Why do businesses use franchising to go international and how do they structure their approach to the international market?
01 November 2007
Franchising has a long history but is still in its infancy as regards its international regulation and the number of legal specialists involved in it internationally.
Early references to franchising include "All franchises and liberties of the bisshopericks..........deryvid from the crowne" (1559) and "Fairs, Markets and other franchises" (c1630), according to the Oxford English Dictionary. Certainly the origins of franchising lie in the mercantile codes and common law of the Middle Ages, when the crown offered feudal lords the right to maintain civil order, determine and collect tax revenues and make other special tax assessments. The barons paid the crown a specified sum from the revenues collected. In 1562 the Council of Trent ended this system of patronage.Franchising later appeared in a more recognisable form in the British ‘tied house' system used by brewers in the early 1800s. The widespread availability of alcohol was causing social concern. Legislation was introduced to restrict the sale of alcohol to those with licences and also to require innkeepers to improve the drinking environment. As a result, the value of those inns with licences greatly increased. However, those with licences often had insufficient funds to improve their properties and were therefore likely to go out of business. It was from this economic difficulty that the ‘tied house' system developed. By granting a landlord a loan, or leasing its own property out to prospective landlords, brewers such as Whitbread managed to retain and expand the outlets for their beer. The ‘tied house' system proved an efficient business mechanism until the competition authorities undermined it in the 1980s.
Franchising is not an exclusively European commercial medium and versions of it were evident in both Japan and China from the 1600s onwards.
However, it was in the US that franchising developed into its current form, as the industrial revolution created a demand for a system of business that would enable new technology to be distributed, sold and serviced across a large geographical area without the benefits of a fully developed infrastructure. One of the earliest examples of franchising in the US was the McCormick Harvesting Machine Company. This manufacturer commissioned local agents to sell and service its machinery around 1850.
The Singer Sewing Machine Company was another early franchise business that sprung up in the US during the 1850s. Agents working on commission demonstrated, sold and repaired the sewing machines.Both the McCormick and Singer franchises were after some years replaced by a company-owned network.
Coca-Cola was conceived in 1886 as a non-alcoholic alternative to ‘hard' drinks such as beers and spirits. It was dispensed from a soda fountain by mixing syrup with carbonated water. It was not potable and so this severely limited the size of its market and growth. The advent of bottling technology changed all that and the rights to bottle and sell Coca-Cola everywhere in the US (other than New England, Mississippi and Texas, where prior arrangements were in place), were granted to two franchisees, Messrs Thomas and Whitehead, in 1899. The franchisees were granted the rights to make and bottle Coca-Cola from syrup provided by the franchisor, which also provided them with bottles, labels and advertising matter. Whitehead soon after sold out to John Thomas Lupton, after realising that he did not have sufficient capital to set up the bottling plants. In due course, the franchisees were granting subfranchises across the US. Pepsi-Cola followed suit and by 1910 had 280 bottlers across the USA.
In the early 1900s, the automobile and petroleum industries also started to use the franchise model to distribute their products across the US, notably General Motors and Ford. Similar trends then developed in the petroleum industry.
In 1925, Howard Johnson established an ice cream business in Massachusetts and expanded it by franchising it to a group of restaurants on the East Coast. By 1940 the first Howard Johnson restaurant appeared, and in 1954 the first motor lodge opened. The Howard Johnson franchise system has since grown internationally to over 200 restaurants and about 500 motor lodges.
However it was not until the early 1950s that the boom in franchising took place. In 1955, Ray Kroc started McDonald's, stressing "quality, service, cleanliness and value". That same year, Harlan Sanders found a niche in the food industry with Kentucky Fried Chicken. Franchising continued to grow in the US during the 1960s but abuses led to it being regulated at both state and federal level by the early 1970s. This push towards franchise specific regulation has spread to more than 25 jurisdictions focusing on precontractual disclosure and the ongoing relationship or termination. Some jurisdictions also require the filing of documentation on public registers.
So why do businesses use franchising as a way of expanding both domestically and internationally? The franchisor's and the franchisee's interests do not always coincide. There is potential for conflict. The franchisee may not always act in the franchisor's best interests and underperforming franchisees are not uncommon. Part of the answer is that franchising replaces much of the need for a costly management system with powerful financial incentives, namely the benefit of the profits created by its endeavours and the risk of losing capital invested in the business. Franchising creates a financial synergy between the franchisor and its franchisees so there is less need for monitoring and a greater probability of maximum performance by the franchisee. Managerial ownership improves performance for both parties.
Another part of the answer is that franchising is also a solution to the capital, managerial and information constraints faced by expanding businesses. Growing businesses use franchising as a way of accessing capital that would otherwise be unavailable in a cost-effective way that offers fair reward to the financier (the franchisee). The former president of Kentucky Fried Chicken, John Y Brown, estimated that it would have cost KFC $450 million to establish its first 2,700 stores, an amount of capital not available to KFC in the early stages of its expansion. The traditional ways for new businesses to access capital are to either sell equity or raise a loan, although raising a loan, may not be possible in the early stages of a business's development due to lack of collateral and a proven track record. Therefore, franchising is often a more cost-effective and realistic option. Indeed, franchisees may be able to provide capital to the franchisor at a lower cost than passive investors can. In addition to capital, franchising also provides an efficient way to obtain the managerial expertise needed to grow the business. Because franchisees put a significant amount of assets and time into their units, they are likely to purchase a franchise only if confident in their managerial abilities.
A further part of the answer is that, on the international front, franchising also allows a business to leverage the local market knowledge of its franchisees as it expands into new geographic areas. Low-cost capital, motivated managerial expertise and better local market knowledge are three key resources that should reduce a franchisor's overall risk and have a significant positive impact on a franchisor's financial performance.
However, the most important advantage of franchising is the improvement in business performance it generates. A study of the US restaurant sector between 1993 and 2002 suggests that US public restaurant franchisors have created more value than their non-franchising competitors, in that they have a higher propensity to create market value and economic value than non-franchisors and generate on average higher added value than non-franchisors.
Franchisors are very clear as to why they franchise their businesses. For example, McDonald's says that it "recognises the benefits of a franchised operation. Franchises bring entrepreneurs, full of determination and ideas, into the organisation. Franchising enables McDonald's to enjoy considerably faster growth and the creation of a truly global brand identity. The more restaurants there are, the more McDonald's can benefit from economies of scale".
There are obviously a number of risks that franchisors must accept as being inherent in franchising their businesses. Apart from the commercial risk resulting from franchisees breaching their obligations and, as a result, damaging the franchisor's brand, there are also certain legal risks. These are contractual, statutory and vicarious liability risks. It is the role of lawyers to identify and reduce them.
So, franchising offers clear commercial advantages to companies considering international expansion. However, unless it adopts an appropriate franchise structure, a business is likely to encounter substantial difficulties and commercial frustrations. Again, this is where specialist franchise lawyers are essential.
There are three structures most commonly adopted by international franchisors: master franchising, development agreement and direct franchising. These are by no means mutually exclusive and franchisors often use a portfolio approach, depending upon what best suits their commercial needs in particular circumstances.
The reasons for franchisors selecting these structures depend upon a combination of factors, including the normal practice within the commercial sector they operate in, their managerial resources, available financial reserves, the professional advice they receive from their lawyers and consultants and the preferences, size and resources of their potential partner.
DIRECT FRANCHISING
Conceptually this is the most straightforward structure. The franchisor grants unit franchisees the right to operate individual units of the franchise in the territory. This is the structure most commonly adopted in domestic franchising but it is also sometimes used as a method for granting international franchises.
MASTER FRANCHISING
This is the most common structure in international franchising. It involves the franchisor granting the master franchisee to grant unit franchises to independent third parties in the territory. This extends most of the advantages of franchising into the international arena. It enables rapid growth with minimal capital requirement compared to the establishment of a subsidiary or a subordinated equity arrangement and minimal managerial requirement compared to direct franchising. It also allows the franchisor to take advantage of the local expertise of the master franchisee, including its knowledge of the local market.
The disadvantages are that there is a lower element of control over the unit franchisees, as this task is delegated to the master franchisee. The lower risk is usually commensurate with a lower gross return for the franchisor compared with direct franchising - although the net return may well be the same or even higher.
DEVELOPMENT ARRANGEMENTS
These grant the developer the right to operate unit franchises within the territory but not to subfranchise them to third-party franchisees. The reasons that franchisors usually grant development rights rather than master franchising rights are the size of the territory and the financial and managerial resources of the prospective partner.
A partner such as Whitbread Plc has the financial and managerial resources to enable it to take on the development rights for TGI Fridays in the UK. It does not need to dilute its interests in the business with third-party unit franchisees.
As there are fewer parties involved, a development agreement is often easier for the franchisor to deal with. On the other hand, the developer can become extremely powerful and so make life difficult for the franchisor.
The structure adopted by franchisors in the EU varies according to a number of factors, including their size and resources, the size and resources of the potential franchisee, the size of the territory, and the type of business being franchised.
CONCLUSION
Franchising has a long history but it is only over the last 50 years that it has become a common feature of international business. This increase of use has led to franchise-
specific regulation across the globe, and there is every sign that this trend is set to continue.
However, it is the franchise structure adopted by businesses that will most influence their chances of success, not the franchise laws. It is therefore important that businesses using franchising take expert advice to ensure that the structure they use is best suited to their particular business and the target jurisdictions.