March 2011 Franchising World
Success at home does not necessarily translate into success abroad.
BY BACHIR MIHOUBI
It all began very well on my way to the Meridian Hotel in Casablanca. The sky was blue as ever in this sun-drenched North African city. Suddenly, the taxi driver braked hard to avoid hitting a motorcycle. It was too late. After the crash, fortunately all of us unhurt, the motorcyclist got up, yelled at the taxi driver, and sped away. The taxi driver laughed and told me that this was not an uncommon event while driving in Casablanca. After arriving safely at the hotel and concluding a successful meeting, I was reminded that although it can seem dangerous to navigate the sometimes intricate roads of international expansion, the rewards can be well worth the trip.
As companies expand their brand internationally, they quickly learn that there are many hurdles that need to be overcome. One of the most humbling realizations is that one’s success at home does not necessarily translate into success abroad. While the world is getting smaller due to the global economy and increasing travel and communication, differences in cultural, legal, and local business practices seem to magnify as interactions increase. Before embarking on an international franchise development program, companies need to make a thorough assessment of their domestic operations, their ability to support international operations, and their financial capability to fund a successful international expansion.
While U.S. legal principles are increasingly permeating international contracts, it is important not to rely solely on the contractual relationship. Understanding that many countries do not have a structured legal environment will help in successfully expanding a brand internationally. Most U.S. companies rely heavily on contractual relationships; however, in many other countries, people conduct business based on relationships first rather than relying on a contract. Companies should consider a transparency spectrum when determining how to negotiate franchise transactions internationally. For example, in highly transparent countries such as Singapore, Australia and the United Kingdom, it is best to focus on the specifics of the contract and provide detailed information when negotiating with prospects or their attorneys. In most Latin American countries, the Middle East and China, it is highly recommended to shift the focus to building a solid relationship with the investor.
Understanding the cultural conceptual divide can save a lot of time and frustration.
Unlike the United Kingdom where there are no franchise-specific laws, many countries have adopted or are considering adopting regulations for franchising. These complex regulations call for disclosure obligations on the part of the franchise. Although these regulations aspire to protect investors from fraudulent or inexperienced franchises, they may end up overwhelming investors and making the transaction more cumbersome. Consequently, localizing agreements and consulting with local counsel is a must. U.S. agreements are written based on common law concepts that are not easily understood in civil law countries: what may be a common practice in the United States may not translate in many Latin American, European or Middle Eastern countries. For example, in the Arab nations under Sharia’h law, the use of the term interest for a late payment can be viewed as contrary to public policy. In China, while U.S. businesses have a very specific understanding of the term joint venture, most Chinese prospects seem to refer to every transaction as a joint venture, even when the franchising structure is spelled out in clear terms. Understanding the cultural conceptual divide can save a lot of time and frustration.
When negotiating an international agreement, it is important that U.S. attorneys avoid rigid adherence to every principle of the franchise agreement. There must always be room for compromise when dealing with international prospects. Insisting on the application of U.S. laws may not always be practical when the deal collapses in the local jurisdiction. Remember, even if there is adjudication by an U.S. court, it may not be enforceable in that country.
Unlike the Unites States where common law rights govern, many countries have adopted the first to file rule of trademark protection. This rule simply allows the first to file for trademark registration to have legal protection over the marks. Companies intending to franchise internationally should plan for trademark protection as early as possible to avoid dealing with creative entrepreneurs or so-called pirates that register your mark and offer to sell it back to you. A possible exception to the first to file, however, is afforded to those marks that have established use in their industry. For instance, a well-known brand that operates and is registered in many countries stands a better chance of prevailing against an infringer than a smaller, lesser known brand. Recognizing the importance of the value of their intellectual property, more and more companies are hiring firms that provide international trademark and domain name monitoring to ensure that there are no existing conflicts with trademark applications.
Structuring the Arrangement
Internationally, the preferred structure has been the master franchise agreement. However, the area development structure has been relied upon by many experienced franchise companies. It is also possible to opt for a hybrid arrangement, which begins as an area development agreement and evolves into a master franchise structure. It is necessary to emphasize that in drafting these agreements, the fundamental obligations of the franchisee and franchise organization must be maintained. Ordinarily, the master franchisee is granted the rights for a specific territory and a specific number of units to be developed. The franchisee is also given the right to sub-franchise the concept to other franchisees. An area developer, on the other hand, is granted a territory and a number of units that a franchisee must develop on his own, without the right to sub-franchise to third parties. A hybrid structure allows an area developer to develop a certain number of units before acting as a master franchisee and then sub-franchising to others after undergoing a thorough operations review.
When granting a territory, it is important to assess the financial and operational capability of the potential franchisee. The ideal master franchise candidate will have prior business or franchising experience, be reasonably well capitalized to develop the brand, and have local resources, personnel and or experience in real estate, financial matters, and training and education. Many franchises have found themselves contractually obligated to a franchisee that was unable to develop the entire territory granted in the agreement. It is critical to assess the potential of the territory and match it to the capability of the franchisee. Some countries and regions should be divided into multiple territories.
Territory Fees. The fee charged for the rights to the territory depend on the demand of the brand in the market, the brand’s international exposure, and the support and training offered by the franchise. These fees can range anywhere from $100,000 USD to $1 million USD or more. The amount of the territory fee also depends on the size of the country and the economic potential. Factors such as median income, consumption power, and exchange rates are also valuable in determining a reasonable territory fee.
Development Fees. The fee charged for the portion of the franchise fee paid in advance for each franchise unit to be opened in accordance with a specific schedule of development set by the franchise company is called the development fee. These fees can range from $5,000 USD to $15,000 USD, depending on the complexity of the brand and its systems, as well as the number of products and services offered.
Franchise Fee. The fee charged by franchises for each unit to be opened by the franchisee is called the franchise fee. Some franchise fees are offered on a sliding scale as an incentive for the franchisee to open the units much faster. These fees may also vary from one system to another and can range anywhere from $25,000 USD to $50,000 USD.
Royalties. Most franchise systems charge the franchisee a royalty based on a percentage of sales. These vary from 3 percent to 7 percent depending on the type of services and or products offered. Some companies also generate revenue from the sale of the product to the franchisee. For instance, many coffee concepts collect a reduced royalty on in-store sales because they also derive revenue from the sale of the coffee to the franchisee.
Advertising Fees. The advertising fee is the annual fee that is paid by the franchisee to the franchise as his share of the corporate advertising expenditure. This fee is charged by a small number of franchises. Unless the franchise has an extensive presence in the region, it would be unreasonable to initially impose an advertising fee on franchisees.
Global Market Outlook
Which countries should companies target for international expansion? That is the wrong question. Rather, each brand must analyze an international expansion based on the viability, demand and need for its products or services. For certain service brands, the focus may be limited to the developed world; in which case, there will be a limited number of countries with prospects that are mainly information driven. For other brands, such as quick service and casual dining concepts, the emerging markets and the BRIC countries (Brazil, Russia, India and China) offer greater opportunities. However, penetrating these markets requires in-depth research as well as international savvy.
Although international franchising is still growing as compared to the United States, more and more countries are adopting the franchise business model. To be successful, a country must have transparency in its banking system, a mechanism for repatriating royalties, and a legal system that protects trademarks and intellectual property. Prospects are looking for a proven brand with international appeal, refined systems, and ongoing training and support. They are also looking for a culturally attuned management that is willing to listen and adapt the brand in accordance with local idiosyncrasies.
The BRIC Countries
Although Brazil is leading Latin America in economic growth, it can be a difficult country to penetrate. Almost 90 percent of Brazilian brands are local. Breaking into this market requires thorough research on the viability and uniqueness of the services and products offered. While Russia has been criticized for its lack of transparency and business environment, many brands have entered that market with an eye to the future and to gain a foothold in the world’s sixth largest purchasing power parity economy. Today, India is the new kid on the block with its rising middle class, large population, strong entrepreneurial spirit and interest in the Western culture and Western way of life. However, franchising is in its infancy and India’s banking system and bureaucracy are often a hindrance to a successful partnership. Also there is considerable economic disparity within the country. Dividing India into individual markets for expansion consideration is strongly recommended. And while China is considered a major focus for U.S. brands for the vast consumer market it offers, it is not for everyone. The distance and time required to conclude a transaction may be prohibitive for small- and medium-sized companies.
The Middle East and GCC Countries
The Middle Eastern and Gulf Cooperation Council countries still provide great opportunities for U.S. brands. With a population of over 250 million, a per capita increase in disposable income, and a great demand for U.S. products and services, many U.S. companies continue to expand successfully in these markets. Recently, Saudi Arabia, not necessarily known for its popular culture, qualified as 11th by the World Bank business rankings, ahead of more transparent European countries such as Finland and Sweden.
If a brand has developed in Europe and the Middle East, a natural and logical expansion would be North Africa and several sub-Saharan countries such as South Africa, Nigeria and Ghana. According to The Economist, the biggest concentration of overlooked markets is in Africa, where collectively South Africa, Egypt, Algeria, Botswana, Libya, Mauritius, Morocco, and Tunisia match the average GDP per head of the BRIC countries.
North and South America
Canada and the Latin and South American countries have emerged relatively unscathed by the latest recession. Countries like Colombia, Chile, Peru and Mexico offer a great platform for U.S. brands. Thanks to an impressive number of trade agreements, democracy and foreign investment have grown by leaps and bounds. Chile has become the region sweetheart, increasing their per capita GDP (Purchasing Power Parity) from US $4,800 in 1990 to US $14,700 in 2009. The proximity of these markets to the United States also makes them viable regions. Investors in these countries understand American culture and U.S. management style. Canada has an established tradition of franchising and nearly one-half of all new retail businesses are franchised. However given the language requirements in this bilingual country, all labels on products to be sold in Canada must be available in both French and English and measurements must be expressed in metric units.
Apart from China, Singapore, Vietnam and Malaysia, where U.S. brands are doing very well, Indonesia has become an attractive market with an economy growing at a steady pace of 6 percent. Many analysts are predicting that Indonesia will be the emerging market star of 2011. Its proximity to Malaysia and Singapore should make it even more attractive for U.S. brands already expanding in the region.
Before the recent recession, many companies were targeting Eastern Europe where the demand for and popularity of U.S. products and services was very high. Although Poland seems to have fared well in this economy, Hungary, Romania, Slovakia and the Czech Republic continue to battle with economic contraction and budget deficits.
Just like the traffic and noise in Casablanca, expanding your brand internationally can seem overwhelming and a little frightening. By conducting thorough legal and business due diligence, by selecting the right partner, and by targeting the right markets, your company can avoid costly mistakes and successfully navigate the world’s increasingly global economy. .
Bachir Mihoubi is president and chief executive officer of FranCounsel Group. He can be reached at 404-384-3317 or email@example.com.