The International Who’s Who of Franchise Lawyers has brought together five of the leading practitioners in the world to discuss key issues facing lawyers today.
Who’s Who Legal: Several lawyers noted that the biggest challenge facing franchisors at the moment is the lack of available finance. Is this the case where you are? How have financing difficulties affected the franchise industry? What methods have been employed to overcome them?
Richard Wageman: China is a unique franchise market when it comes to financing the establishment and expansion of franchise systems. Established Chinese domestic franchisors either are well financed or have access to financing from Chinese banks or Chinese private equity/venture capital funds. New Chinese domestic franchisors will normally fund their start-up from their own resources and their initial development from the sale of franchises. In most cases new domestic franchisors will require financial assistance when they need to bolster their franchisee support infrastructure.
Foreign franchisors that enter the China franchise market, in nearly all cases, do not need onshore financing as they either set up a cross-border arrangement that does not require a China legal entity or they set up a China legal entity that is financed by offshore capital contributions.
With respect to franchisee’s access to financing, a single unit franchisee will have difficulty obtaining financing unless the franchisee is able to contribute a significant amount to the business to minimise the financing institutions risk. Master franchisees/area developers face the same problem, so in most cases they will bring in equity partners to inject funds into the business.
As the Chinese government has implement policies to tighten bank lending, franchisors and franchisees need to present a strong business case to the financing institutions and be prepared to make a significant financial contribution to the business, before the financial institutions will provide financing. That said, the China Franchise industry is generally well supported by financial institutions.
Subject to my comments above, franchisors and franchisees will look to bring in new equity investors.
Joycia Young: Financing difficulties have certainly had a number of effects on franchising in the Middle East region. Most notably, in new franchise deals, franchisees are trying to manage cash flow by refusing to pay large up-front development fees, and instead are offering higher store fees or royalties. Financing has also affected the development of stores, either due to delayed completion of new retail premises such as shopping malls or the ability of franchisees to open new stores in line with agreed development schedules. For new deals, many franchisors and franchisees are being patient. Having spent time and money finding the right partner, neither party wishes to start again. There needs to be an acknowledgement of the difficult economic situation on both sides, and a genuine desire to have the franchise succeed.
Rupert Barkoff: No doubt, the limitations on financing during the last few years have been an albatross around a franchisor’s and its prospective franchisees’ necks.
But the problem must be broken down into two parts: franchisor financing and franchisee financing. Both constituents are suffering, but the effect on each group is different.
As to franchisor financing, franchisors are not much different from other businesses. Most businesses will rely upon the revenues and profits they generate to foster growth, and borrowing is the traditional way to leverage their growth. With more capital, a franchisor can increase its sales efforts, develop better systems, hire more field personnel to teach and monitor their systems, and do more advertising and marketing. Without growth capital, all these improvements are less likely to happen, and in fact, may result in a franchisor implementing cutbacks, which in the long run may be bad for the franchisor and its franchisees.
As for franchisee financing, there is little doubt that the absence of capital for franchisees has stunted franchising growth. Most prospective franchisees do not have the personal wherewithal to finance a new business, and existing franchisees may not be able to finance growth if they have to wait until they have made enough money to finance additional units or opportunities.
However, if one were looking for a silver lining here, it is that the limited access to capital will force franchisors to find new franchisees who have more capital to finance their acquisitions or expansions, which means less leverage, and which, in turn, means less risk in case the franchised business doesn’t develop as quickly as anticipated. Lack of capital, in my experience, has been one of the most common, if not the most common, cause of franchisee failure.
I get particularly concerned when a franchisee whose capital is tied up in his (or her) retirement plan is encouraged by the franchisor to draw on this fund to finance the franchise’s development. Personally, I am not a person who likes government sticking its nose where it does not need to be, and I believe that individuals should have the right to invest their capital as they so choose and accept the risks that an investment goes bad, rather than a government say at the outset, “you can’t do that”.
When an individual invests a small portion of his retirement funds to start up a franchise, if it turns out to be a bad decision, the result for the franchisee may be a lower standard of living during retirement. When the individual is encouraged to invest substantially all of his retirement funds in a franchise opportunity, financial ruin may result such that the unsuccessful franchisee may become a ward of the state. The younger generation may have time to make up for this financial setback. However, for a person who is in his late fifties, or older, that may not be the case.
Marco Hero: Financing franchise businesses in Germany is mainly driven by private commercial banks with the assistance of specific funding by State Banks. With respect to financing the interior of franchise outlets, several leasing companies have specialised on the franchise sector. In addition, breweries are allowed to provide financial assistance to customers, mainly restaurant franchises.
Mainly three banks have started to focus on franchising, among them Deutsche Bank (roundabout 770 branches) and Sparkasse (roundabout 14,000 branches). Both banks centrally assess the franchise system and list them internally visible for branch offices. Branch offices accordingly focus during due diligence mainly on the end customer the financial assistance applying franchisee.
It goes without saying that the franchise sector suffered over the past two years with respect to allocating successfully bank financing. The worldwide bank crisis hit the German franchise industry double as the main financial source dried out. On the other hand, financing franchising with comparably low amounts regularly not superceding microcredits up to €25,000 or small loans up to €250,000 remained one of the few low-risk investment sectors for banks. During that period a third player even emerged on the market of franchising financing banks.
All in all, the German franchise industry suffered during the past years from the worldwide financial crises as most countries did. However, the German economy has made a strong recovery and many industries are back on their way back to the limit of capacity. Franchise sales are increasing again both on single-unit as well as on the master or development level.
Jennifer Dolman: The lack of available financing is clearly a problem for franchisors in Canada. Franchisors are having difficulty obtaining financing from conventional sources for their own growth and expansion requirements. Canadian banks have demonstrated through the recent recession that they are among the most stable in the world. However, one of the reasons for this stability is that all banks in Canada must be incorporated in Canada and are highly regulated by the federal government in terms of loan ratios, permitted activities, and ability to source funds from the Bank of Canada. As a result, most Canadian banks lending to franchisors demand significant security and will not lend on high ratio exposure. These restraints are preventing franchisors in Canada from growing their systems, expanding internationally, making acquisitions and developing new products and services for their franchisees.
From the franchisees’ perspective, typically franchisees have obtained financing from the Canadian chartered banks, usually by way of small business loans, which are guaranteed by the Bank of Canada to the lending institution if a franchisee defaults on its loan from the lending institution. Local banks have tight default quotas, which they need to protect in order to maintain government guarantee support. As a result, the banks have been reluctant to lend to franchisees, particularly those with newer systems, and franchisees requiring small loans without a significant asset base. For franchisees in market segments with high inventory, low capital assets, and limited real estate requirements, the banks have effectively stopped lending unless the franchisor provides a guarantee or a comfort letter backed by security with a market value.
To overcome these challenges franchisors have been required to resort to secondary market financing from private institutions, equity capital lenders, limited partnerships backed by individual investment capital, and supplier support. These sources of financing are usually short term and relatively expensive. The consequences are limited growth, difficulty in sourcing new franchisees, and in some cases buy-outs of franchise systems at low multiples, often by competitors.
Who’s Who Legal: A number of lawyers we spoke to reported that difficulties attaining finance coupled with market saturation in traditionally strong franchising jurisdictions have led to franchisors looking to emerging markets for future expansion. Which foreign markets are the most popular choices for international expansion? What competition or barriers to success do franchisors face when entering these new markets? What conditions should they be looking for to maximise their success?
Richard Wageman: As a foreign lawyer working in the franchise and distribution sector in China for nearly 10 years, I have seen a steady upward trend by foreign franchisors entering the China market. As China is such a large country with 100s of cities with large populations and a growing middle class that is spending money on all types of products and services, it is my opinion that China is the best location for international expansion by foreign franchisors.
In China foreign franchisors experience a number of competition challenges and barriers to overcome: Firstly, franchisors will need to navigate the complex legal requirements of setting up either a cross-border or an onshore franchise structure, that can be time consuming and expensive. Secondly, franchisors will face significant domestic competition from Chinese franchisors and retailers that have large franchise and licence systems in all parts of China in key commercial locations.
In China, foreign franchisors need to firstly, seek out strong commercial or equity partners, or both, that understand the China market and who can assist the foreign franchisor with Chinese business practices and local regulatory requirements, and secondly, adapt the franchisor’s brand to suit the “taste” and “needs” of the Chinese public without comprising the brand.
Joycia Young: Many US and European clients are still looking to the Middle East region as a source of growth. While development fees are generally lower than over the past few years, retail confidence remains high and revenues from royalties are strong. As an emerging market that is largely dependent on franchising and the in-licensing of intellectual property, the Middle East presents a unique opportunity. Those opportunities are not without the challenges that any business faces when entering an emerging market. Perhaps the most important consideration when evaluating a franchise opportunity in the Middle East is finding the right franchise partner. Many countries in the region do not yet have franchise specific legislation and instead, franchisees rely on commercial agency laws for protection. These laws typically protect the franchisee and can have the practical effect of imposing contractual protection over and above what the parties may have agreed in the franchise or development agreements.
Rupert Barkoff: The obvious answers are Brazil, Russia, India and China, or the “BRIC” countries as they have been dubbed. I think, however, there are still good opportunities in other countries that are moving up the economic scale. It is not surprising to see US franchisors look abroad, for there are various countries where, as the middle class grows, economic opportunities abound, while the domestic market in the US has been stagnant for three or four years.
The one country other than the US that I am most familiar with is Australia, where franchising is already a way of life. The citizens of Australia are fairly well-heeled financially. It is said that there are more franchise systems per capita in Australia than in any other country but New Zealand. However, Australia is, relatively speaking, a small country. But it is an easy one to franchise in. While it has a regulatory scheme based on the US model, the laws there are less complicated. Franchise disclosure is only regulated at the federal level, and there are no registration requirements. Thus, the regulatory barriers for franchising are considerably less than they are in the United States and Canada. The fact that Australia has an almost common language with the US also makes the barriers less difficult to overcome. Cultural values are also similar to those in the United States, although Australia, like Canada, cannot be viewed as being an interchangeable culture with what we have in the US.
Another country where I see opportunity is South Africa. Until recently, franchising was, effectively, unregulated, but regulation has not yet reached the level that we see in the US. The country has a growing economy, and its basic abundance of resources offsets some of the race issues as well as the economic imbalance of wealth among the population, which are current barriers to successfully franchising there. The desire for Western franchises, in my observation, is something to keep track of.
I have also seen franchisors going into what were previously untapped markets from the US perspective. The Middle East is another obvious candidate for growth activities by US franchisors, but so are some of the Asian markets, which have large populations, such as Malaysia and Korea. However, language and cultural differences make these more difficult markets for a US concept to break into, as compared to other English-speaking countries.
Marco Hero: Germany becomes an increasingly interesting market for foreign franchisors. First, many industries have not yet reached saturation especially with respect to nationwide penetration as franchise-systems typically do. Those markets include many services as Germany, historically, is rather strong in production than providing services. There is an increasing and ongoing demand to fill theses gaps. Especially US franchisors with many highly sophisticated and standardised well-tested service franchises might find interesting market opportunities. But also other sectors show increasing market potential for business formats including brand reputation, again a typical strength of franchising.
The outbound perspective in Germany and surrounding countries is mainly driven by the fact that cross-border franchising becomes more and more popular. The European Union provides an interesting market potential combined with widely harmonised legal and financial framework for international expansion in 27 member states including “old” markets such as France, the UK, Italy but also emerging markets in eastern Europe. Many European franchisors accordingly focus first on this market. More and more franchisors focus on markets beyond, including the Middle and Far East, the US and Latin America, mostly Brazil.
Entering into Germany foreign franchisors face rather low legal barriers as it is a member of the European Union with a widely harmonised legal framework. At the same time the market potential provides for more than 80 million comparably wealthy people. Franchising is not regulated, no disclosure law applies and case law on franchising is comparably balanced. Mandatory and specific industry related rules apply but can be handled with the assistance of local counsel. Cultural, language and other typical barriers in an international transaction are comparably low.
In the European Union an increasing number of member states have established regulations on franchising, including registration, disclosure and relationship laws. Regularly, foreign franchisors must comply with these laws as soon as they intend to start doing business in those countries.
In order to be successful in a foreign country franchisors should invest significant time, due diligence and money in analysing internal capacities as well as the foreign target market for compliance with the international expansion strategy. International franchising usually cannot be handled on the sidelines and needs additional financial and human resources comparable to any national expansion. Franchisors should try to fully understand the success factors of the brand and how these could be applied comparably successfully in the targeted foreign market.
Jennifer Dolman: This is not an area in which I have significant experience. However, we have seen a number of Canadian and US-based franchisors explore opportunities in international markets. The most common destinations have changed over the past year. There continues to be active interest in the BRIC countries (Brazil, Russia, India and China), but also increased interest in emerging Asian markets like Vietnam, Thailand, Indonesia and Cambodia. The Middle East markets are still very receptive to established franchise concepts, although local prospects are more difficult to find in many of the countries that have undergone recent civil unrest and whose infrastructure is still being transformed. The most important factors for expansion into many of these countries has not changed – know your franchisee, engage in detailed investigation of your franchisee’s experience, reputation and success, do intensive research on the market acceptability of your product or service, understand what roles franchise legislation and government approvals play in establishing your franchise in the foreign market, and retain reputable and practical local counsel.
Who’s Who Legal:Which industries have seen a high level of franchise activity over the past year?
Richard Wageman: Food and beverage, clothing retailers, education/training and the service area.
Joycia Young: Fashion retail and quick service restaurants remain buoyant areas of activity in the Middle East.
Rupert Barkoff: Restaurants have remained a strong sector for franchising both in the US and abroad, notwithstanding the world global crisis.
The most intriguing markets I have recently noted are health care and systems geared to helping senior citizens. On one of my most recent forays into Australia, I listened to a demographer who had statistically observed and analysed the ageing population challenges in Australia, which are very similar to those we are seeing in the United States. This in itself demonstrates a multi-cultural opportunity for entrepreneurs, and franchising may be the best way to tap into this opportunity. In the US, new home care franchised and independent services – especially those aimed at the senior sector – are popping up like mushrooms, and I have the sense that, overall, they are successful.
Health care is more of a mystery. I sense that here there is a market that historically has had high profit margins, and was very fragmented at least in the US. Thus, the fundamentals for franchise success were present. But perhaps the Golden Years for health care have ended, as competition increases, as have the costs of providing health care; government intervention and the influence of health insurance have inserted themselves into this industry, increasing the challenges.
To me, the most interesting trend in this industry, although still new-born, so to speak, is concierge medicine, where doctors limit the number of patients they see, and the professionals make much of their profit by charging an annual fee to be “on call”. I am only familiar with one chain that is trying this approach (although there may be several), and it was interesting that this chain did not consider itself a “franchise”, even though it had all the definitional elements: use of trademark, fee, and control. What’s more, the several doctors I know who signed up for this programme terminated the arrangement after a couple of years, having decided that what they were paying for “the brand” did not result in value to the doctors.
Perhaps, franchising is a dirty word to medical (and other) professionals, but I predict that these industries are no place for old men, who are not adapting to the changing ways of doing business in the US and other countries.
Marco Hero: The restaurant and hospitality industry remain strong franchise sectors. In Germany and other European countries service franchises increasingly enter into the market from abroad or newly established nationally. Brands surrounding key words like fitness, wellness and care grow significantly while related industries such as health care and pharma still face legal regulations clashing with franchising principles.
Jennifer Dolman: We have seen a migration in Canada away from capital-intensive franchises in market segments affected by the recession and the lack of available funding. Mid-scale dining establishments are definitely in limited growth modes, as are hotel and car rental franchises. What is currently driving franchising in Canada is the ageing population and its demand for quality health care systems, senior services, therapeutic massage, and home service and repair franchises. Other sought after and fast-growing franchise areas in Canada are specialty food franchises (especially self-made frozen yogurt concepts, healthier “fast-casual” food with smaller and more affordable footprints, and restaurants specialising in international or ethnic foods), children’s education and tutoring centres, business training franchises, and outsourced sanitation and cleaning services.
Who’s Who Legal:Do current legislation and court rulings in your jurisdiction protect franchisees and franchisors adequately? Are there any reforms you would like to see take place?
Richard Wageman: At this stage in the development of the franchise industry in China, it is my opinion that the current China Franchise Regulations do protect franchisees adequately, but with it comes to franchisors, there are still some “gaps” in the regulatory framework that need to be addressed by the regulatory authorities. One example is the lack of regulatory direction to deal with situations where an offshore franchisor terminates an onshore franchise arrangement (master franchisee) and the franchisor needs to cross-border franchise but does not meet the franchisor filing requirements.
As China is a civil law jurisdiction, court rulings do not bind Chinese courts to make similar rulings. In some cases certain courts in China will issue opinions or guidelines as to how that court will deal with a specific legal issue that may come before the court but again such opinions to not bind other Chinese courts. On 24 February 2011, the Beijing High People’s Court issued guidelines on certain issues concerning the application of the Franchise Regulations involving disputes over franchise agreements that will be followed by such court. In my opinion the guidelines have balanced the interest of the franchisor and franchisee and hopefully will assist such court to arrive at a fair resolution of disputes brought before the court.
I would like the relevant China authorities to accelerate the issuance of additional regulations or policy statements to cover: 1) exempting franchisors who have operated as franchisors for number of years (experienced franchisors) from the requirement to own and operate “two units for one year”, 2) expand the definition of “own and operate a unit” to reflect the reality that many franchisors do not own units, 3) development of a format for disclosure statements as there is a wide gap between what domestic franchisors and foreign franchisors use, 4) franchisor filing office document protocols, 5) setting up a system that if the franchise agreement is filed with a specific agency, such filing will facilitate remittance of franchise fees off shore without the necessity of filing collateral licensing agreements or use of service agreements, that is now the case, and 6) situations where a franchisor needs to take back a franchise system due to the default.
Joycia Young: Many countries in the region do not yet have franchise specific legislation and instead, franchisees rely on commercial agency laws for protection. Typically, these laws are generally weighted in favour of the franchisee, particular where that franchisee is a national of the country. In practice this means that it is often difficult to terminate a franchise relationship (even in accordance with the signed agreement) because the franchisee will have the added benefit of the statutory protection from the law. Obviously, greater balance between the protection afforded to each party would be ideal but these laws have a long history and legal reform generally takes longer in the region than in more established legal jurisdictions. In the meantime, franchisors will need to place greater emphasis on ensuring they have done full due diligence on their proposed franchise partner.
Rupert Barkoff: In the US, one might say that reasonable minds differ as to the adequacy of legislation and judicial rulings. The analysis needs to be divided into two sections: franchise sales and disclosure, and franchise relationships.
I don’t think that either franchisor – or franchisee-advocates sense that the federal and state disclosure laws in the US are substantially inadequate. The area of difference between these two camps relates to remedies. Under our Federal Trade Commission’s Franchise Rule, there is no private remedy for breaches, and the FTC itself lacks the resources to give its Rule much in the way of teeth. When the FTC decides to pursue a violator of its Franchise Rule, its bite can be painful. But rarely are cases brought except in situations where the violations are widespread and the harm is substantial. Some states have what are known as “Baby FTC Acts”, which state that a violation of an FTC rule also constitutes a violation of a state’s Baby FTC Act. Many of these statutes, however, are limited to consumer situations.
At the state level only about 14 states have statutes that govern disclosure and sales regulations. Most of these statutes do not go beyond the FTC Rule as to the substance of the disclosures, but these statutes generally provide for an aggrieved franchisee to pursue a breach on his own behalf, and also grant significant power to state regulators. In most of these states, franchises cannot be offered for sale or sold unless the franchise offering is registered with the state. As part of the registration process, states will examine the franchise disclosure documents and request that certain changes be made before the franchise may be offered for sale. From the franchisee’s side of the table, the states, like the FTC, have limited resources when it comes to bringing enforcement actions.
While we may quibble over some aspects of the FTC Franchise Rule and the corresponding state laws, overall the system has proved to be a fairly successful means to regulate the sales process, but this is primarily because the franchisor community has accepted the concept of regulation through disclosure.
The effectiveness of relationship laws, which have been adopted in some 21 states I believe, invokes a much higher level of controversy. These statutes govern a whole array of issues, including terminations, non-renewals, restrictions on transfer, rights of association with other franchisees and sourcing restrictions, to name most of the subjects regulated by them. Most of these statutes address termination and non-renewals, requiring that “good cause” (generally, a violation of a provision of a franchise agreement by the franchisee) be present and, in the case of most terminations and in some cases non-renewals, notice must be given and the franchisee in most circumstances is given the right to cure a default. The other subjects listed above are covered on a hit-or-miss basis among the state statutes.
Franchisors don’t like restrictions on the way they do business; franchisee advocates argue the concept of fairness to justify their attempts to correct the perceived imbalance of power that exists in most franchise relationships. I think it safe to say that franchisees lose more often than they win in litigation, whether or not they are located in a state that has a relationship law. Why? Because (1) franchisors draft the franchise agreement; (2) there are more franchisor than franchisee lawyers; (3) franchisees typically do not have the resources to fight the Goliath franchisors; and (4) franchisors are more willing to settle the situation where their cases have weaknesses, meaning that most franchisee-favourable decisions are never reported. To the franchisor, a fight with one franchisee is not life threatening to the business. For the franchisees, it may in fact be the last battle ground. This is not to say that we need more regulation in this area; it is simply a statement that franchisors win more often than not, for whatever reason.
Going back to the disclosure/sales issue, the result of federal and many state statutes has been a collection of statutes that franchisors have to navigate to have a national or even in some cases regional sales programme. Is this efficient? Clearly not as long as states insist on exercising their power to review franchise offerings. Differing statutes, different regulations, different state administrative policies, and different franchise examiners reviewing the franchisor’s filings all lead to a puzzling series of challenges to the franchisor’s ability to sell franchises.
With respect to state relationship statutes, franchisors have also learned to live with the differences in state laws. However, it does result in some inequities. A franchisee in state X, which has a relationship law, may be afforded better protection than a similarly situated franchisee in state, which does not. Is this fair, or for that matter should fairness be the appropriate standard? I will leave that to others to answer.
Is there a solution? Yes: federal pre-emption that would essentially do away with state regulation of franchising. Is this a real possibility? Not in my