Keep Your International Expansion Expectations Realistic
February 2010 Franchising World
All too often franchisors require that their international agreements be substantially the same as those which they use in their home countries .
By Frank Zaid
International franchising can be glamorous, exciting and exotic for both the franchisor and the international franchisee. The risks and rewards for both parties can be significant, and the negotiations and business arrangements can be lengthy and complex. Franchisee entities involved in international expansion are usually much more sophisticated than domestic franchisees. They are much more aware of the local and relevant cultural and legal considerations, and are often well connected to important business and government entities that will be necessary for a successful launch in their countries.
While franchisors generally refuse to negotiate franchise agreements in their own countries, international franchising follows a much different pattern. Negotiations are difficult because of travel and language barriers, costs of multiple legal, business and accounting advisors, and delays relating to required foreign legal and government compliance. Franchisors will be concerned about the fact that they have little control in international franchise operations while their trademarks, business systems and reputation are exposed to potential adverse risk. To the contrary, the international franchisee will be concerned that it may not receive sufficient support and assistance from the franchisor for successful development of the franchise program. These conflicting objectives and concerns can lead to unrealistic expectations by both parties.
All too often franchisors require that their international agreements be substantially the same as those which they use in their home countries. Again, all too often, franchisors do not take the time to understand the relevant local customs, business practices and economic conditions in the target country, and to temper their expectations accordingly.
Similarly, international franchisees, caught up with the excitement and exuberance of the opportunity, too frequently agree to unrealistic commitments and legal arrangements.
A few concrete examples will illustrate how both parties can enhance their opportunity for successful international franchise expansion by keeping their expectations and commitments realistic. Assume that the international franchise arrangement takes the form of a master franchise agreement allowing the master franchisee to sell subfranchises in the territories involved. This arrangement will allow for rapid market penetration, accelerated growth of the franchise system and attraction of sophisticated investors. Since the development and operational expansion efforts will be with the master franchisee, the franchisor’s financial and management resources will be reduced from what would be the case in direct unit franchising. However the financial rewards to a franchisor the international franchisee is successful will be significant in terms of the return on invested capital. But if the relationship ultimately fails, the franchisor risks financial loss by reason of the expenses required to salvage the franchise system in the foreign market.
Territory and Exclusivity
Often a matter of first negotiation in international franchising relates to exclusivity and territorial rights and restrictions. The franchisee entity will expect complete exclusivity within the foreign market. The franchisor, accustomed to reserving certain rights in its favor domestically, may insist upon similar rights being reserved in the foreign market. For example, the franchisor may wish to reserve the right to sell the same or similar products or services associated with the franchise system under different trademarks, or through other channels of trade, including on the Internet. These reserved rights are often unnecessary and unrealistic, and if implemented can result in competition and conflict between the franchisor and the international franchisee. In most cases it is best for the franchisor to cede responsibility for development of the franchise system to the international franchisee without any expectation that the franchisor will intervene or compete directly or indirectly.
Another similar issue which may result in conflict or unrealistic expectations is the description of the territories involved. For countries whose borders may be under scrutiny or subject to political change, both parties must understand what may happen if there is a change of borders or country description. For example, how would a franchise agreement entered into several years ago giving exclusivity to a franchisee for the Union of Soviet Socialist Republics or Yugoslavia be interpreted after the demise of either of these countries? A map or a description of the boundaries as they exist at the time of the agreement could be referenced, or the agreement could provide that if the political boundaries change during the term of the agreement any affected parts of the territory are forfeited and automatically withdrawn from the exclusivity grant.
Another topic often subject to intense negotiation and unrealistic expectations pertains to the fees payable for the international franchise rights being granted. Most international franchisors seriously underestimate the costs involved in developing their franchise systems internationally, particularly in less developed countries.
It is not uncommon for franchisors to require a large, front-end fee. Such an approach may be unrealistic in the sense that it will impair capital needed to ensure successful development of the system. A more practical approach may be to accelerate or increase payments as the international development reaches certain milestones.
Similarly, some franchisors seek reimbursement of their expenses in developing products and services for the franchise system for foreign markets. However, from the franchisee’s perspective, an open requirement to reimburse all such expenses could result in a completely unrealistic financial outlay at the initial stage of the arrangement. It is wise for both parties to be realistic and definite as to their expectations. For example, the agreement could provide that only certain expenses incurred in connection with the conversion of a franchisor’s packaging, signage and advertising materials for the foreign country, or expenses incurred in connection with governmental reviews and approvals, are required to be reimbursed. Similarly, the agreement could specify that expenses incurred for training of the franchisee and its staff, and translation and other development costs for the operations manual will be required to be reimbursed.
Some international franchise agreements stipulate that the fees payable by the franchisee will be subject to an inflation factor or adjustment based on a published cost-of-living index. Many franchisors insist that the cost-of-living index applicable in their home country should be inserted in the agreement. But this approach is unrealistic in countries where there has been an historical record of high inflation. The franchisor’s may be better served by insisting on a cost-of-living index relevant in the foreign country. The franchisee, however, may wish to put a cap on the inflation factor to have some degree of certainty in its financial commitments.
The subject of taxes payable on the payment of fees by the foreign franchisee to the domestic franchisor needs to be understood by both parties and approached realistically. In most countries withholding taxes will be eligible on royalty, interest and similar payments from a franchisee to a franchisor residing outside of the target country. The franchisee will usually be responsible for calculating, withholding and paying such taxes to the foreign country’s tax authorities, and to provide the franchisor with receipts for payments for the franchisor to be able to claim foreign tax credits in its own country. But often international franchisors insist upon a “gross-up” clause requiring the franchisee to pay the full amount of the royalty, interest or other payments without regard to any amount being withheld under local law. Gross-up clauses like these will impose a huge financial burden on the franchisee as the franchisee will still be required to make the withholding payments, but at the same time must make full payment to the franchisor without deduction of the taxes withheld. In many jurisdictions this may result in what a 15 percent or greater burden on the franchisee, making the financial arrangements unrealistic.
Another area of unrealistic expectations in international franchising often pertains to the franchisee’s development rights and obligations which may be set out in a development schedule specifying a minimum number of outlets to be opened and operated within a particular time framework. Franchisors are often unrealistic in their expectations by applying domestic growth criteria to the foreign market. They should not seek and franchisees should not commit to unrealistic development obligations. Both parties should also realize that if the development obligations are not met, the ultimate sanction does not have to be termination of the arrangement. More realistic consequences, such as the possible reduction of exclusivity or surrender of a part of the exclusive territory, may be more sensible.
If the franchisee cannot meet the development schedule due to unexpected economic or market changes, the agreement should allow the parties to negotiate a reduced development schedule. Clearly the recent worldwide financial crisis and economic recession have illustrated that development schedules entered into with the best of intentions can be made unrealistic due to events beyond the reasonable expectation of the parties.
Another area in which international franchisors are often unrealistic is with respect to the ability of the franchisee to modify the franchise system in the foreign market. It is a fundamental fact that franchise systems require modifications and adaptation in the target due to local country laws, regulations, customs and cultural considerations. While some elements should not be subject to modification unless absolutely necessary, others should be subject to reasonable modification by the franchisee.
Typical franchise system development criteria which may have to be modified in the target country include site selection, franchisee selection, specifications for equipment, fixtures, furnishings, decor and signage, and modification of approved products or services. With respect to the operations manual, the franchisee should typically be allowed to suggest modifications or changes to comply with local standards, including language requirements, but the agreement should state that all modified versions of the manual will be owned by the franchisor. While the international franchisor may wish to maintain approval rights over each and every change or modification, such an approach is both impractical and unrealistic.
It is common in international master franchise arrangements for the form of subfranchise agreement to be in a standard form approved by the franchisor. It is not unrealistic for an international franchisor to require approval of modifications or changes, but at the same time the franchisee should be able to make nonmaterial modifications or changes for compliance with local requirements. The franchisor should be given notice of such changes, and perhaps to be given a reasonable right of approval.
Most international franchise arrangements need to address the subject of supplier issues at an early stage. Franchisors will typically wish to have the right to designate or approve suppliers or sources of products and services, but should not insist that the arrangements be the same as in the franchisor’s domestic operations if local suppliers or sources are available. The more practical approach is for the franchisor to provide standards and specifications to the franchisee which the franchisee must adhere to. The franchisor may have a right to inspect and monitor the suppliers’ premises and facilities, to receive samples for testing purposes and to change or disapprove of an approved supplier or source of supply. arrangements. These are all realistic business arrangements.
Finally, the subject of dispute resolution always needs to be addressed in a realistic manner. Neither party wants to be involved in lengthy and costly judicial or litigious proceedings. A practical approach in international franchising is that the first step in attempting to resolve any dispute should be the requirement that there be discussions and meetings of the chief executive officers of the parties as a prerequisite to the initiation of dispute-resolution proceedings. If the parties cannot resolve the dispute by such means, then the agreement could specify that third-party mediation be undertaken.
If neither of these dispute resolutions produces an acceptable result for both parties, the agreement may provide for international arbitration rather than litigation.
With respect to choice of governing law, a franchisor will typically wish to have as the governing law of the agreement the law of its home country. The franchisee, not unexpectedly, will wish to have the law of the target country. Generally, unless there are some specific political or jurisdictional reasons why the governing law of the franchisee’s target country should not apply, the governing law provision should favour the laws of the target country since remedies will have to be sought before the courts of the target country. Franchisors that insist that the governing law of their home jurisdiction apply in international franchise arrangements are not only unrealistic, but impractical in taking such an approach.
In a similar manner, the agreement must address a realistic choice of forum clause. The franchisor may wish to designate the forum for dispute resolution as being in the franchisor’s home country, while the franchisee will wish to designate the forum as being within the target country. One solution which is sometimes used is to provide that the courts of the jurisdiction of the party that does not initiate legal proceedings be used as the choice of forum. While this may not necessarily lead to a practical result, it does impose a substantial obstacle on the party wishing to initiate legal proceedings. Another possible solution is to confer concurrent jurisdiction on the courts of both the domicile of the franchisor and the franchisee. A third, but somewhat less practical approach is to confer exclusive jurisdiction of the courts of a neutral country.
Keep It Realistic
The examples discussed above are only some of the more common issues which are negotiated in almost all international franchise arrangements. Each one is complex and involves serious economic, business and legal considerations for both parties. There are many other issues which will be encountered in most international franchise arrangements. What may be the most desirable approach for one party will often be the least desirable approach for the other. Therefore, it is critical that both parties be understanding, practical and reasonable in their demands, negotiations and ultimate arrangements. As is often stated by both franchisor and franchisee in an international franchise arrangement, and their respective advisors, if both parties feel that they achieved some degree of recognition of their respective positions on issues most important to them, but at the same time yielded in a similar manner on the issues most important to the other party, the arrangement will likely have the best chance of success. And that, of course, is exactly what both parties hope for in the first instance.
Frank Zaid is senior partner at the law firm Osler, Hoskin & Harcourt LLP. He can be reached at 416-862-6415 or firstname.lastname@example.org .