". Area or territorial development arrangements will be most advantageous where the area or territorial franchisee has deep knowledge and extensive connections in a market that is more distant from the markets in which the franchisor is already present.

The agreements that support such arrangements need to be carefully constructed. Some important considerations are:

  • The territory should be no larger than is manageable by the franchisee;
  • There should be clear and appropriate performance criteria that must be met by the franchisee to maintain exclusivity in the territory;
  • There should be cross termination provisions among the agreements for each unit;
  • The support commitments of the franchisor should be appropriately adjusted, given the greater resources and responsibilities of a territorial franchisee;

Any special arrangements with suppliers, given the territorial franchisee's greater purchasing power, should be addressed.

Master Franchising

When done properly and timed correctly, master franchising can be one of the most effective means of expanding a franchise network. This is particularly so when the expansion is into foreign markets. In fact, master franchising is the most frequently used vehicle for international franchise expansion. When it works, it is an ideal blend of the franchisor's expertise in the business being franchised and the business of franchising with the master franchisee's knowledge of and relationships in the local market.

Nonetheless, it remains one of the least understood and most poorly implemented expansion strategies in franchising. According to one study1 out of 142 restaurant master franchisees only 55 were in business at the end of the development term, 21 master franchisees did not open a single unit and 6 master franchisees met or exceeded their development commitments. It is important to set clear growth (and unit maintenance) targets for the master franchisee. On the other hand, most targets in master franchise arrangements are not met.2 It is even difficult to arrive at a consensus on the definition of master franchising, as it is used to describe an array of relationships and arrangements, including sales agencies, multi-unit agreements with no sub-franchising rights and arrangements by which the franchisor grants exclusive rights for the development of the system within the territory to the master franchisee with the right to sub-franchise.

It is always a challenge choosing the best unit franchisees, but that process pales in comparison to the difficulties in choosing good master franchisees. The mistakes made in choosing master franchisees are often the result of insufficient time and effort being taken to thoroughly investigate, not only the financial capability of the master, but the master's personality strengths and weaknesses and business philosophies as well. Too often a candidate is chosen who has had some prior business success, and thus can finance the franchise expansion and, perhaps more importantly, write a sizeable cheque for the front-end franchise fee for the master rights, without regard to the "fit" with the franchisor and the goals and philosophies of the franchise system. In these situations, the master rights are being viewed too much as investments by both parties.

On the other hand, fatal errors have been made in selecting master franchisees who do not have sufficient financial resources to weather the initial difficulties encountered in establishing the franchise system in the foreign territory. The franchisor may have forgotten how long it took before the system became self-financing initially or, more likely, may underestimate how long it takes someone else to get sufficient revenues flowing in the particular territory. Often the master franchisee cannot perform at the same level of productivity and efficiency as the franchisor and the franchisor is better off planning for a more mediocre performance from a master franchisee.

Deal Points of Importance

The Territory

Most master franchising arrangements provide that the rights are granted, often on an exclusive basis, for a specific territory. Master franchisees frequently attempt to negotiate the broadest possible territorial rights, which is understandable. One of the most common mistakes made by franchisors, however, is to grant exclusive rights to territories which are far too large, with the consequences that the territory remains underdeveloped and/or the franchisor realizes much less from the territory than would have been the case had the one large territory been broken up into smaller territories. Sometimes this occurs because of the lack of knowledge, on the part of the franchisor, of the potential of the system in the territory and sometimes it occurs because the franchisor feels it would be easier and more cost effective to deal with just one master franchisee in a larger area. While there is some validity to these latter considerations, the franchisor will most often have a stronger, and arguably a more profitable system ultimately, if territories can be kept as small as possible.

By having more master franchisees, rather than less, say in one country or region, the franchisor has some manoeuvring room, if a master franchisee fails or fails to perform adequately. One of the other master franchisees in the country or region can, either temporarily or permanently, move in to fill a void left by the failed master franchisee. It is also less likely that a particular master franchisee, "bites off more than he can chew". The franchisor is also able to exert more control or influence over the performance and conduct of a number of less powerful master franchisees than would be the case with one very powerful master franchisee.

Canada, for example, functions commercially more like four countries than one. Few master franchisees have done a superior job of fully developing a franchise system throughout Canada. In some countries, one master franchisee may not be able to manage the entire territory. Granting the whole of the European Union or the Middle East to one master franchisee may result in strong development in only parts of those territories, leaving other valuable opportunities unrealized.

Even if a franchisor is tempted to deal with only one master franchisee in a country or region, careful drafting of the master franchise agreement can help to limit the potential problems. For example, the franchisor can grant to the master franchisee a smaller initial territory, which will increase in size as the master franchisee is proven to be competent and committed and impose performance quotas, which will allow the franchisor to reduce the size of the territory, if they are not achieved in the future.

The Term

Similarly, it is a common mistake on the part of franchisors to grant indefinite terms or terms that are too long. With a shorter initial term and more frequent and shorter renewal terms, the franchisor can more easily control the actions of the master franchisee and the quality of development in the territory. At the very least, there should be very clear performance criteria and thresholds which the master franchisee must meet for a variety of things, including the right to renew, the maintenance of exclusivity, the extent of the territorial rights, and the degree of independence of the master franchisee in directing the system in the territory.

Initial Payments for Master Rights

One of the most difficult numbers to ascertain in all of franchising is the amount that should be charged for the front-end franchise fee or territorial rights fee for the grant of master franchise rights. This number will be influenced by many factors, including the length of the term of the grant, the history of success of the franchise system, the amount of training and initial support to be provided by the franchisor and the level of additional investment required of the master franchisee. Drawing analogies to other existing systems, with master franchise structures, can be helpful in deciding upon the amount to charge, but it is best to relate the fee to the potential for profit and return on capital of both parties. In one survey3, of the master franchisees studied, 36% invested $100,000 to $250,000, 28% invested less than $100,000, 21% invested $250,000 to $500,000 and 17% invested more than $5000,000.

From the franchisor's point of view, the most common mistake made in this area is to set the fee too low. One way to alleviate this problem is to set a minimum amount and calculate the final fee based upon the performance of the master franchisee, either by number of units opened or percentage of sales or some other basis that increases the front-end fee as the system is expanded within the territory. On the other hand, master franchisees often pay too much for such fees upfront, which can drain the master franchisee of much needed capital during the critical early stages of development of the territory. For the master franchisee, the best approach is to fix the amount of the front-fee, but have its payment dependent upon the number of franchises opened over an extended period of time.

Dividing up the Spoils and Job Allocations

Without a doubt, the most poorly handled issue in master franchising is the division of the front-end franchisee fees and continuing royalty fees, for the unit franchises in the territory, between the franchisor and the master franchisee. It is not unusual for the franchisor to base its decision on the allocation of these fees on its anticipated or desired return from the development of the system in the territory without serious or careful regard for how the master franchisee will finance the necessary development and support services for the unit franchisees. Mistakes with this issue will either ensure the demise of the master franchisee or reduce the quality and performance of the system in the territory.

For example, if the continuing royalty is 6% of gross revenue of the unit franchisee and the franchisor decides it is entitled to 3%, when it costs 3% to do a proper job of developing and supporting the system in the territory, the master franchisee is faced with either making no profit on royalties or reducing the level of support to the unit franchisees. If, however, the franchisor keeps some of the responsibilities for administering the system, such as field support or supply chain management, the 50-50 split on royalties might work. The problem is even more apparent in the division of the front-end fees. Such fees are often, at best, compensatory to the franchisor for the costs of properly setting up the unit franchisee. Therefore, where the master franchisee assumes all of the responsibility for establishing the franchises, but the franchisor takes a percentage of the front-end fee, something has to be compromised. The point is that the responsibilities for the development and administration of the system should be decided first as between the franchisor and master franchisee. Then the division of the various fees should be based upon the costs of discharging those responsibilities and only after that should the parties divide up the remaining "profits".

Selection of Unit Franchisees and Locations

Often, one of the principal motivations for the franchisor in choosing to expand in a foreign market by means of master franchising is to pass on to the master franchisee the responsibility for finding quality franchisees and locations within that market. However, it is a common mistake for the franchisor to abdicate the responsibility for final approval of franchisees and locations, before the master franchisee has proven itself capable in these crucial areas. The end result being that, if the master franchise arrangements fail, which happens most often in the early stages of the relationship, the franchisor may be saddled with inadequate franchisees and second rate locations. It is advisable then, that the franchisor contractually retain the right of final approval for franchisee and location selection, and exercise it in the early years, even if this right is later passed on to the master franchisee. Even if the master franchisee ends up with the de facto right of final approval, the franchisor will want to be able to step in and assume those responsibilities if circumstances change.

Governing Law

The franchisor is understandably more familiar and, therefore, more comfortable with the legal regime in its home jurisdiction. This leads many franchisors to provide that the governing law of the master franchise agreement is to be the law of that jurisdiction. However, it can happen that the law in the franchisor's home jurisdiction is less favourable to the franchisor than the law of the master franchise territory. The franchisor may simply be placing an unnecessary additional layer of complication upon the problem of enforcement against the master franchisee. Certain remedies, such as injunctions, may be delayed, while the local judge ascertains the rights of the parties under the franchisor's home jurisdiction. Additionally, franchise specific statues tend to require that the governing law of franchise agreements be the law of the local jurisdiction.

The Unit Franchise Agreement

Considering the importance of the unit franchise agreement to the control of the system in the master franchise territory, it is surprising how many franchisors do not insist upon the use of the franchisor's form of franchise agreement for unit franchises in that territory. Even if the local law requires some amendments, it is still better for the franchisor to start with its pro forma agreement and make the necessary changes to comply with the local law. In a similar vein, the master franchisee should be required to obtain the consent of the franchisor to any changes to any unit franchise agreement. This approach avoids the problem of the franchisor inheriting an array of different agreements or agreements with unsatisfactory provisions, if the master franchise arrangements have to be terminated.

The franchisor, in a master franchise situation, is often surprisingly reluctant to require three party unit franchise agreements to be used, where the franchisor, master franchisee and unit franchisee are all parties to the agreement. This fear is most often rooted in the misplaced belief that it will create more liability for the franchisor. Any such increase in liability may be easily alleviated with proper drafting. Further, the advantage of having direct privity with unit franchisees if the master franchise arrangements have to be terminated, may outweigh any other concerns on the part of the franchisor.

Conclusion

Franchising is one of the best and most efficient ways of expanding a business. Once a solid foundation is built for the success of the system in the home jurisdiction, international expansion is a sensible and potentially profitable strategic choice. That said, a poorly executed international expansion can drain the resources of the franchisor to the point of destroying the entire system. The moral being that it is less important what you do than how you do it.

The foregoing has only touched the surface of a complex and challenging business expansion model. However, the complexity and challenge is far more in the areas of research, planning, growth rate, franchisee selection, training and support to name a few, than in the underlying business concepts. As mentioned earlier, it is not rocket science.

With the right approach, international expansion through master franchising can be one of the best strategic decisions a franchisor can make.

Footnotes

1. Arturs Kalnins, Biting Off More than They Can Chew: Unfulfilled Development Commitments in International Master Franchising Ventures, 5.12 CHR Reports 1, 8 (2005).

2. Ibid.

3. From a 2000 survey of master franchisees by John P. Hayes, Ph.D, Hayes/Worldwide.

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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