Incoterms_® and Commercial Contracts

2.1 WHY GO INTERNATIONAL THROUGH FRANCHISING?

2.1.1 The reasons for international expansion

Building an international network can bring great rewards, not only in terms of profits made, but also by increasing awareness of the brand. International development most often follows national success of the network (e.g. McDonald’s). Some companies have nevertheless adopted the franchising model for their international expansion, although they do not offer franchises in their home market (e.g. Starbucks, Laura Ashley). Franchising is commonly seen as a great export business model, for several reasons.

The development of the network within a large Territory can be a genuine asset to the success of the brand’s expansion since the local Franchisee will be able to adapt (or to assist the Franchisor to adapt) the franchise concept to suit particular customs within the target market or local culture. The benefits of international franchising can be summed up as follows: a Franchisee is aware of local legal, cultural and business practices;

• capital and human resources are gathered at the Franchisee and the subcontractors’ levels;
• a Franchisee is motivated by its investment and opportunity to succeed;
• the risk of loss is shared between the different levels of the network, given that a Master Franchisee undertakes more responsibility for local legal compliance;
• a Master Franchisee’s compensation is based upon revenues generated from Sub-Franchisees in the Territory;
• a Master Franchisee pays the Franchisor for the rights granted; and
• a Master Franchisee has contractual control over Sub-Franchisees in the Territory and enforcement of agreements.

International franchising is a real export asset as it allows growth and support using local companies’ capital. Indeed, a Master Franchisee provides not only local market and culture knowledge, but also capital, management and support to Sub-Franchisees; and fees to the Franchisor. As for the Sub-Franchisees, they provide capital at the Unit level, local management and human resources, micro market knowledge and fees to the Master Franchisee and Franchisor.

For all these reasons, Franchisors may well be interested in expanding abroad. Nevertheless, international expansion implies that they have well
[Page21:]
developed and defined their scheme in their home market to be in a position to adapt the concept to other markets, as will be further explained in this Chapter.

2.1.2 The risks of international expansion

Achieving international expansion requires a thorough analysis of the operating business model and the target market and legislation of the target countries, given the risks related to such an expansion, such as:

• less Franchisor control and involvement in the development of the network (which is undertaken by the Master Franchisee);
• the potential increased costs resulting from the adaptation of the concept in the target Territory;
• the risk of a serious breach of the functioning of the network due to the possible double function of the Master Franchisee, who may function as a Franchisee and as a Franchisor, depending on the provisions of the MFA;
• enforcement of agreements can be difficult and expensive under certain laws; and
• the consequences of the termination of the MFA on any SFAs.

Therefore, it is necessary to review the existing contractual documentation to assess the suitability of the national system, its strengths and potential flaws, for the markets under consideration.

Moreover, many other factors also need to be taken into consideration, such as cultural and legal differences, the growth potential of the target market and the major differences between national and international franchising, which can affect international success (the scope of the hosting target market, translation, transportation, real estate, equipment and financing of the franchise). The value of the services or products should be evaluated according to the characteristics of the target markets and to the local competitors. In other words, it is necessary to evaluate the impact of distance, language, culture and economy of each market to assess competition.

The determination of the target countries can be done through an international expansion feasibility study, once the resources and budget have been assessed (international trademark, and other IP registrations; training and manuals; market research; travel and expense; international legal advice, financing; new entity formation). A feasibility study should also deal with IP protection, tax research, restriction on conducting business and efficiency of the judicial system. As above, Franchisors often start the expansion of their network in neighboring countries or in countries in which cultural or legal differences are not significant.

Once the suitability of the Franchise has been duly assured and the international Franchise development business plan developed, possibly with necessary adaptation of the Know-how, the intellectual property rights must be secured. The Franchisors then will be able to determine the nature of the implementation, propose the signature of the distribution agreement and create the pre-sale documentation and the promotional materials.

[Page22:]

2.2 WHEN TO GO INTERNATIONAL?

Timing is crucial in any business investment, including international franchising. The decision may be a market-driven, rather than legal, one. The Franchisor should understand well its business model in the home market. It is not necessary that the home market already be saturated before going international, but the Franchisor should have a thorough understanding of its success factors, sales process, strategy, logistics and any factor of importance for its System’s growth. As many factors will change when entering a new country, the Franchisor should have understood well ahead which factors to consider in the preparation of an international franchise strategy. This will usually not be the case until the national franchise network has reached a size that allows the Franchisor to derive enough experience from the existing operations.

Questions for a Franchisor to consider include: Why would someone buy in another country? Would the System be accepted in another country and can it be adapted? What are possible new success factors in the target location? Is there potential to multiply existing success factors in a new country?

2.2.1 Steps Franchisor’s headquarters should take regarding cross-border control, compliance and enforcement⁹

Granting and supporting Franchisees in other countries requires the total support of the Franchisor’s organization. If senior management or any of the Franchisor’s functional divisions are not fully behind the expansion to another country, support of the Master Franchisee and Sub-Franchisees or the Area Developer will suffer and the brand will not develop to its full potential. Worse yet, the brand may be so damaged that the relationship must be terminated and the Franchisor will find entry into that market at a later date either much more difficult or impossible.

Franchisors and Franchisees both want to be successful and there is clearly a lot at stake, as international Franchise Agreements can be difficult and costly to unwind. To determine if the Franchisor’s organization is ready for an international transaction, a good first step is to identify the critical factors that drive success in the Franchisor’s home market. The same factors are likely to be at the foundation of the franchise System’s success in international markets as well. This “recipe for success” is what Franchisees are expecting to receive, and it likely includes a combination of ingredients, such as brand equity built over time, a set of core competencies supported by unique or proprietary assets, scale, etc. Only when the Franchisor has a clear definition of these “key factors for success” for its brand can the Franchisor determine how it will replicate those in other markets. Some factors such as “brand equity” or “scale” may be difficult to replicate at first and Franchisors will have understand what they can do to compensate for their absence.

[Page23:]

A second important step is to define the roles and responsibilities of the Franchisor and Franchisee for each of the core processes which support the business (e.g. store development, brand development, product innovation, quality assurance, sourcing and distribution). The Franchise Agreement should address some of these questions, but may not cover all of them. A lot more detail will need to be provided to operationalize the relationship fully. To leverage the strengths of the Franchisor, Master Franchisees and Sub-Franchisees or Area Developer, the Franchisor will need to map these core processes and define who does what, when, and with what information.

Finally, the Franchisor needs to take a hard look at its organization and make sure it has the resources in place to support its Franchisees and fulfill its part of the bargain. Leveraging its domestic organization and sharing resources is a good idea in some areas, but not in others. Dedicated international resources with be needed and gaps will need to be filled to ensure success. The path lies in finding the right balance, between focus, skill set, and synergies within and between functions. Flexibility will be important as the Franchisor’s international organization will evolve over time as its international business grows.

WHERE TO GO INTERNATIONAL?

2.3.1 Selection of the target market

There is no single answer to the question as to which countries Franchisors should target for international expansion since the solution will depend on multiple factors such as: market size; market growth; level of competition; purchasing power; political, economic, legal, tax, IP, linguistic and cultural differences; logistics; the possibility of finding an appropriate Franchisee; and geographic distances. Indeed, the identification of the Franchisor’s optimal country to expand to depends notably on:

• the Franchisor’s knowledge of the target markets;
• the similarities between the operating market and the target markets;
• the lack of restrictions in financial or human resources;
• the stage of development of the target markets;
• the level of competition in the target markets; and
• the possibility of having a standardized marketing strategy¹⁰.

The analysis of these factors often leads Franchisors to start with neighboring countries, which may offer an easy expansion in some cases. However, regional expansion is not necessarily the optimal international market to target for entry or further expansion. Therefore, Franchisors have to assess and select properly the countries with high potential market opportunities and low market risks.

[Page24:]

HOW TO GO INTERNATIONAL?

In certain environments, for example the European Union, cross-border direct franchising may be possible¹¹. Otherwise, the Franchisor may develop the cross-border business on its own through the creation of a subsidiary or a joint venture, or collaborate with third parties.

Different forms of Multi-Unit or third-party agreements can be used to expand abroad, but most Franchisors who have ventured into this manner of development have utilized one of these first structures: including (1) MFAs, (2) ADAs or (3) ARAs. Choosing the right franchise structure requires considering, among other things, the costs, investments, strategy and target market.

2.4.1 The steps to go international through franchising

The key steps involved in going international through franchising were summarized many years ago in an issue of IFA Franchising World and are still valid today¹²:

• “Establish an [i]nternational [d]epartment;
• “Define a general strategy for international expansion and pick target countries based on the plan;
• “Define the characteristics and business profile of ideal international [F]ranchisees and the expectations you have for them;
• “Develop a separate business plan for your franchise for each country in which you wish to expand;
• “Pick a business format for your international expansion;
• “Calculate the value of the [Franchise Agreement];
• “Prepare a similar financial analysis with respect to Franchise Fees;
• “Be prepared to offer training in the operation of the franchise and in the development of the local parent company;
• “Be aware of the differences that exist between the country in which you are already successful and the new countries and their cultures;
• “Operate a pilot Unit.”

2.4.2 Master Franchise Agreements

The Master Franchise structure involves three levels and three participants: the Franchisor, the Master Franchisee and the Sub- Franchisees.

Typically, the Master Franchisee will pay an Initial Fee and agree to a minimum development schedule. The Master Franchisee will benefit from a designated Territory, the right to open and operate Units directly and the right to grant third parties the right to open and operate Units under SFAs.

This type of relationship is often well suited for international development, as the Master Franchisee is often far more knowledgeable and connected in the culture and business of the designated Territory

However, the Franchisor loses a substantial part of control over the System resulting from this transfer of responsibility and the enforcement of System standards may be more difficult in this type of relationship. Accordingly, selection of the Master Franchisee is a crucial endeavor critical to the success of the relationship. Furthermore, Franchisor’s liability is more or less important depending on the Master Franchisee’s involvement in the adaptation of the concept.

2.4.3 Area Development Agreements

ADAs are often used by Franchisors who desire to expand their System using Multi-Unit Franchisees, whose activities are dedicated to creating and developing several franchised Units within designated areas. The Units may be operated under the ADA or pursuant to separate Franchise Agreements with the Franchisor. Generally, the Franchisee will pay an area development fee and agree to a minimum development schedule. The Franchisor usually grants a designated Territory. This form of network has a horizontal development contrary to master franchising, which develops vertically with local Franchisees. The Area Developer may open and operate Units only for its own account.

Such an agreement provides the advantages of Multi-Unit franchising, such as the potential for accelerated growth with less investment or capital demands upon the Franchisor and benefits the Franchisor by affording a reasonable degree of direct control over the Franchisee and the development of the Territory. Nevertheless, among the most significant challenges related to area development are the difficulties encountered by Franchisees in achieving the schedules given the scope of their Territory; and by the Franchisor in managing Multi-Unit Franchisees.

2.4.4 Area Representatives

The Area Representative enters into a representation agreement with the Franchisor to act as an intermediary between Franchisor and Franchisees. Unlike the Master Franchisee the Area Representative does not act on its own account but in the name of and on behalf of the Franchisor. The franchise relationship is directly between the Franchisor and the Franchisee.

The Area Representative’s main obligations are evaluating, referring and procuring potential Candidates to the Franchisor and providing certain services to Unit Franchisees within its designated Territory, such as training, site selection, grand opening assistance and on-going support. Accordingly, Franchise Agreements are entered into directly between the Franchisor and each individual Franchisee. The Area Representative frequently receives a portion of the Franchise Fee for each Unit franchise opened in its Territory and is often entitled to a portion of the Franchise Fees collected from each Unit Franchisee.

The most significant advantage of an Area Representative program is that the Franchisor retains ultimate control over who becomes a Franchisee. However, this relationship increases the Franchisor’s liability for the Area Representative’s activities during the sales process.

[Page26:]

A separate issue that may arise is whether the Area Representative can be qualified as an agent under the applicable law and consequently be entitled to benefit from the rules on commercial agents in force in several countries, particularly as regards the goodwill indemnity in case of termination¹³. Under some laws, an Area Representative may perform an activity that may include the promotion of contracts between the Franchisor and the Franchisees, which in principle falls under the generally accepted concept of commercial agency.

The concept of “commercial agent” contained in the European Commission directive 86/653/EEC of 18 December 1986 does not cover the above situation, since it refers only to intermediaries who have the authority to negotiate contracts of sale. However, several European countries that have implemented the directive have opted for a wider concept of commercial agency, which conceivably could cover an Area Representative who acts as intermediary for the conclusion of franchise agreements.

2.4.5 Joint ventures or subsidiaries

Franchisors often consider setting up in the target market either a subsidiary over which they have control or a joint venture with a local partner with knowledge of the target market in order to share risks and expertise for the purpose of establishing and developing the Franchisor’s System. In a joint venture, the respective parties’ contribution may differ widely from one case to another. Often Franchisors strengthen their position by requiring the joint venture company to enter into a MFA, and possibly also a trademark license, in respect of the trademark to be used in the franchise business.

Joints ventures are suitable for any type of Multi-Unit agreement; they complement but they do not replace the Master Franchise or Area Development network.

2.5 EXIT STRATEGY

2.5.1 How can a Franchisor terminate a Master Franchisee but keep a presence in the market?

Both the MFA and SFA need to explain clearly what happens to the Sub-Franchisees if the MFA is not renewed, expires or is terminated. Will the Sub-Franchisees have the right to continue to operate using the marks of the System until their SFAs expire? The answer may depend on whether the Franchisor wants to keep a presence in the market. If the Franchisor wants to keep a presence in the market, in order to avoid a situation where the Sub-Franchisees do not get the goods or services promised in the SFA, the Franchisor should include an option in the MFA to have the SFAs assigned to itself or a designated entity when the MFA is not renewed, expires or is terminated.

Because the Franchisor will not have selected the Sub-Franchisees, it
[Page27:]
might not want to have the duty to take an assignment of all SFAs. An arrangement where the Franchisor has an option of selecting which SFAs to have assigned to it and having the Master Franchisee terminate the others is often called “cherry-picking.”

If the SFAs do not address what happens when the MFA is not renewed, expires or is terminated, the Master Franchisee runs the risk that it can be sued for breach of contract if the Sub-Franchisees cannot continue to operate their businesses. If the SFAs are silent on this issue, and if the Franchisor wants to continue to have a presence in the market, one possible solution is for the Franchisor to take an assignment of all SFAs and allow the Sub-Franchisees to continue to operate until each SFA expires or terminates. Alternatively, the Franchisor could give each Sub-Franchisee a healthy notice period that allows the Sub-Franchisee to restructure its means of income. This latter proposed solution may involve negotiations and perhaps even a new agreement for the remaining term.

In some situations a Franchisor may need to intervene to protect the trademark and the System. Such situations might be prior to a termination or while waiting for the expiration of the MFA. Such situations might be due to force majeure or other causes inside or outside the control of the Master Franchisee.

To enable the Franchisor to keep a presence in the market and fulfill the obligations of the Master Franchisee towards the Sub-Franchisees, both the MFA and the SFA need to address this issue.

2.5.2 How can a Franchisor terminate a Master Franchisee and leave the country?

The Franchisor has the power to decide if the franchise System should remain in a country or not, subject to any applicable laws prohibiting termination or non-renewal without good cause. A Franchisor who has had presence through a Master Franchisee will have to make a decision and let the Master Franchisee know that the MFA will not be renewed after the present term or terminated in advance due to valid circumstances. Depending on the circumstances, the Franchisor should give the Master Franchisee sufficient advance notice of its decision to allow the Master Franchisee and the Sub-Franchisees to restructure their means of income. That way the amount of possible damages is reduced considerably¹⁴.

The decision by the Franchisor to pull out of a country might not be permanent. Re-entrance into that country would be much easier if the exit were handled in a positive way. The Franchisor may want to honor guarantees, vouchers, gift certificates, etc. connected to the trademark, just to protect the value of the trademark.

[Page28:]

2.5.3 Does a Franchisor have other means than to terminate a Master Franchisee when breaches of contract occur?

In an MFA the Master Franchisee has agreed to develop the Territory in a certain way. The pace and sometimes even the geographical structure are laid out in a development schedule, which is an appendix to the agreement. Failing to meet the development schedule is a breach of contract. Unfortunately, development schedules are often not met¹⁵.

Other breaches of contract may occur during the term of an MFA, both generally and locally. Some can be solved, some cannot.

The most common remedy for breach of contract is termination, either with or without a cure period of some 14-30 days. Some breaches, such as a failure to meet the development schedule, might not even be able to be cured within such a period. In those situations termination might not be the best way to solve the problem. The Master Franchisee might be very prosperous in other geographical areas or in specific locations, but failed in one case or in a minor case. An alternative remedy to termination in such a case would be taking away exclusivity or part of the Territory or part of the scope. Taking away exclusivity would allow the Franchisor to establish a new Master Franchisee or establish a business of its own, next to the business conducted by the present Master Franchisee. Having a shared Territory has not proven to be a good idea in many cases. A better alternative might be to limit the Territory to a smaller geographical area or scope, maybe even to an area that the Master Franchisee has already fully established and is proven prosperous in.

It will help if these remedies are already agreed in the MFA from the start. It is a good strategy to have loss of exclusivity or diminished Territory or scope as alternative solutions to termination at Franchisor’s sole discretion. If these alternatives have not been agreed in the MFA, they may be introduced as a solution to the situation when the Franchisor may terminate but would rather continue with the Master Franchisee in a shared Territory or a smaller Territory or diminished scope.

2.5.4 Exit Strategy

The discussion of exit strategy in this section is of a general nature, intended to highlight overarching considerations. Depending on which contractual basis you use for your international expansion, also see more particular solutions in Chapter 7 on MFAs, Chapter 8 on ADAs or Chapter 9 on SFAs.

Even though it might sound backward, one should consider an exit strategy before going international. The reason for an exit may be different depending on the circumstances and the strategy will depend on those circumstances. The exit might not be the result of a decision by the Franchisor but by the Master Franchisee. The Franchisor should be prepared for the situation if the Master Franchisee wants to transfer or sell its interest or company. The MFA can bar the Master Franchisee from transferring or selling during the term. Such a clause may cause a desperate Master Franchisee to take other actions to get out of the
[Page29:]
agreement. A softer solution may be to allow transfers or sales but with the provision that the transferee has to be approved by the Franchisor. This situation can also be combined with a right of first refusal for the Franchisor to take over the business. The MFA should cover this situation and even set the parameters of the pricing issue. A provision that the Franchisor has to offer the same price and conditions as a third-party buyer should be avoided to prevent the possibility of an extremely high price offered by a third-party buyer. The solution to that problem is a preset price formula in the MFA.

The exit may be decided by the Franchisor because it wants to terminate, close, sell or just pull out. In these situations the Franchisor has to consider what will happen with the network in the target country. What rights does the intermediate party (joint venture, Master Franchisee etc.) have and what rights do the operators (local Franchisees) have?

In Master Franchising, the Franchisor actually has a legal relationship only with the intermediary (i.e. the Master Franchisee). The Franchisor grants rights to the Master Franchisee, who, in turn, grants rights to Sub-Franchisees according to an SFA. The Master Franchisee can never grant rights that it cannot refer back to the holder of a right (e.g. trademark). As an expiration or termination of the MFA extinguishes the rights that the Master Franchisee can sub-license to the Sub-Franchisees, the critical issue is what rights, if any, do the Sub-Franchisees continue to have.

If this situation is not addressed in the MFA or SFAs, there is a risk that the SFAs may be terminated by the Sub-Franchisees as the Master Franchisee will not have the ability to deliver the goods or services according to the agreement with the Sub-Franchisees. Such terminations will most likely be combined with lawsuits for damages.

The MFA and SFAs need to clearly spell out the Franchisor’s rights in such situations and the Master Franchisee and Sub-Franchisee must acknowledge the Franchisor’s rights to take such action or to assume the SFA. See the discussion in § 9.5 below.

The exit strategy should be considered early on in the international expansion. The strategy must be settled between the parties in each agreement. If an agreement is silent on these issues, the parties will be uncertain and ignorant about how to resolve future problems.

---

---