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Support Systems Key As Companies Pursue International Expansion
Companies, and their owners, often choose franchising as a business model because of the promise of great expansion opportunities. It is, therefore, a rare franchise system that does not have national and even international aspirations. As a system expands, however, issues regarding the best way to support the system’s expansion take on greater importance. The franchisor has a number of options, ranging from assigning home office employees to travel regularly to particular territories, establishing regional offices, appointing independent contractor area developers (“ADs”) or, particularly in overseas markets, entering into master franchise agreements.
Each of these approaches has practical and legal benefits and detriments. For example, assigning home office employees to travel to distant franchisees may provide the most control but may also increase the franchisor’s expenses while decreasing its efficiency. ADs generally establish offices near the franchisees whom they oversee. While this theoretically provides better support and enhances communications, franchisees may feel that ADs have too much power, which they use to the franchisees’ detriment, and that they inhibit direct communication with the franchisor.
Master franchise agreements often require franchisors to give up significant control, but may be the most efficient way for expanding into foreign markets. Obviously, each franchisor should evaluate system expansion support alternatives to determine which is right at that particular point in the franchisor’s growth. Franchisors should also seek to achieve maximum flexibility to change as market conditions change.
Evaluating System Expansion Support Alternatives
As stated, each alternative has advantages and disadvantages, some of which depend on the specific talents and personalities of the individuals with the most direct franchisee contact. Following is an overview of some of these advantages and disadvantages.
Traditional approach. Many franchisors prefer to retain the organizational model with which they started, i.e., staffing their main (and often only) office with support personnel. As the system grows, personnel may be assigned to cover specific regions. These personnel may live in the regions to which they are assigned or may periodically travel to those regions to inspect franchised units and meet with franchisees. This approach gives the franchisor the greatest level of control – – all of the support personnel are its own employees and it directs their activities on a day-to-day basis. A significant disadvantage can be the cost of employees’ travel. Hiring employees who already live in each region will reduce travel costs but finding the right employees in the right places can be difficult, and managing employees from afar creates its own set of problems.
Establishing regional offices. When a franchisor achieves a critical mass of franchisees in an area, it should at least consider establishing a regional office there. Establishing an office may be less expensive than having employees travel from the home office to the region. The types of support personnel employed at regional offices vary widely by system but often comprise franchise sales, operations and other support functions and may include regional vice presidents or similar executive positions.
Appointing ADs. As franchisors become geographically diverse, they often see the need for a physical presence in each area with a significant number of franchisees. Because establishing multiple offices can be administratively and financially difficult, some franchisors enter into independent contractor (rather than employment) relationships with ADs. AD agreements are generally long-term contracts, for which 10 or 20 year terms are not uncommon. ADs usually establish offices, with staff, in their assigned territories, and act as the franchisor’s primary representatives in the field, helping to identify suitable locations for new units, inspecting units, and providing operational and marketing advice to franchisees.
Appointing master franchisees. Master franchise agreements are popular vehicles for managing system expansion, particularly in foreign markets. The crucial difference between master franchisees and ADs is that a master franchisee becomes the actual franchisor for a territory. That is, an AD may help sell a franchise, but the franchisee enters its agreement with the franchisor, and the AD is not a party to it. By contrast, the master franchisee generally has the right to franchise the system and license the intellectual property to franchisees in the territory.
The master franchisee is also commonly responsible for selling franchises, providing site selection and construction advice, inspecting units, and providing business advice to franchisees. In short, the agreement essentially turns system rights for the territory over to the master franchisee subject to the terms of the agreement. Franchisees enter into their agreements with the master franchisee, and the original franchisor is not a party to those agreements and has little direct contact with the franchisees. A master franchisee for a large country or territory may also choose to have its own employees or ADs, adding yet another layer between franchisees and the original franchisor.
Quality Control
The foundation of any franchise system is its trademark and related intellectual property. Quality control is, therefore, a key component to any franchise system. Under the Lanham Act,1 a trademark exists only as a symbol of goodwill and has no independent significance without it. A franchisor has a legal duty to take quality control measures or risk “abandonment” of its trademark. In order to avoid “abandonment,” a franchisor must regulate the activities of its franchisees to protect the public against deceptive uses of its marks. This regulation typically includes providing franchisee training and inspecting units to ensure compliance with system standards.
Lack of quality control can have both immediate and long-term effects on a franchise system far beyond the risk of “abandonment.” It can result in unhappy franchisees and customers and reduced sales at all units, not just those that are out of compliance. Because franchise systems are built on name and concept recognition — i.e., reputation — bad customer experiences at one unit can affect sales at others, even those without similar problems. Franchisees generally pay a percentage of sales in royalties to the franchisor; therefore, declining sales also decrease the franchisor’s revenue and reduce the desirability of the system in general, leading to fewer sales of new franchises.
Poor quality control can also lead to customer lawsuits. A customer sickened, mistreated or injured at a franchise will frequently sue both the franchisor and the franchisee. While franchisors often successfully move for summary judgment on these claims, which generally seek to hold the franchisor vicariously liable, litigation is time-consuming and expensive, and can result in adverse publicity. While effective quality control is critical to the success of any system, it can be a double-edged sword, which plaintiffs use to try to establish that the franchisor has sufficient control over the franchisee’s operations to create an agency relationship. The problems of allowing franchisees to operate substandard units, however, generally far outweigh this risk.
The franchisor should consider the potential effect on quality control when choosing an expansion model. Some systems have maintained excellent quality control with home office or regional office employees. If employees are not well-trained or do not visit franchisees often enough, however, quality control can suffer. In addition, employee compensation may not be directly tied to the success of the system, although performance bonuses can be used. ADs and master franchisees, on the other hand, are not salaried workers but generally receive a percentage of royalties and fees paid in their territories, which serves as a built-in incentive to support the franchisees and ensure that they adhere to the franchisor’s quality control standards.
Franchisee Relations
Franchisees communicate with each other, either informally or through a franchisee group. Shared complaints can affect morale, and color the lens through which other franchisees view whoever oversees their stores. When franchisees do not trust that individual, cooperation and sales may decline, and franchisees may look for ways to strike back, including blaming the individual, and the franchisor, for any and all problems. A franchisor’s decision concerning system expansion should, therefore, take into consideration how that decision is likely to affect its franchisee relationships.
If not handled correctly, franchisee support by home office personnel and, perhaps to a lesser extent, regional office personnel, can make geographically distant franchisees feel abandoned, particularly if in-person visits are few and far between. Franchisors using these methods should ensure that all franchisees are receiving substantially similar support and have equal access to the franchisor.
ADs, when used, are involved in the sales and franchisee approval process and may be better acquainted with the franchisees and their abilities than the franchisor support employees. The AD is also generally closer to the units he oversees which can, if the AD is good, enhance franchisee communication.
A bad AD, however, even one not bad enough to terminate for cause, can engender lawsuits from franchisees in his territory. ADs often have, or are perceived to have, a significant amount of power. ADs are involved in many important decisions, and often have input into the location of new units, whether a franchisee qualifies for additional units, and even whether the franchisor should terminate a franchisee. These decisions can lead to claims of discrimination, favoritism and bad faith. ADs may also be franchisees. Because AD offices generally inspect the units in their territories, franchisees may perceive that the AD’s units are inspected less rigorously. Franchisees may also fear that the AD will obtain better sites for new units, leading to accusations of self-dealing.
Because they act as the franchisors for their territories, master franchisees have even more power than ADs and can act as a barrier to communication between the franchisor and the master franchisee’s franchisees. The franchisor may also have difficulty controlling quality because of the independent contractor nature of the master franchise relationship. Using master franchisees may, therefore, give rise to vicarious liability claims by customers, franchisees and others to looking to the “deep pockets” of the franchisor.
Relationship Structure
A franchisor and its employees generally have typical employment relationships, terminable at will under most circumstances. If an employee is not performing well, or is the subject of franchisee complaints, the franchisor can terminate her. An AD or master franchisee relationship can be more difficult to undo, and more costly in the undoing.
An AD relationship can be like the old children’s rhyme – when things are good, they are very, very good, but when they are bad, they are horrid.2 If a territory does not succeed, an AD may assert a whole host of claims against the franchisor that are not available to an employee. While careful franchisors do not represent that an AD will realize a particular level of profits, ADs may claim that the franchisor’s incompetence, lack of support or discrimination prevented them from succeeding. In addition, some agreements require the AD to sell, or “develop,” a particular number of units. If the AD does not meet this requirement, the franchisor can terminate the agreement. If the franchisor terminates for failure to develop, the AD may allege wrongful termination, blaming the franchisor for the failure. Claimed damages may be substantial, and can include the return of any fees paid by the AD to enter the agreement, lost profits and punitive damages under common law and unfair competition laws.
Master franchise agreements also generally require good cause for termination, meaning that a franchisor may be stuck with an undesirable master franchisee whose conduct, while unsatisfactory, may not constitute good cause for termination. Master franchisees faced with termination may complain that the franchisor doomed them to failure by providing inadequate support or by neglecting to ensure that the system would succeed in the particular country.
What’s a Franchisor to Do?
As established franchisors have learned, lawsuits are brought no matter how many precautions are taken. There are, however, ways to minimize the number of suits, and maximize the number for which summary judgment may be appropriate.
The selection process. Sometimes, the lure of rapid expansion can blind a franchisor to the long-term risks of entering an agreement with a particular candidate. Desirable characteristics vary by system, and the franchisor should make sure that the candidate has those characteristics. Some franchisors require a candidate to own and operate a system unit before entering an AD or master franchise agreement, which can help them better understand and assist franchisees. Other franchisors have found that experience in the particular industry is not important. Indeed, too much experience, particularly with other systems or in independent businesses, can cause problems because the master franchisee or AD may not follow the uniform operating rules that define the system and may introduce “innovations.”
Regardless of the level and type of experience the franchisor desires, one key characteristic that many franchisors seek is a willingness to get involved at the lowest levels, rather than viewing the business as an executive-level position insulated from the day-to-day concerns of franchisees in the field.
Vicarious liability. Most franchisors consider ADs and master franchisees to be independent contractors, rather than agents, and their agreements should contain clauses expressly disclaiming agency. While contractual disclaimers are not dispositive, courts will consider them as evidence against agency. The franchisor should also ensure that the lack of agency is communicated to third parties wherever possible. For example, the franchisor may require master franchisees and ADs to disclaim agency in every contract and to post disclaimers in their offices.
Managing expectations. Franchisors should never make representations concerning the likelihood of success or level of profits that a master franchisee or AD will reap. Every agreement should state that the franchisor has made no representations of success or profits, and that the business depends on many factors beyond the franchisor’s control, including the economy, trends, local and national laws, and the candidate’s own abilities and efforts.
Quality control. Franchisors should be familiar with the operations of their ADs and master franchisees. Some franchisors have established “ombudsman” positions to be the franchisor’s eyes and ears. Franchisees are free to contact the ombudsman to complain about a master franchisee, AD or even franchisor employee. Providing a mechanism for venting concerns may reduce the risk of franchisee lawsuits, and may also reveal shortcomings that the franchisor should address.
Other drafting issues. Franchisors may consider including arbitration clauses in their agreements and requiring master franchisees and ADs to indemnify the franchisor (including legal fees) for claims based on their own acts or omissions. Particularly in international agreements, the franchisor should consider including a disclaimer that it cannot warrant that the system’s trademarks have been, or will be, validly registered, and cannot guarantee that others in the territory do not already have rights to those marks.
Conclusion
There is no single right expansion approach for every system. Each option has risks and benefits, which may vary depending on the type of product or service the system provides. A franchisor should carefully consider those risks and benefits, and discuss them with franchise counsel, before choosing.
1. 15 U.S.C. §1051 et seq.
2. “There was a little girl, who had a little curl, right in the middle of her forehead. And when she was good, she was very, very good, but when she was bad, she was horrid.” Henry Wadsworth Longfellow.