Franchises Eye International Expansion

Pepper suggested another creative solution to the money-repatriation problem. “We had about $60 million sitting in Europe. We lent it to U.S. franchisees who were having difficulty getting capital,” he said. “Rather than having that money sit there, we used it.”

Kevin Adler is associate editor of this newsletter.

With many U.S. franchise markets saturated and capital for new franchisees difficult to obtain, franchisors have increased their efforts to identify the most promising non-U.S. markets for growth. But international franchising carries numerous complications that must be addressed by a franchisor's business and legal strategy, said several experts at the 2011 International Franchise Expo. The Expo was sponsored by the International Franchise Association in Washington, DC, on April 1-3.

“Does the future of U.S. franchising lie outside the U.S.? One can make an argument that it does,” said Philip F. Zeidman, senior partner, DLA Piper LLP.

“As globalization has taken hold over the last 20 years, international growth has become a 'must' for any company seeking high rates of sustained future growth,” said David Pepper, senior vice president, Choice Hotels International, which has nearly 1,100 non-U.S. franchised units.

“I'm seeing a lot of major and mid-size franchised food brands concerned in this country about running out of space and steeper competition,” added William Edwards, CFE, founder of EGS LLC, a franchise consulting firm that specializes in international expansions. “They are looking to go global to fund their growth.”

In addition to the obvious attraction of new sources of franchise fees, royalties, and product sales, Edwards listed additional benefits of expanding a franchise outside the United States:

• Reduced dependence on the U.S. market. “We've just been through a downturn here that no one thought would ever happen,” he said.
• Opportunity to leverage existing intellectual property and resources. “This is extremely important, especially as the appetite for Western products grows,” he said.
• Building a global brand. “Being known internationally helps franchise sales ' [even back] in the U.S.,” he said.

How to Franchise Internationally

While the rewards of international franchising can be immense, Pepper warned that “you have to throw out everything you know about franchising in the U.S. ' As anyone who has tried to expand their brand internationally can attest, it's easier said than done.”

Success begins with a well-devised, long-term business plan that targets a few highly promising markets. “If you're looking for short-term revenue and fees, don't go into international franchising,” said Edwards. “Things will go badly, and you'll wind up with lawyers' fees greater than your licensing revenue.”

Edwards counsels franchisors to first look at the economic growth of potential entry countries. He suggested that an annual growth rate of at least 4% is a good target. “This has become even more important in the last two years,” he said. “Low-growth countries don't have investment capital. And remember, from their perspective, you are a new business, even if you are well-established in the U.S.”

However, Pepper countered that European countries with large, mature, slow-growth economies can hold a great deal of promise, too. “We are converting unbranded hotels throughout Europe, even though economic growth is weak,” he said. The European markets have many experienced hotel operators and strongly established tourist and business trade, whereas strong partners in emerging countries can be harder to find.

Regardless of growth rates, size matters, too. Choice targets countries in which it can foresee having at least 50 hotels because of the resources it must invest to get started in a new country.

With promising markets identified, then a franchisor should consider a series of other issues: a prospect country's political stability, rule of law, and protection of intellectual property, among other factors. “How easy will it be for you to maintain control of your brand, how easy will it be to get it back if you lose it?” Edwards asked.

Finally, a franchisor needs to assess whether it can achieve an acceptable return on investment for itself and its franchisees. It's essential to attracting top-notch licensees, said Edwards and Zeidman, which they agreed is the most critical factor to international success. “Prepare a pro forma business plan, and make sure it works for you and your franchisee,” said Edwards. “You will likely be dealing with wealthy families or investors who are sophisticated. These people have experience operating real businesses, and they will want to see profit-and-loss statements about your franchisees and other information.”

Zeidman emphasized the importance of keeping franchisees' financial prospects in mind. “When a client comes to me and only has a pro forma for itself, not for the licensee, I will say to him that maybe we should meet at another time,” said Zeidman. “If the guy at the 'retail level,' the licensee and the local franchisees, can't make a good living, then don't franchise.”

Legal Issues

When entering a new country, franchisors will encounter uncertainty, and the panelists said that expert advice is necessary. “You will need a lawyer and a tax accountant,” said Pepper. “You can't afford to set up your business incorrectly. Whether it's protecting your trademark or getting your profits out of the country, you need expert advice.”

“It's not difficult to come into the U.S. as a franchisor. You are truly treated the same as a U.S. franchisor,” said Zeidman. “The U.S. is a big country, and it's expensive to start a business here, and you will have to report under GAAP. But you are not discriminated against. There was significant discrimination elsewhere in the world, though it has declined in recent years. Still, you might have to buy a percentage of your supplies from local sources, or a certain percentage of franchisees might have to be from a disadvantaged class, for example.”

However, Zeidman emphasized that “the legal tail should not wag the business dog” in making a decision about which markets to enter. “The deal needs to be a factor of the economics,” he said.

Pre-sale disclosure laws in many countries will be familiar to U.S. franchisors, and Zeidman recommended that a franchisor use its U.S. Franchise Disclosure Document as the baseline from which to develop disclosures applicable in other countries. “We see a desire, especially in Asia, to regularize commercial laws and to show they have laws that protect foreign investors,” said Zeidman. “In general, the franchise laws are not comprehensive compared to U.S. franchise laws, but they pick up pieces of them.”

Some franchisors choose to make pre-sale disclosures even in countries where it is not required. “There's no consensus in the legal profession on whether this is a good idea,” said Zeidman. “The franchisor is exposing itself to liability if the disclosure is seen as an implicit promise, but it does protect them against a rogue salesman. Also, it can help the franchisor exert more control.”

Some countries also have franchise-relationship laws, which are not present in the United States. DLA Piper regularly surveys franchise laws worldwide, and Zeidman said that relationship laws exist in four Canadian provinces, several countries in the European Union and the former Soviet Union, and in Asia.

Stronger laws are a double-edged sword, said Edwards. On the one hand, they might limit a franchisor's control over franchisees. On the other hand, they can provide protection against local competitors and a framework for resolving disputes. “Watch out for whether the laws favor domestic or foreign companies,” he added. “Vietnam's laws are very balanced, but those in Korea and Russia aren't.”

Franchisors also need to decide which legal structure to use for their franchise arrangement abroad: direct investment, area license, master franchise, etc. A direct investment, such as McDonald's has done, will allow for maximum control of the brand and system, but it will require the greatest investment. An area license, in which a licensee/franchisee is allowed to open a certain number of units in a territory by using the licensee's funds, can allow for quick expansion with a more moderate investment and oversight by a franchisor. Area licenses are popular with quick-service restaurant chains, which are the most commonly franchised brands. A master franchise or regional license will give a licensee the right to sub-franchise ' that is, to expand without using the licensee's capital exclusively. Thus, a master franchise can support even more rapid growth than an area license, but the franchisor cedes even more control.

“I'm wary of master franchises,” declared Pepper. “Our master franchise in Japan has been terrific, and we have opened 54 hotels. But the master franchise in India was a disaster, and we bought out the franchisee. Choice Hotels does not do them anymore.”

A Few War Stories

Finally, the panelists shared mistakes that they or their clients had made. Edwards described one franchisor that allowed a licensee to do the paperwork to obtain the registration of its trademark with the European Union. That licensee trademarked the brand in its own name and then offered to license it back to the franchisor for $800,000 per year. “The lesson is to get your trademarks ' all of them ' in advance. Same with your domain names,” Edwards said.

Pepper mentioned that Choice Hotels selected a United Kingdom master franchise partner that was under-capitalized and could not maintain standards at its hotels. Choice eventually bought out the franchisee and started over. “At the peak, the franchise had 90 units. Today, we have only 39, but they make more money than when we had 90,” he said. “Make sure your franchisee has the capacity to do what needs to be done.”

Zeidman said that franchisors sometimes ignore the matter of being able to repatriate funds back to the United States from profitable ventures. “This is not as much a problem as it was even a few years ago, but you don't want your money locked up,” he said. “There are ways to do it, and you just have to follow the process [established in that country]. For example, in some countries, money earned through a technology license can be repatriated more easily than money from a trademark license, so maybe you change the terms of the contract to reflect the technology.”

Pepper suggested another creative solution to the money-repatriation problem. “We had about $60 million sitting in Europe. We lent it to U.S. franchisees who were having difficulty getting capital,” he said. “Rather than having that money sit there, we used it.”

Kevin Adler is associate editor of this newsletter.