Options for Growing a Franchise System

Growth is at the very essence of franchising.  It is a more efficient method of distributing products or services than other methods because of its ability to quickly grow the business throughout broader geographical territories. While growth will fuel the financial success of a franchise system, it can also lead to its demise.  Many failed franchises reveal that a failure caused by mistakes made in expansion, are readily foreseeable and avoidable.

Timing and speed

Timing is a constant issue in franchising. Starting a franchise program before the business concept has been adequately developed can be a mistake from which the franchisor never recovers. Expanding too quickly can stretch financial and human resources to the extent a franchisor cannot adequately manage what it sells. Choosing a complex expansion vehicle before the franchisor has learned what is needed to effectively franchise the particular business can ultimately bring down the entire business.

The franchisor must grow its head office infrastructure in a manner that keeps pace with the expansion of the franchise system and add new capabilities as required. As the number of franchisees increases, the communications capability within the system must grow. After a period of rapid growth, most franchise systems will benefit from a period of consolidation and intentional restructuring to ready itself for the next phase of expansion.

Expansion vehicles

Franchisors can grow their systems in a number of ways, each of which carries with it its own set of advantages and disadvantages.

Direct franchising

Granting franchises directly to franchisees will, often, be the first expansion method a franchisor will choose. In direct franchising, the franchisor shoulders the entire burden of selling franchises and supporting franchisees. As a franchisor looks to expand in more distant markets, other expansion vehicles become more appealing and, at times, essential.

Development arrangements

Multi-unit franchises, area development arrangements and territorial development arrangements all refer to situations where a single franchisee is given the right to open two or more franchises in a given territory. Sometimes franchisees acquire multiple units by operation of rights of first refusal, originally granted to the franchisee for additional units within areas contiguous to the franchisee’s original territory.  However, one school of thought considers the granting of rights of first refusal dangerous, and should not be done until the franchisee proves themselves to be capable and trustworthy.  Otherwise, the franchisor is permitting the unit franchisee to become a multi-unit franchisee solely because another party is interested in purchasing a franchise.

A cautious approach should always be taken when considering granting to one franchisee the right to open multiple units in a system. Area or territorial development arrangements will be most advantageous where the area or territorial franchisee has deep knowledge and extensive connections in a market more distant from the franchisor’s current markets.

Master franchising

When done properly, master franchising can be an effective means of expanding a franchise network, particularly for foreign markets. Nevertheless, it remains one of the least understood and most poorly implemented expansion strategies in franchising.

The problems resulting from expanding too quickly and too soon will be made worse and the consequences will be more serious when master franchising is chosen as an expansion vehicle too early in the franchise system’s development.

Choosing a master franchisee

While choosing the best unit franchisees is challenging, it often pales in comparison to the difficulties encountered in appointing good master franchisees. Too often, a candidate is chosen based on prior business success, without regard to how they might ‘fit’ with the franchisor’s goals, style and philosophy.

On the other hand, fatal errors have been made in selecting master franchisees who do not have sufficient financial resources to weather the initial difficulties encountered in establishing the franchise system in the new territory. Often, the master franchisee cannot perform at the same productive and efficient level as the franchisor, and the franchisor should manage its expectations of a master franchisee.

The territory

Most master franchising arrangements provide that the rights are granted, often on an exclusive basis, for a specific territory. Understandably, master franchisees frequently attempt to negotiate the broadest possible territorial rights. However, one of the most common mistakes made by franchisors is to grant exclusive rights to territories which are far too large. The franchisor will most often have a stronger system, if territories can be kept as small as possible.

Having more master franchisees in one country or region allows the franchisor more maneuvering room, if a master franchisee fails or performs inadequately. One of the other master franchisees in the area can either temporarily or permanently fill the void. The franchisor can exert more control or have more influence over the performance and conduct of several less-powerful master franchisees rather than one very powerful master franchisee.

However, if a franchisor still wants to deal with only one master franchisee in a territory, careful drafting of the master franchise agreement can help to limit potential problems. Also, the franchisor may impose performance quotas, which will allow them to reduce the size of the territory, if performance is not up to par in the future.

The term

Another common mistake is granting indefinite contract terms or agreements that run too long. With a shorter initial term, plus more frequent and shorter renewal terms, the franchisor can more easily control the actions of the master franchisee and the quality of the territory’s development. There should be clear performance criteria and thresholds for the master franchisee to renew, maintain exclusivity and independence, and extend territorial rights.

Initial franchise fees for territorial rights

One of the most difficult numbers to ascertain is the front-end franchise fee or territorial rights fee for the master franchise rights. It is best to relate the fee to the potential for profit and return on capital for both parties.

From the franchisor’s point of view, the most common mistake is setting the fee too low.  Allocating a minimum amount and calculating the final fee based on the master franchisee’s performance can alleviate this problem. Master franchisees often pay too much for such fees up front, which can drain the master franchisee of capital during the early stages of development in the territory. From the master franchisee’s point of view, the best approach is to fix the amount of the front fee, but have payments dependent on the number of franchises opened.

Dividing up the spoils and job allocations

The most poorly handled issue in master franchising is the division of the front-end franchisee fees and continuing royalty fees from unit franchises between the franchisor and the master franchisee. It is common for the franchisor to base the decision on the allocation of these fees on the anticipated return from the franchisees in the territory, without considering how the master franchisee will finance the necessary development and support services for the unit franchisees.

Selection of franchisees and locations

Often, one of the franchisor’s principal motivations in choosing master franchising as a means of expansion is to pass on to the master franchisee the responsibility of finding quality franchisees and locations within the territory. However, it is a common mistake for the franchisor to abdicate the responsibility of final approval for franchisees and locations before the master franchisee has been proven capable of making these judgment calls. The franchisor should contractually retain the right of final approval for franchisee and location selection, and exercise those rights in the early years. If the master franchisee ends up with the de facto right of final approval, the franchisor will want to be able to step in and assume those responsibilities if circumstances change.

Joint venture franchising

Joint venture franchising occurs when the franchisor takes an equity position or a partnership role in the franchisee entity. Joint venture franchising can be used with virtually any franchise vehicle and has two distinct levels of contractual relationship. At the franchisee level, the franchisor will want to have a shareholders agreement, partnership agreement or joint venture agreement. Additionally, the franchisor will want to have in place its customary franchise documentation with the franchisee entity in which it has an interest.

Sometimes, joint venture franchising is used as a transition to the full implementation of one or another franchising vehicle, as the franchisee assumes full ownership of the franchisee entity.

Acquisition

The acquisition of a competitive business can be one of the quickest ways to expand a franchise system. Such acquisitions raise issues of territorial exclusivity and encroachment, rebranding, changes in business culture and management transition. The franchise issues are laid on top of the usual and customary issues in any business acquisition.

Conclusion

Franchisors must be careful in their expansion choices. Expanding too quickly, without careful planning, can lead to long-standing issues with its franchisees, and without sufficient control over its system, for the long haul.

Edward (Ned) Levitt is a senior partner of Dickinson Wright LLP, Toronto, Canada. He served as General Counsel to the Canadian Franchise Association from 2000 to 2007 and, as a member of the Ontario Franchise Sector Working Team, was instrumental in the creation of Ontario’s franchise legislation.  Among his many publications is Canadian Franchise Legislation published by Butterworths/LexisNexis.  Mr. Levitt can be reached at 416-646-3842 or [email protected].

Richard Schuett is an associate of Dickinson Wright LLP, Toronto, Canada. His practice primarily focuses on franchising, commercial transactions, and commercial leasing. Mr. Schuett can be reached at 416-646-6879 or [email protected].