So, You Want to Franchise Your Business?
What is Franchising
Ask people what a “franchise” is, and many would mention fast food, car rental and hotel chains. Seasoned businessmen would tell you that it’s a time-tested mode of sharing costs and risks that was used by the owners of brands like McDonald’s, Hertz, Coca-Cola, GNC, and Anytime Fitness to expand globally.
The modern franchising model can be traced back to Isaac Singer, founder of the Singer Corporation, maker of the iconic Singer sewing machine. Since then, franchising has become one of the most popular models of business expansion and licensing, and it now seems inevitable that any fast-growing education, food and beverage, retail, or spa business to quickly consider or be asked to consider franchising.
If used correctly, franchising, is a win-win arrangement, which allows:
– a first-time entrepreneur to lower his risks and to break into an established market, by tapping on an established brand, a proven business method, knowhow and a customer following, and
– fast-growing companies tap on their intellectual property and goodwill to increase revenue, grow distribution channels and market presence and share risks and costs in expanding overseas.
Here is a slightly more detailed listing of some of the pros and cons of franchising:
|Access to capital and increase in income:
Franchising revenue, particularly from the initial franchise fee, is a useful source of capital to expand the franchise business and also the franchisor’s core business. The increase in revenue doesn’t hurt the franchisor’s books either.
|Loss of Control:
The biggest disadvantage of franchising is the loss of control over the franchisor’s brand and business, especially with certain types of franchising.
Once the brand is affected by bad publicity or the illegal activities or other detrimental actions of one franchisee, the entire franchise network is affected, and it is often hard to repair the damage, even if the franchisor can claim damages.
|Economies of Scale:
A franchise creates potential economies of scale because of the opportunity for bulk buying, centralised training of franchisee staff, cost sharing, and access to centralised information technology solutions.
If the franchise network is big enough, the franchisor can even negotiate for substantial discounts on goods, services and locations.
While an established franchise business or system is a source of revenue and capital, many businesses underestimate the financial, human resource and management resources that are required to set it up.
A franchisor will have to hire advisors and franchising professionals, to help it prepare its books and a prospectus for registration with regulatory authorities. It will also need to negotiate contracts with franchisees, prepare a franchising manual, and register trade marks overseas, all of which add to the set-up cost for a new franchise.
|Risk-sharing or Transfer
The direct entry into certain markets is particularly risky, due to complex regulation, foreign investment restrictions, and complex cultural differences.
|Additional Legal Risks
While a franchisor will usually transfer to or share risks with a franchisee, it will still be directly liable to dissatisfied customers or regulatory authorities, on top of disgruntled franchisees or ex-franchisees.
It will need understand the legal risks of franchising, and for each country. For example, countries like Indonesia, Malaysia and Vietnam have stringent franchise registration and disclosure requirements, while Singapore, Thailand and the Philippines have more lax franchise laws.
|Speed of Expansion:
A franchisor is unlikely to be able to muster up the cash and other resources to expand into multiple markets at the same time, without taking up significant borrowings, or raising equity investments, both of which expose it and its owners to risks that they may not be ready for, particularly if the franchisor is a closely-held or family business.
Franchising allows the franchisor to enter new markets and market its brand faster than it could through its own funds or external funding.
|Arming Potential Competitors:
It is inevitable that a franchisor must share with each franchisee valuable confidential information on its operations, business, and financials.
Along the way, the franchisee also acquires key information on the local market, customer behaviour, costing and pricing.
If the franchise relationship ends and the franchisee continues to operate the business, whether outside the restrictive covenant period or in breach of the covenants, it then becomes a competitor to the franchisor.
As experienced franchising lawyers (we helped some of Singapore’s most successful brands franchise locally and overseas), we set out in this 4-part guide on strategic franchising (as opposed to the type of franchising which ends up in your destroying your brand and core business, creating future competitors, and getting sued by your franchisees), an overview of the different types of franchising, the franchising process, how to avoid pitfalls, and on designing and negotiating franchise agreements.
Types of Franchising
We focus on business method or format franchises in this article, in which a brand owner licenses its trademarks and proven business methods to others in exchange for payment, usually a fixed fee and a recurring payment which is a percentage of gross sales.
Examples of such franchises are those used by KFC, Marriott, Domino’s Pizza, and Carrefour. This is contrasted with product distribution franchises where the franchisor sells a manufactured product to the franchisee and allows it to use its name and trademark, with Osim, Ikea, Heineken, Topshop, and Coca-Cola examples of brands that use this franchising method.
There are broadly, three types of business method or format franchising, and these are:
- direct franchising (or single unit franchising)
- master franchising
- area development
In direct or single unit franchising, the franchisee is often an individual that is granted a franchise for a single location to be operated as an owner-operator. The franchisor and the franchisee enter into single unit franchise agreement where the franchisee invests in the unit, often with no promise or expectation of opening additional locations in future, with the franchisor promising not to grant other franchises within an agreed geographic range.
In an area or master development or developer arrangement, the franchisor gives the franchisee (also called the “area developer”) the exclusive right to open and operate several stores or units within a wider geographic territory, or area, i.e. to develop the area, as the name “area developer” suggests. For example, an area developer may be granted the right to open donut stands or pizza restaurants within the city of Kuala Lumpur, in Malaysia, or the province of Guangzhou in China.
The area developer will usually be required to open a certain number of stores within a timeframe set by the franchisor. The key benefit to the franchisor is that its brand and revenue grows much faster in this way, compared to direct franchising, as it does not have to identify and train multiple individuals to be franchisees, and relies on one person to open and operate multiple units. Of course, the franchisor’s risks are increased, since it relies more on a single person, and incurs greater opportunity costs if the relationship sours or the area developer does not perform according to expectations or fails to meet the store opening schedule.
Some franchisors appoint area representatives, who are not themselves franchisees and do not open or operate the franchised business themselves, but instead markets and sells for the franchisor single unit franchises. The franchisee then contracts directly with the franchisor, and the franchisor pays the area representative a commission or fee. Often, the area representative also trains and monitors franchisees.
A master franchising model is similar to an area development, as the franchisor grants rights for an entire country or region to a person called a “master franchisee”. The difference from the area developer is that the master franchisees not only has the right to open and operate franchised businesses, but it gets to behave like a franchisor as it has the right to appoint other franchisees (called “sub-franchisees”) to own and operate franchised businesses. These sub-franchisees enter into contracts with the master-franchisee, and not with the master franchisor, and the master franchisee will be responsible for training and monitoring them as well as collecting royalties and other payments.
This model is most commonly used for international expansion, as it allows a franchisor to tap on the capital and local country knowledge of a master franchisee who would usually be experienced in operating businesses in the same field as the franchised business.
It offers greater speed in expanding a franchisor’s brand presence and revenue, but on the flipside, the franchisor must share revenue and profits with the master franchisee and represents the most risky franchising model for the franchisor, as it has to depend heavily on the master franchisee to help it protect its intellectual property rights and to control the sub-franchisees, i.e. it loses significant control over the running of the franchised business in the country or region.