Master Franchising - Global Opportunities

We have all read about the recent growth in franchising and the very impressive statistics which have come out of the 2001 survey. However, little has been said about master franchising and just what an important role it plays in the development and growth of franchising in New Zealand - and the potential it offers for New Zealand companies overseas.

Of course, master franchising has been around for some time as a concept, but just what does it mean?

A master franchisee is a person or company awarded by the franchisor the right and obligation to open and operate a number of locations in a defined area - a region or, often, a whole country. The master franchisee also has the right to offer and sell franchises to other people looking to become franchisees of the system. That is, the master franchisee has the right either to open its own outlets, or to sub-franchise, or to do both.

In most cases the emphasis is on sub-franchising. Where this is to happen, the master franchisee will often be expected to establish one or more of its own outlets first as pilot operations - making sure both that they understand how the franchise system operates in practice, and that they have fine-tuned the franchise to its new market before sub-franchising.

Because of this, the master franchisee is often referred to instead as the sub-franchisor. In either case, the master franchise agreement is the key legal document which establishes the relationship between the parties.

How To Expand

If you have a successful franchise system, one of the things which you will continually be doing is looking at ways of expanding it. Once you have the market in New Zealand fully covered, this means looking overseas. A number of options are available to the franchisor with international expansion on his or her mind.

By far the most common is the master franchise arrangement, by which a local person or company is appointed in the role of sub-franchisor for that country. Alternatively, some franchisors expand by way of direct franchising, which involves the franchisor entering into an agreement with each individual franchisee in the target country. In this situation, the franchisor will have to provide back-up and continuing support, and this can sometimes put an added strain on a franchisor based in another country. Another way is to have a company-owned operation which the franchisor manages and runs. In order to do this, the company needs to have both the financial resources and the manpower to establish and sustain such an operation - few franchise companies possess either.

A more popular method is a joint venture arrangement. The franchisor which enters into a joint venture may find that there are many potential problems - the key one being the need to identify and do a deal with the right person. The franchisor will have to negotiate what share it wishes to take up and decide how it will finance its contribution.

I have mentioned four possible ways of expanding, but by far the most common and most successful is master franchising.

Preparing To Franchise Internationally

Many franchisors head overseas after an unsolicited query gets their adrenaline pumping. Others pursue international markets out of ego. A few are lured by the idea that going international is a quick fix for domestic cash flow problems, and some others just like the appeal of international travel. None of these is a good reason for making a business decision which will take up a good deal of financial and human resources - let alone business focus - for a few years at least.

Smart franchisors head overseas only after intensively planning for international expansion. Before entertaining international proposals, franchisors should have a strong and profitable base at home. Internally, executive management must be committed to being around for the long haul - too many international programmes are severely damaged when franchisors pull back resources because early results fall short of expectations.

Long term commitment to international franchising includes shifting or adding staff who focus solely on the foreign jurisdiction. It is not unusual to have field staff, marketing support, product sourcing, operations and training staff all focused on international expansion and being supported by the rest of the organisation. Franchisors also need to have surplus capital resources for providing support services, modifying operations and making on-site visits.

Training also has to be adapted to the overseas market. If your master franchisees will be sub-franchising, you need to be prepared to train them on how to be franchisors at home. After all, they will be performing many of the same tasks that you do as a franchisor including franchisee selection, training and support. They will certainly need training in the areas of recruiting and selecting franchisees, administrative functions, site selection, marketing and advertising, local personnel training, enforcing standards and discipline procedures and all those other services which they will provide in the market.

Choosing The Right Person

This is probably the number one issue in franchising, and it applies no less to choosing a master franchisee. Careful research, checking, skill and a bit of good luck is involved in selecting the right person or company. The franchisor really needs to be like a psychologist and delve into the inner mind to ensure that the person will follow the system rules while being capable of exploiting market opportunities, is trustworthy, capable of being trained, is capable of training others and has a real desire and hunger both to be part of the system and to be financially successful. That desire must be very strong, and many a franchisor has made the mistake of appointing a well-qualified and financially independent person who does not have the passion and zeal for wanting to expand and be successful. There is no room for complacency in the master franchise arrangement and both parties have to be committed.

Master Franchise Agreement

This is the key legal document - it will be tough, and it has to favour the master franchisor in order to ensure the system is properly utilised and protected. Having said that, what are the key issues for the master franchisor to consider? As I have already said, I think that the major issue is in identifying and selecting the right person or company to be the master franchisee. However, there is also the need to have a strong home base to sustain the demands which will be made upon the master franchisor - experience shows it will alwaystake more people and cost more money than expected.

In order to protect the system and the brand the master franchise agreement must include provisions for the following:

• Intellectual Property

  This will always be owned by the master franchisor and can include the franchise system, registered trade marks, patents, trade secrets and other forms of confidential information.

• Governing Law

  Most master franchisors will want the governing law to be where the master franchisor operates and lives. Therefore, a US master franchisor will want the governing law to be in the relevant state of the US where the franchisor resides. While this may seem sensible, from a practical and enforcement point of view it can be far from cost-effective. If the master franchisee in New Zealand defaults and steps have to be taken it is far better, in my opinion, for the governing law to be the laws of New Zealand.

• Territorial Restrictions

  It is important for the grant of master franchise to include a clear definition of the territory. If this is a whole country like New Zealand then it is easy. The territory will be exclusive and the master franchisee will have the right, after setting up a successful pilot operation, to appoint franchisees around New Zealand. The territorial matter can become more difficult when there is a larger country - for example, Australia. What commonly happens in Australia is for separate master franchisees to be appointed in each state or certainly in Queensland, New South Wales, Victoria and Western Australia.

• Upfront Fee

  The master franchisor will require an upfront fee paid by the master franchisee. Quite often, a deposit is paid initially and then the balance of the upfront fee is paid in full when the master franchise agreement has been executed. When acting for a master franchisee, I always like some of the upfront fee held back until the master franchisee has successfully developed and operated the pilot operation and is about to appoint its first franchisee. Only then should the balance of the upfront fee be paid. Sometimes, you can negotiate further and allow for the full upfront fee to be paid only when the master franchisee has, say, appointed the sixth franchisee.

• Royalty/Service Fees

  The master franchisor will require the master franchisee to pay royalties, usually based on gross turnover. When the master franchisee appoints new franchisees and those franchisees sign franchise agreements between the master franchisee and each franchisee, royalties are paid by each franchisee to the master franchisee. Normally, the master franchise agreement will provide for part of the royalty paid by each franchisee to be paid to the master franchisor. For example, if a 6% royalty on gross sales is payable by a franchisee to the master franchisee then one-sixth of that 6% (ie, 1%) may have to be paid by the master franchisee to the master franchisor.

• Products

  If the supply of products is a crucial part of the franchise arrangement then the master franchise agreement will have to handle this aspect. If the master franchisor is going to make a profit on the supply of products to the master franchisee, this must be allowed for in calculating any subsequent royalty payments. Further, the supply of products by the master franchisee to each franchisee is very important and the logistics must be clearly thought through.

• Initial Term and Right of Renewal

  I have seen some master franchise agreements with a term for perpetuity. This is not a sensible arrangement in my opinion, as nothing lasts forever. Most agreements are for a fixed period of years with perhaps a right of renewal. For example, an initial master franchise agreement could be for 10 years with a right of renewal of 10 years, so care must be taken to ensure that this aspect works for both parties.

• Taxation Aspects

  If a New Zealand person or company takes a master franchise from (say) the US, then both parties must understand the taxation implications. For example, if any money has to be paid from New Zealand to the US the New Zealand Inland Revenue requires a 10% withholding tax to be deducted. This is in the nature of a non-resident withholding tax since the US franchisor is deemed to be a non-resident. The US franchisor may want to receive the full amount, which means that the extra amount payable has to be grossed up so the extra is an additional cost for the New Zealand master franchisee. When royalty income is repatriated from New Zealand to the US, non-resident withholding tax has to be deducted. There is a double taxation treaty between New Zealand and the US (as with many other countries) which means that the US entity can claim a tax credit and does not have to pay double taxation.
  
  It is important for the parties to obtain expert taxation advice from local tax experts so that there is no misunderstanding of the taxation position for otherwise the result could be disastrous.

• Dispute Resolution

  I have noticed that some foreign agreements do not contain dispute resolution or alternative dispute resolution clauses where mediation is the favoured option. In Australia, dispute resolution is mandatory under its Code of Practice and mediation is used extensively. In New Zealand, mediation is widely accepted and used, and I am sure that the same will apply in many overseas jurisdictions. Mediation has the advantage of being quick, confidential and cost effective. Some agreements provide for arbitration as the only means of resolving a dispute. Although mediation is preferred, arbitration is also widely used. Great care must be taken in drafting the appropriate dispute resolution clause so that the implementation is exactly as contemplated by the parties.

Other Issues

The above points relate to the master franchise agreement. However, consideration of the following points is important:

(a) Financial Aspects

The master franchisee must make its own financial calculations as to whether the proposition will be financially rewarding. A large investment of cash will be needed, often requiring additional borrowing, and the master franchisee must be confident that the funds will be secure and there will be a return on capital invested. It is important to have expert accounting and taxation advice to ensure that the budgets and cash flow forecasts are properly done.

(b) Market Research

It is important for the master franchisor to research the country and the local conditions, and to have confidence that the appointment of a master franchisee in the overseas jurisdiction will work. In turn, the master franchisee must undertake its own independent research and be confident not just that the system will be successful, but that the market is big enough to develop the system profitably.

(c) Training

Training is never to be underestimated. I often find that training is not comprehensive enough both for the master franchisee and for the ongoing training of each franchisee. The quality of both initial and ongoing training is crucial to the success of the operation, and this aspect must be fully investigated by the master franchisee.

(d) The Brand

The power of the brand is a direct influence on how successful the franchise will be, and great care must be taken by a potential master franchisee to ensure that the master franchisor is totally committed to exploiting the brand in the overseas jurisdiction. Some franchisors are unwilling to spend money to protect and develop their own brand adequately in overseas jurisdictions, and this is bad. The local master franchisee must understand the brand values and must be aware of the master franchisor's plans to market and develop the brand in the local market.

Master franchising is a very complex topic which requires careful thought and consideration by both parties. Properly done, it is a fantastic way to expand a brand and a system in an overseas country. However, at the end of the day, the success of the operation will always depend upon the people involved on all sides. After all, franchising is about relationships and the relationship between master franchisor and master franchisee is of paramount importance to the success of the franchise operation internationally.

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