Building an Empire on a Borrowed Foundation

By: Michael Daigle
Published: March 2nd, 2011

Contract negotiations are usually about the relative value of "things." Each party seeks the highest value for their "thing" while downplaying the value of the other's "thing." Negotiations around those "things" are particularly difficult in international franchise transactions where relationships can span generations, territories can include entire countries, and the franchisor's system is at the core of the franchisee's business. In other words, the franchisee will set out to build an empire on a foundation it only borrows from the franchisor. That fact critically shapes the parties' negotiations.

• Structure. Most international franchises follow either an area development or a master franchise model, with the fundamental differences stemming from how the franchisee must develop the market (in simplest terms, an area developer owns units while a master franchisee subfranchises). Subfranchising allows the franchisee to tactically control the level of investment they make in their empire. But the franchisor may view subfranchising as a threat to its foundation, with the structural decision often hinging not only on the assessment of the franchisee's capabilities (good sales/support organizations are not necessarily good operators, and vice versa), but also on factors such as the availability of the franchisor's resources and its willingness to take on unit-level contractual obligations.
  
  To resolve this tension, the franchisor might consider a blended approach where, before subfranchising, the franchisee must vet and firmly establish the brand in the territory; even then, they might be required to directly own a certain number or percentage of units. But the franchisor must be careful not to overly constrain the franchisee such that the rewards of subfranchising are insufficient to justify the costs of the support infrastructure.
• Trademarks. While trademark ownership is rarely at issue, the franchisee's authority to act like an owner of the "borrowed foundation" can be contentious. The franchisor should never relinquish control over its marks; and because of the nature of trademark law and the lack of prior use in the franchisee's territory, it should resist becoming a guarantor of its marks. That clearly puts the franchisee at risk, particularly when it is prevented from taking its own action to protect the marks.
  
  The franchisor might consider indemnifying the franchisee against attacks on the marks. It might also give the franchisee greater latitude over secondary marks and allow it to terminate if prevented from using primary marks, particularly during the initial years when its investment is lowest and the trademark risk is greatest.
• Brand adaptation. Many new international franchisors believe that, while the franchisee has local expertise, it is not a brand expert. Therefore, the franchisee must pick up the concept and plop it down into the new market, as is--but most brands require adaptation in international markets. The mission must be to find the balance between brand integrity and brand viability, an exercise that can be affected by legal and religious requirements, by local supply chain, real estate and other market conditions, and by consumer preferences. That requires a collaborative approach that uses the franchisee's local market expertise and the franchisor's brand expertise. The level of adaptation appropriate to making the brand relevant in the franchisee's market while preserving the brand's core values might vary from country to country, but finding the balance will enhance both the franchisee's empire and the foundation on which it is built.
• Fees. The franchisor seeks maximum compensation for the long-term value its foundation brings to the franchisee's empire. To some franchisors, that means collecting huge up-front fees with less emphasis on ongoing royalties. This could not only hamper the franchisee's initial development efforts (money might be better spent conducting product relevancy studies and building units), but also leave the franchisor without a long-term stake in the success of the franchisee's business. The franchisee, meanwhile, will acknowledge that the foundation has value, but will argue that its real value will come only once it begins to build the empire. To recognize the validity of each position, the parties might consider alternative fee structures such as royalty ramp-ups or ramp-downs and other payment incentives that reflect the master franchisee's position as a pioneer of the brand, while also providing the franchisee with incentives to develop more quickly but with an eye to strong unit volume.

At the heart of every international franchise negotiation is the fact that the franchisee will build its empire on a foundation that, both during and after the relationship ends, belongs to the franchisor. This forces the parties to act collaboratively, in good faith, through what is often the most difficult part of the relationship: negotiating the contract.

Michael Daigle, a partner with Cheng Cohen LLC in Chicago, has been advising franchise clients in transactions around the world for 25 years. Email michael.daigle@chengcohen.com or call 312-957-8366.

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