Who Goes Where?

Many franchises are granted with ‘exclusive territories’, promising that the franchisor will not give another franchisee the right to operate, market or otherwise seek business within that territory. It’s an attractive proposition for a franchise buyer, stopping them competing directly with other franchisees and helping to create positive and supportive relationships within the network. You are more likely to help one another if you know that they won’t be trying to steal your customers.

But such exclusive territories aren’t always practical or even desirable. For example, 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 it. For example, if a franchisee can’t handle all the business available in an area with a growing population, it’s just leaving the door open for competitors to move in.

The setting and operation of territories is one of the more complicated components within franchise systems, and can potentially be a contentious issue. A franchisee’s attachment to his or her territory once granted is understandable, but may be emotional rather than practical. The right structure can help avoid these headaches ­– the wrong structure can lead to ongoing discord and lack of growth.

For these reasons, territories are one of several key franchise system elements (like fees) that need to be configured with the utmost care in the first place. It’s better – and a lot easier –  to get it right at the start than try to change things later. And it also helps if franchisees understand why a franchise system has chosen to use a particular structure. Here’s a guide.

Which option is best for you?

There are many possible territory options to choose from. 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 both franchisee and franchisor (and they must work for both for the  franchise system to be sustainable long-term).

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 involves 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 and examine their differing advantages, disadvantages and applications. We also look at options available to cater for the future growth of, or changes to, the marketplace. It is important to note that this is not an exhaustive list; there are further nuanced territory structures available to suit individual industries and circumstances.

No Territory

Let’s start with the most open one – no territories at all. 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, and is sometimes referred to as an open territory structure.

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 anyone and, moreover, can do some or all of the work from home (thereby 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 where franchisees, instead of being licensed a territory, are licensed the right to service a specified set of contracts (ie. customers). Examples of these include many home service businesses, where the franchisor or area/master franchisees develop most 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 franchisor or area/master franchisee, or by the franchisee securing more contracts themselves (if allowed). Sometimes, contracts sourced by franchisees themselves can be ‘sold’ at a pre-agreed rate to another franchisee or back to the area/master 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.

b) For retail businesses

It’s 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.

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 market and 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.

Regional territories can also be beneficial in densely-populated metro areas where there is simultaneously a need for multiple franchisees and it is difficult to define discrete marketing and/or fully exclusive territories.  

The difficulty with this structure can come when franchisees are naturally concerned about time and value associated with prospecting for the same potential customer. Sometimes this is not a major issue, but other times it can be. One mitigating solution is for franchisors to operate an ‘interest’ or ‘dibs’ system where franchisees register their claim to a prospect. However, the practicality of such a register depends on the situation.  

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.

It is hard to avoid situations where relatives, customers moving locations, or customers with 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 franchisee from the one with whom they have built up a relationship. The franchise system needs to be able to cope with such eventualities.

An example of this could be an electrical business that has a defined ‘marketing territory’ whereby a particular franchisee must actively promote their service within but not outside their territory, but may be allowed to service out-of-territory customers who request their assistance. Similarly, other franchisees may not actively promote within that franchisee’s territory, but may service customers who have requested their help directly.

Such structures can have many further nuances, like a need to provide the customer with the local franchisee’s details (as a potentially more convenient option), details of commissions payable, limits on out-of-territory work, and so on.

At the same time, a non-exclusive territory might also allow for the franchisor to service large commercial or national customers, with specifics identified as part of the territory design.  

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 will only have external competition. It can also be advantageous where it is valuable for the customer and product/service delivered for the franchisee to be ‘local.’ It is also 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. 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 by competitors.

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 mentioned above 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) Other

Other options are also possible, including providing franchisees with potential sub-franchising rights, but are not particularly practicable for most business models and the New Zealand market.

Franchisors will also often have rights to alter territories, based on a number of factors, such as franchisee performance levels and territory demographic changes.

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.

Territory size

Territory structure and protocols are one thing, territory size is another. When designing territories, the potential business to be gained from each territory needs to be taken into account. There should be an important connection with unit-level franchisee feasibility modelling – in particular, a clear understanding of the level of business needed for franchisee success and how different territory sizes can impact the level of franchisee investment and returns. Another consideration is the practical level of complexity when it comes to franchisee management.

When defining territory size, franchisors need to consider the criteria most relevant to their particular business model. What’s appropriate for, say, a home service business can be quite different from what suits a scaffolding business. There is an exhaustive array of variables that might be considered, such as: population size, number of dwellings, growth of an area, number and size of schools, school deciles, number of businesses/commercial premises, numbers of businesses within certain industry types, level of income/economic strata, road traffic, foot traffic, local competition, proximity to other key influencers or sources of business, planned roading changes or shopping complexes, marketing media and relevant areas used to attract/secure business.

Defining 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, if both sides of a particular road are included).

Depending on the territory structure chosen, there could be further markings. 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.

Again, many further nuances are possible and it depends on the territory and operating structure employed.

E-commerce implications

E-commerce is another important marketing and/or distribution channel for many franchising companies. As such, the e-commerce commercial structure involving franchisor and franchisees needs to be very clear, including what role each plays (or not), and who benefits. In turn, the specifics of how e-commerce is handled need to be reflected within the particular franchise territory structure.

Clearly, the key to success with territories and the internet is to take a fair and long-term approach. As technology evolves and customer behaviour evolves, there can be a need for both franchisor and franchisee business models to change. This ultimately requires both franchisor and franchisees to work together to ensure the brand’s total offering is not outmoded.

Recent legislation and territories

The new Cartel Amendments to the Commerce Act in 2017 should be considered when finalising a franchise territory structure (see page 58). That is because franchise territory structures and protocols might be regarded as cartel clauses relating to market allocation –even though there may be a genuine collaborative activity and any clauses are specifically designed to help optimise customer access to products/services, franchisee and franchisor efficiencies, brand viability and competitiveness, and so on.  

Similarly, changes to the Fair Trading Act involving Unfair Contract Terms rules should also be considered in relation to franchise territories – particularly to franchisor-initiated established territory changes. Good legal advice will be essential when finalising or changing a territory structure.  

Conclusion

If you are designing a territory structure, you need to determine which structure has the most (and strongest) advantages and the least (and least important) disadvantages for your particular business. You also need to work out how certain systems or checks can minimise or eliminate the impact of any potential disadvantages for both franchisor and franchisees.

If you are buying a franchise, take the time right from the start to understand what the territory structure allows you to do, what it stops you doing, and the reasons why it has been designed that way.

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.

This article appears in full in Franchise New Zealand magazine (Year 31 Issue 3).

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