Luiz Henrique O do Amaral and Mariana Reis Abenza, Dannemann Siemsen Advogados
In this article, Luiz Henrique O do Amaral and Mariana Reis Abenza at Dannemann Siemsen Advogados assess the franchising challenges faced when dealing with international brand expansion.
In an ever-changing and increasingly demanding global marketplace, franchising has showed great resilience and sustained continued growth despite the economic and political challenges presented over the past decades.
Franchising has historically proven to be a rather efficient way of expanding the market penetration and consumer basis of retail brands, both locally and internationally. This is so because it allows the brand owner, the franchisor, to expand its business faster and with less financial and human-resource investments, while at the same time ensuring the maintenance of the quality and operational standards of the brand, especially when compared to other structures such as trademark licensing, agency and setting up a local legal entity or joint venture with a local partner.
Although licensing and agency deals, as well as franchising, allow the brand owner to enter different markets without actually investing capital or assuming the risks of the local operation, franchising grants the brand owner more control of the point of sale and the operation as a whole, and also allows it to demand compliance with all the standards and uniform procedures of the original operation – therefore maintaining the quality and identity of the brand.
Additionally, due to the complex nature of the franchising relationship, the broad spectrum of rights, support granted to the franchisee, and the required level of standardisation of the operation, with full disclosure of the franchisor’s operational know-how and methods, certain restrictive covenants and limitations that could possibly be argued under simple licensing or agency agreements are generally accepted and actually deemed inherent to the franchising model. These include, for instance, non-compete obligations and strong confidentiality provisions, as well as requirements related to designated suppliers and specification of the mix of products and services to be offered by franchisee to the consumers.
On the other hand, in order to effect the desired control and standardisation of the operations, franchising requires a more active role of the brand owner. The franchisor must have developed a franchised system to be implemented by franchisees and be ready to offer at least certain support and supervision, as well as render training programmes to franchisees, so as to ensure that they are able to operate the franchised business in accordance with the standards and quality required by franchisor.
Another aspect to be considered is that franchising will often require compliance with different local pre-contractual disclosure requirements. There may also be certain foreign exchange control, tax and registration requirements to be assessed and considered when exploring the type of contractual structure in connection with the international expansion of a brand.
The franchisor’s interference and control over the franchisee’s operations may also increase the risks of tax, labour and consumer claims against the franchisor based on the franchisee’s activities, depending on the circumstances and the applicable laws.
As to the possibility of setting up a local legal entity, although it ensures the maintenance of the operation and use of brand with the brand owner, thus avoiding associated risks of a third party doing so, it implies the immediate need to invest capital and directly undertake the risks of developing the business in a new territory often not familiar to the franchisor.
The option to set up a foreign joint venture with a local partner reduces the required investment; and it allows the brand owner to share the risks of the new venture, and to count on the expertise of a local partner to develop and adapt the business to the new territory. At the same time, it entails the risks associated with potential disagreements and a lack of shared vision between the partners, along with control issues and possible risks associated with the intellectual property rights, know-how and even goodwill associated with the local operation.
In any event, the success of any international expansion will greatly depend on how the franchisor prepares and structure this venture. Any attempt to expand abroad should thus be preceded by certain marketing and legal researches, including the assessment of market data, applicable laws related to international franchising, vicarious liability, intellectual property, taxation and importation of products, for instance, in order to minimise risks and avoid undesired liabilities. This early stage of international expansion will necessarily require a certain level of investment of both time and capital from the franchisor, which must be taken into consideration when exploring the possibility of expanding to a new territory.
Below we offer a non-exhaustive list of key aspects to consider in the preparation phase of any international franchising expansion:
Trademark and patent (if applicable) clearance searches must be undertaken to ensure that the intended franchised trademarks do not infringe any local industrial property rights of third parties. The franchisor must also proceed with the registration of the franchised trademarks, patent(s) and other related intellectual property rights to be licensed to local franchisees.
With the assistance of specialised consultants, the franchisor must assess the potential market environment, including possible regulatory requirements or restrictions, as well as certain cultural aspects which may require adaptations to the franchising system.
Consulting with expert local counsels about any existing pre-contractual disclosure obligations or even recommendations, in the absence of specific legal requirement. The franchisor must also learn about applicable registration requirements and possible foreign-exchange control regulations that may impair its ability to receive royalties and other franchise fees. In order to be able to prepare a realistic business plan, especially as to the time expected for the franchisee to potentially return its investments and set out the franchise fees to be charged, the franchisor should also understand local operational costs and taxes to be faced by its franchisees.
The most common structures for international expansion are master franchising, area development or a combination of both. Under the master franchising structure, the local master franchisee will be granted the rights to act as local franchisor, prospecting sub-franchisees, executing the applicable sub-franchise agreements and offering support to the local sub-franchisees. The master franchisee usually collects the royalties and other franchise fees from sub-franchisees and then pays the due amounts of royalties and other fees to the franchisor under the master franchise agreement.
The area development structure is basically an international multi-unit franchise agreement, where the local area developer is granted the right to directly open and operate a certain number of outlets in a given territory. The royalties and fees are paid directly to the franchisor.
It is also possible to combine both structures, for instance, by initially granting only development rights, with a minimum requirement of directly operated outlets. After this the franchisee would be eligible for master franchising rights within the territory. This enables the franchisor to ensure that the local partner is already well trained and experienced in the business before taking on the responsibilities of acting as master franchisee.
The direct single-unit franchising model allows the franchisor to fully control the expansion, and to retain all the royalties and fees to be paid by each franchisee. However, this model is not very common in international expansions since it requires the direct involvement of the franchisor with local franchisees, including in connection with all training, supervision, marketing, supply and support efforts and, consequently, related investments and risks. Also, generally the expansion under this model is slower, as it goes one unit at a time.
Experience shows that choosing the adequate contractual structure and most promising market to explore as just as important as selecting the right local partner. The local partner must share the same goals and objectives as the franchisor, and the parties must enter into discussions with honesty and transparency, and in good faith from the beginning through to negotiations, execution and performance of the agreement. In addition to the personal chemistry and shared mutual interests, which are subjective criteria, the franchisor should develop tools to objectively evaluate the prospective local partner’s fitness for the proposed deal, similarly to what is done in connection with local expansion and selection of new franchisees for domestic deals. The research and due diligence in international franchising should, however, be even deeper and more detailed, as the franchisor will have less involvement and control over the foreign operations and will have to rely much more on the franchisee’s skills, as well as its knowledge of the market and financial health, and its capacity to invest in the business.
Given (i) the risks of exploring a new market; (ii) the uncertainty of the actual ability of the local partner to proper and efficiently develop the territory; and (iii) the potential difficulties for terminating an international agreement based on underperformance of the franchisee, it is essential that the parties stipulate a minimum opening schedule during the term of the agreement. This will allow the franchisor to enforce the fulfilment of the agreed-upon opening schedule and, depending of the terms of the agreement, terminating it or revoking the exclusivity rights to the originally granted territory in case of default of the franchisee’s minimum opening obligations.
Franchisors wishing to expand, but not to lock down an entire country with one master franchisee/area developer before having concrete evidence of its ability to deliver the expansion envisaged during negotiations, can begin by granting a limited territory with certain goals and milestones to be reached. After this, the master franchisee or area developer may be granted additional territorial rights and exclusivity.
In light of possibly applicable anti-corruption, labour, tax, data protection, regulatory and consumer laws, among others (as well as case law) – which may, depending on the level of control imposed by the franchisor over the franchisee’s activities, entail vicarious liability to the franchisor for actions or omissions of the franchisee – it is very important that the applicable franchising structure is tailored to mitigate such risks to the fullest extent possible. It is also important that the agreements – which must be validated by local counsel – have strong and enforceable indemnification provisions protecting the franchisor from any such liabilities and third party claims.
When deciding to grant franchising rights abroad, franchisors must take into account that they will be supplying all the know-how and trade secrets of their operations to the local partner, and, thus should make sure that the chosen territory affords foreign franchisors the desired level of protection, especially in connection with the protection of trade secrets, brand ownership and associated goodwill. The same applies to the ability to enforce post-term non-compete covenants and confidentiality obligations, which may vary from country to country. These are usually points of main concern to franchisors and may directly affect their decision to expand to a certain location or not.
When entering into an international franchise agreement, franchisors must also be prepared to deal with possible disputes with the franchisee. In such circumstances, although the general preference of franchisors is to choose the governing law and jurisdiction for arbitration in their home country, the convenience and actual effectiveness of such choices must be checked locally. It must also be verified that the target country allows the enforceability of foreign court decisions or arbitration awards; and, if so, the applicable requirements must also be verified. This is important to avoid the franchisor having a final favourable decision at the court chosen in the agreement, but being prevented from having it locally enforced against the franchisee. This would mean having to litigate the case all over again, hence risking a totally different outcome.
As some matters are very urgent and require preliminary injunctions, it is advisable to at least carve out in the franchise agreement the issues that should be pursued in courts at the domicile of the franchisee, especially involving use of trademarks after termination, intellectual property, unfair competition practices, repossession of inventory and equipment (if relevant) and non-compete covenants. For these issues the franchisor should be able to apply for preliminary injunctions directly with local courts.
This is one of the major challenges international franchisors face. There are a number of possibilities and the decision will, of course, depend on the value and relevance of the market to the franchisor and the potential risks of claims, as well as damage to the reputation of the brand if the territory is abandoned.
The franchisor may choose to terminate all existing franchises along with the termination of the master franchise or area development agreement. It is also possible for the franchisor to only terminate the development rights of the master franchisee or area developer, keeping the outlets then in operation until the expiration of their relevant terms. The franchisor should consider, if terminating an area development agreement, that it will remain in business with the same developer in connection with its existing outlets and, if the default that led to termination of the area development rights was too severe, this may be practically and commercially impossible.
On the other hand, if the franchisor decides to terminate a master franchise agreement, while allowing sub-franchisees to continue their operations under the franchised system and brand, the franchisor will have to opt between being directly involved with such sub-franchisees as the franchisor, offering all required support and assistance; or appointing a new master franchisee to take over the local operation and the existing sub-franchise agreements.
The master franchise or area development agreements must, therefore, contemplate, in as much detail as possible, the possible scenarios and options available to the franchisor in the event of termination, being always very clear as to the fact that, in any event, termination of all existing operations due to the master franchisee or area developer’s fault shall exempt the franchisor from any and all liability and claims in connection with the existing operations of area developer or from sub-franchisees. The agreement must stipulate strong “hold harmless” and “indemnification rights” provisions, including clear right of regress to the franchisor.
There is a growing trend of investment and equity participation acquisition in franchising chains by private equity funds, due to their relatively steady and predictable revenues’ flow and maturity of the management of the business. Therefore, franchisors who foresee this possibility, or who are at least open to the idea of seeking this type of investment or sale of corporate control at some point, should already draft their agreements to allow for that to happen as smoothly as possible. The intention is to avoid the language of the agreements and the risk of complaints from franchisees being seen by investors as a liability and affect the price to be paid in the transaction. The agreements should allow for franchisors to freely change their corporate control and, depending on the circumstances, allow the franchisor the option to acquire franchisees’ operation in an event of change of control.
Based on our experience, although all commercial ventures, including franchising international expansion, involve a certain degree of risk, franchisors who carefully prepare for this expansion, investing both time and capital in market research and expert legal counseling to develop the most appropriate business model and contractual structure, along with extensive due diligence on prospective partners, tend to be much more successful and achieve sustainable growth in foreign markets.