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Legal Issues Related to International Franchise Expansion

While the world offers U.S. franchisors a host of potential new markets, every international expansion must be undertaken with care. 

More U.S.-based franchisors have looked outside of their own country for growth opportunities as a result of the challenging U.S. economy of recent years.  International expansion can be extremely appealing because it offers the potential of large untapped markets. While the usual international markets, such as Canada and Mexico, remain appealing to U.S. franchisors looking to expand, there are now “hot” new markets all around the world, including such countries as Brazil, China, India and regions such as the Middle East, North Africa, South East Asia and the Pacific Rim. However, without careful research, planning and execution, international expansion can be a significant challenge for the franchisor that is not well prepared. Not only do costs rise with distance, but different legal systems, economies, cultures and languages can all create problems.

The Best Structure

The structure your franchise business chooses for any expansion into a new market will be an important factor in determining its eventual success. However, no single vehicle is ideal for all international expansion. Instead, the best structure will vary according to the characteristics of the target market, the nature of the individual franchise business and the resources available to the expanding franchisor. For instance, one must generally balance desired control with available resources. The fewer resources the franchisor has to invest, the more likely it will have to relinquish tight control of the system.

While a single-unit or direct franchising arrangement is most frequently used in domestic markets and provides a franchisor with maximum control over the system, it requires the most time, money and attention by the franchisor. For those reasons, it is not a common way for U.S. franchisors to expand to foreign markets, except perhaps to Canada, with its unique position in terms of geography, language, economy and legal system.

Master franchising is often used by many U.S. franchisors to expand to some of the more remote regions of the world. That is because the responsibility for developing the system in the new territory, including distribution networks and training programs, rests with the master franchisee, rather than the franchisor. As a result, this system requires fewer resources and significantly less capital investment by the franchisor. Additionally, the local master franchisee’s familiarity with his market allows the entire system to benefit from his knowledge and contacts. This helps ensure compliance with local laws. Despite many advantages, master franchise arrangements are not without drawbacks. Notably, the system’s success depends upon the abilities and resources of the master franchisee.

Area development arrangements are similar to direct franchising, except that the franchisee is permitted to develop multiple units across a designated territory. As a result, where the territory is small, such an arrangement may be very similar to direct franchising. Where the territory is large, and the developer sophisticated, it can resemble a master franchise as many of the functions of being a franchisor are delegated to the large developer to undertake in the territory.

Another alternative is an area representative arrangement, under which the franchisor grants rights to a local entity, allowing it to market, offer and perhaps even train and service franchisees on behalf of the franchisor. This is more an agency or broker arrangement than a franchise structure. However, like single-unit franchising, the franchisor often ends up dealing with unit franchisees directly despite the presence of the representative. Thus, it may not offer significant advantages over other structures.

Control and “Carrots” to Comply

Regardless of the structure selected, the ultimate control of a franchise system and a franchisee often involves enforcing the franchise agreement or registering an arbitral award in a court of law. Given this practical reality, the franchisor expanding internationally should have plans in place to do all it can to achieve control short of litigation or arbitration.

  • Development Rights. Often, franchisors rush to “cover the map” and sign franchisees for whole countries or regions. Exclusive rights conditioned on compliance with development obligations may not be viable, because the onus will be on the franchisor to establish a breach to remove or reduce the exclusivity. An alternative approach may be to provide the franchisee with incentives. For example, if the franchisee opens more than a certain number of complying outlets in a particular city or province within a specified period, the franchisee will have a first right of refusal for additional territory.
  • Threat of Suspension. While not always practical, suspension (or the threat of suspension) can be an effective tool for the franchisor. Non-compliance with the franchise agreement could trigger a right to remove a franchisee’s access to a central reservation system or to the franchise system’s website.  Alternatively, the right to open new stores to sub-franchise or the right to new products could be suspended until a default has been cured.
  • Periods of Exclusivity. Rather than burdening the franchisor to establish a breach before it can remove rights from a franchisee, the franchisor could grant a franchisee initial exclusivity for a limited period.  At the expiration of this period, the franchisor could grant the franchisee an additional exclusivity period, but only if the franchisee has complied with its development obligations, the franchise agreement and the system.
  • Two-Tier Royalty Structure. In some cases, a two-tier royalty structure may prove to be useful. The franchisor could provide that the franchisee pays a lower amount if it complies with its contractual obligations under the franchise agreement.

Other Considerations

While control and resources are perhaps the most important factors that must be addressed, other key considerations include the unique characteristics of the local market, local legal barriers, training, available human resources and the challenge of creating and maintaining local distribution networks. Too often franchisors are pulled into a new market because of interest expressed in that jurisdiction. While that is flattering, any expansion plan should consider the following with the assistance of U.S. and local advisors:

  • Trademark Protection. The ability to use and protect your principal trademark in another country cannot be assumed. Trademark protection in any target country needs to be undertaken at the earliest opportunity.
  • Corporate Structure and Taxes. Different structures have different tax implications. It is important to first determine whether the franchisor will be a U.S. entity or a local subsidiary or joint venture. Every structure will have tax implications, including non-resident withholding taxes on payments from foreign franchisees to a U.S. franchisor.
  • Franchise Laws and Other Regulations. Every year one or more countries introduce franchise legislation that likely affects the ability to offer and sell any one of a single unit, multi-unit or master franchise. Some countries do not have franchise specific laws, but other types of laws that affect distribution models, including franchises.
  • Relationship Issues. The right human resources are essential to the success of larger master franchise and area development arrangements. In western countries, the contract is most important to governing the relationship of the parties. In the developing world, the personal relationship can be just as or more important than the contract.
  • Resource Issues. Available resources often dictate what structure will be used. If resources are limited, a master franchise arrangement may be the only practical international expansion model available to the franchisor.

While the world offers U.S. franchisors a host of potential new markets, every international expansion must be undertaken with care.

International franchising often has more differences than franchising in the United States, and can itself vary greatly from country to country. While the potential remains, care and good planning are essential. ⎯

Larry Weinberg, CFE, is a partner with the law firm Cassels Brock & Blackwell LLP
in Toronto and Kendal Tyre is a partner with the law firm Nixon Peabody in Washington, D.C.  Weinberg, who is a member of the IFA 2013 Legal Symposium Task Force,
can be reached at 416-860-2987 or lweinberg@casselsbrock.com and Tyre can be reached at ktyre@nixonpeabody.com.

 

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