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WHO GOES WHERE?

by Marcus Whittington,
last updated 23/07/2009

Exclusive, non-exclusive, large or small? Marcus Whittington takes the mystery out of franchise territories

The setting and operation of territories is one of the more complicated components within franchise systems. Second only to fees, territories are potentially the most contentious issue for franchise networks.

New franchisors may be tempted to grant over-large or over-protected territories as it makes the first franchises easier to sell, but they can later regret a decision which restricts the system's ability to service a developing market. A franchisee's attachment to his or her territory once granted is understandable, but may be emotional rather than practical. The right structure can avoid these headaches - the wrong structure can lead to ongoing discord and lack of growth.

In fact, there are many possible options to choose from when deciding how - or whether - to set franchise territories. Once you fully understand the options and their implications, it soon becomes apparent which structures will work for both franchisee and franchisor (and they must work for both). From there it is a question of comparing the implications under every potential scenario you can imagine and choosing the one that, on balance, works best for your system.

It is also worth remembering that all franchise systems are individual. Although a structure might have worked well for one system in a similar industry, that doesn't guarantee that it will work for yours - or that it is the best structure possible. Often the structure that is individually designed leans on a combination of factors or elements that are used in a number of different systems or system types.

In this article we identify the different basic structures, examine their differing advantages, disadvantages and applications and look at options available to cater for the future growth of, or changes to, the marketplace.

No Territory

In some circumstances, a franchise will be granted with no territorial or geographical restrictions or protections on the franchisee's business. This may apply either to service or retail-based franchise systems.

a) For Service Franchises

This happens generally in one of two situations:

(i) Where a franchisee is likely to get a considerable amount of their business from existing contacts and word of mouth. For example, a mortgage broker who can sell products to any potential person and moreover can do some or all of the work from home (therefore not being hampered as much by geographical constraints). They are typically franchises with an active sales role where franchisees build their own customer base, especially via contacts or referrals, and then continue to service their customer base thereafter.

(ii) Within contract franchises. This is a term I use to describe franchises where, instead of being licensed a territory, you license the right to service a specified set of contracts (ie. customers). Examples of these types of franchises are many home service businesses, where the franchisor or master/area franchisees get most of the clients and then pass them on to be serviced by a franchisee once there is enough business to sustain the franchisee.

Often contracts can be added either by the franchisee taking on more from the master or area franchisee, or by the franchisee securing more contracts him or her self. Sometimes contracts sourced by franchisees themselves can be 'sold' at a pre-agreed rate to another franchisee or back to the master/area franchisee to be redistributed. The selling back of 'surplus' clients in this way enables the franchisee to concentrate their business in a smaller area, reducing their travelling time and increasing productivity. It also provides some capital gain on the work they have done to establish the business.

Commercial cleaning companies often work in this way too. Sometimes there is a larger area (normally that of the area/master franchisee) outside which franchisees cannot either solicit for new business or service customers. Such a structure can work well for franchises where business is sourced centrally on behalf of the franchisee to a large degree, and the contracts are clearly in place.

b) For Retail Businesses

It is quite common that no territory will be granted where a retail outlet (such as a coffee shop or fast food outlet) has the right to operate from a specific location only. This generally only works where individual units can operate successfully in close proximity. It can lead to potential conflict with the franchisor if franchisees feel that the franchisor is siting the outlets too closely (which is what happened to McDonald's in the US some years ago).

The risks can be minimised for a franchisee if there is an option for the franchisee to establish nearby outlets themselves (for example, with an automatic first option on the rights for a new outlet within a specified radius) or where the franchisor limits the number of franchisees to be established in a specific area or over a specified period of time (in order to help the franchisee get established).

Regional Territories

A regional territory is a set region within which a number of franchisees operate, each of whom can work anywhere in the territory. These work best where the franchisee's customer base is largely attracted through existing contacts but the franchisor wants to give its franchisees the security of knowing that there is a limit to the number of franchisees who will be operating in an area.

For instance, in a house building franchise someone in the industry may have an existing range of clients or contacts spread out across an entire region or major urban area. Both the franchisor and franchisee want those customers to be serviced personally rather than being passed on to another franchisee - or possibly not serviced at all. It allows the franchise to operate equitably while retaining the all-important franchisee/client relationship and saves any squabbles between franchisees. They know the position when they sign up and there is usually no need for referral fees between individual franchisees.

The difficulty with this structure can come when franchisees start targeting new clients, as potentially two franchisees could pitch for the same client at the same time. Sometimes this is not a major issue, but other times it is - it tends to depend on the amount of new business sought and the value of the transaction (large value = large potential income = big competition = disgruntled franchisee).

One way around this is for franchisors to operate a 'dibs' register, ie, a list of new clients being targeted. When a franchisee wishes to approach a new client then they have to check with the register that no other franchisee is currently targeting them. This sort of register must have a time limit on the prospecting period to provide equal opportunity for all franchisees. However, even such a register cannot allow for the unpredictable targetting of, say radio advertising or mail drops, which is why some franchises insist that these are cooperative affairs between franchisees.

Non-Exclusive Territories

Non-exclusive territories are nominal territories in which you operate as a franchisee, but in which other franchisees (or the company operations of the franchisor) may also conduct business. Depending on the franchise agreement, there will normally be restrictions of some sort (or perhaps commissions payable to you) if someone else operates in your territory, or vice-versa.

A good example of this is where a milk distribution franchisee has a defined territory in which he/she can service all homes and standard retail outlets (e.g. dairies), but the franchisor services supermarkets or other major chains (eg. Mobil, BP) direct. To carry and distribute the necessary level of stock to service such chains would be beyond the ability of many franchisees, and would inevitably distract them from the brand-building work of growing the home and standard retail business. Another example is where a training franchisee trains all customers in his or her territory except for a nominated list of clients that are serviced directly by the franchisor - perhaps a national company requiring specialist consistent training.

A non-exclusive territory can also operate where a franchisee is permitted to secure a client in another franchisee's territory but then has to pay a commission or 'out-of-territory' fee for doing this work. This can be difficult to monitor however.

There can also be the situation where a franchisee operates with an 'area of primary responsibility' where they cannot actively solicit for business outside of their specified area, but can service referred clients outside of their territory, normally for no fee payable to the franchisee whose territory it is.

It is hard to avoid situations where relatives, customers moving locations or multiple locations result in a franchisee being required to operate outside their territory. It is not always practical, or commercially realistic, to insist that the customer must now be serviced by a different franchisees from the one with whom they have built up a relationship, and the franchise system needs to be able to cope with such eventualities.

Exclusive Territory

An exclusive territory is one where no other franchise of the same system can be established or operate in your territory, and the franchisor cannot establish a company-owned business or operate in the specified territory either.

This arrangement provides a lot of security for the franchisee as he or she only needs to worry about external competition. It is often preferred by banks, accountants and lawyers, and therefore makes a franchise easier to sell. However, it too has its weaknesses as an exclusive territory often offers little flexibility for change if the territory size has not been defined accurately, or if the market changes.

If the territory initially granted is too big then the franchisee will not be able to service all the customers in his or her territory. If that happens then there will be a gap in the market, encouraging more competitive outlets who may then be able to get the upper hand in a region. This is clearly not in the interests of either the franchisee or the franchisor. It is always better to work with a company outlet or other franchised outlet and have the dominant brand in an area than to be squeezed. At the same time, the franchisor is disadvantaged if sales turnover is not reaching its potential due to the reduced royalties or production margins generated in the region. A similar effect also occurs if a franchisee reaches his or her 'comfort zone' and stops building the business in the territory, allowing sales to plateau rather than to continue climbing.

It is for these reasons that some of the following options may be built in to franchise agreements.

a) Right to establish further outlets

As touched on under non-exclusive territories, this is where a franchisee can establish additional outlets in their region. This often takes the form of a first right to establish the next outlet, but is normally subject to the satisfactory past performance, financial and management capabilities of the franchisee.

b) Right to expand trading operations

Under this option, a franchisee can take on more staff or contract other parties to conduct some of the surplus business in the territory. It could also cover the right for a home-based franchisee to operate from a business office, using more staff, or the right for a franchisee to expand his or her retail premises or move to smaller or larger premises, or the right for a mobile service franchisee to add extra vans.

c) Right to subdivide territories

This allows a franchisee to sell off part of their territory back to the franchisor or, more commonly, to another franchisee reporting direct to the franchisor. In the case of it being sold to another franchisee, there is often a fee payable to the original franchisee by the franchisor (often a share of the upfront fee paid by the new franchisee). This acts as an incentive for a franchisee to sub-divide their territory rather than merely fail to service it properly.

d) Sub-franchising

With sub-franchising, the franchisee has the right to subdivide his or her territory, but has the responsibility of directly supporting the new franchisee/s in a specified manner. This means there will be a legal agreement between the original franchisee and the new sub-franchisee.

This creates a set of obligations between the two parties and, in recognition of the support services provided by the franchisee to the sub-franchisee, a proportion of the sub-franchisee's royalty payment (or product margin) is usually payable to the franchisee.

The rationale behind this is that the franchisor only has to deal with the one franchisee in the territory, and both franchisee and franchisor receive an additional return from the territory. However, it is a rare breed of franchisee who can effectively operate as a franchisee and a pseudo-franchisor, and it can be more difficult for the franchisor to ensure that standards of

sub-franchisee operation are being adhered to.

While the final structure chosen for any franchise system is usually one of these basic four options, it must also take all of the potential factors into account. The key thing to remember is that there must be the right for either the franchisee or franchisor to effectively expand the business in the region to meet market demand, or the entire franchise will suffer. However, this right needs to be addressed in a manner which is positive and realistic for both parties.

How to Develop a Territory

When designing territories, the potential business to be gained from each territory needs to be taken into account. The factors that need to be considered when defining the size or location of a territory can include the following:

a) population size

b) number of dwellings

c) growth of an area (normally via population or dwellings)

d) number of businesses/commercial premises

e) numbers of businesses within certain industry types

f) level of income/economic strata

g) other demographic data such as racial mix, age etc

h) price of housing

i) road traffic

j) foot traffic

k) amount of competition in the area

l) proximity to other key influencers or sources of business eg. shopping malls

m) planned roading changes or shopping complexes

n) marketing media used to attract/secure business

eg. direct mail areas, television regions, etc.

How to Define a Territory

The most common way of dividing physical territories is via a detailed map which is often appended to the franchise agreement. This will normally mean drawing on a map and then, if necessary, clarifying in writing (for example, are both sides of a particular road included?).

Some franchisors set their territories to match 0800 or 0508 toll-free number areas and then use that toll-free number for all promotion, secure in the knowledge that responses can be directed to the correct territory.

Depending on the territory structure chosen there could be further markings on a map. These could include: the area within which the franchisor undertakes not to set up a further outlet for a period of time (or for the term of the franchise agreement); the territory in which the franchisee can solicit (market) for business; the area within which a franchisee is allowed to service a customer; the area within which the franchisee can market for business until a franchisee is placed in that area. Still another could be the area in which a franchisee receives a commission on a sale or margin on a product if it is sold and possibly also distributed by the franchisor from mail-order, 0800 number inquiries or the internet. It depends on the territory and operating structure employed.

Impact of the Internet

The internet is just another marketing and potential distribution channel. Unfortunately, most existing franchise agreements do not include clauses covering its use so the integration of e-commerce or e-marketing can disrupt some systems, both retail and service.

The key to success with territories and the internet is to take a fair and long-term approach. Either use the website as a means of generating business that can be effectively directed to the franchisee, or have the franchisor (or a contracted third party of the franchisor) promote, secure the business and distribute the product, then pay a commission to the franchisee in whose territory the customer is in. It is vital to invest in a system that works and keep good records so that the level of trust between franchisee and franchisor is maintained. Ignoring the need for a website or e-strategy is not an option. At the very least, the potential introduction of internet marketing should be covered in the franchise agreement.

Another possible option is that franchisees each own a share of the internet marketing channel so that they can all profit from internet sales.

Conclusion

If you are designing a territory structure, what you need to determine is which structure has the most and strongest advantages and the least and least important disadvantages for your particular business, and how certain systems or checks put in place can minimise or eliminate the impact of any potential disadvantages.

The bad news is that no territory structure is perfect. There will always be exceptions and new developments which cannot reasonably be allowed for. However, a good structure will be fair, flexible, and provide a clear understanding of the rights and obligations of all parties in all foreseeable circumstances. It is worth taking the time and trouble to get it right.

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