International Development: Balancing the Risks

Now, more than ever, is the time for every franchisor to look at opportunities to expand its system outside the United States. A bold statement, especially coming from a lawyer who, for the past 27 years, has cautioned clients and employers against moving too quickly outside the U.S. when the brand hasn't yet been fully exploited within the U.S.

So what's changed? The global economic crisis has had less impact on some countries than on others, some countries have recovered from the economic downturn more quickly than others, and the explosion of social media and advances in technology have helped shrink the globe and made it easier for franchisors to impart knowledge to franchisees and to monitor how their brands are being exploited and presented to consumers without ever having to leave their home offices.

These factors, among others, have created new opportunities that should be given serious consideration by any franchisor interested in expanding its system. But international development is a long-term proposition and is not without its risks. It requires appropriate vision, a willingness and ability to commit, and a clear understanding of the risks and how to balance and minimize them. This article focuses on five such risks: 1) legal, political, and social unrest, 2) system adaptation, 3) currency exchange, 4) economic vulnerability, and 5) franchisee selection--particularly in the context of the recent global recession and the events unfolding in the Middle East.

1) Legal, political and social unrest. Franchisors focused on operating only in the U.S. will often be faced with challenges resulting from things like union strikes and lockouts, an ever-changing legal landscape resulting from new or inconsistent lower court rulings, pronouncements by state supreme courts and the U.S. Supreme Court, and, of course, new laws and regulations that are often driven by which party is in power at any particular time.

However, it is unlikely that purely domestic franchisors will also have to deal with the additional impact caused by the amazing events that have unfolded in Egypt and are now unfolding in other parts of the Middle East. Revolutions that have toppled longstanding and what were believed to be stable governments are spreading throughout the Middle East, and while their ultimate impact on franchising and franchise agreements remains to be seen, these events have, at a minimum, caused damage to or interruption of businesses and have called into question the timely access to courts, the ultimate interpretation and enforceability of contracts, the applicability of force majeure provisions to excuse non-performance, and the access to capital that is critical to expansion of the system. They provide real-life examples of the importance of strong contracts that anticipate what could happen over the life of the relationship (or at least provide the franchisor with options so it isn't paralyzed by unforeseen events) and for action plans designed to assist local franchisees and to protect the brand during periods of unrest.

2) System adaptation. For younger systems, expanding from one state to another can present certain risks and challenges, particularly around things like brand awareness (it's often nonexistent), supply chain (in most cases, the supply chain will exist, but the costs of critical goods and services may be higher until critical mass is reached), and the franchisor's ability to provide meaningful support. But for most franchise systems, expansion from one state to another will require little or no adaptation of the brand, the operating platform, or the products or services offered to consumers.

Not so when developing internationally. Going from one country to another will typically present the same challenges franchisors face when going from one state or one market to another, but those challenges can be magnified because they often trigger, or are often triggered by, the need for adaptation of system standards or operating platforms, if not of the products or services themselves. Generally, a franchisor that expects the franchisee to pick the system up from the U.S. and simply plop it down, unchanged, in a new country is doomed for failure. Factors such as consumer attitudes and preferences, legal and religious requirements, costs of real estate and other items, and the availability of critical supplies at reasonable prices will force some degree of adaptation.

International franchisors should be prepared to adapt their systems to the specific requirements of the local market. The challenge for most will be determining the appropriate level of adaptation necessary to make the brand relevant in the particular market without destroying the core values and essence of the brand. ­That equation will likely be different from country to country and will be affected by the factors listed above, as well as by the local economy, the country's infrastructure, and the uninterrupted availability of resources.

3) Currency exchange. Since all U.S. states and territories use a single currency, domestic franchisors are not subject to currency risks. But internationally, franchisors must deal with the possibility that payment in U.S. dollars might be limited or prohibited by certain governments, that withholding taxes will affect how much the franchisor ultimately receives, and that there are costs associated with converting from one currency to another.

In addition to determining who bears those costs, the fact that they exist will often affect how, and the frequency at which, a franchisee wants to pay royalties. A franchisor accustomed to receiving weekly payments through automatic debit should be prepared to address the franchisee's request to pay less frequently (typically monthly) and by wire transfer. Franchisors should also be specific as to how and when currency is converted from local currency to the currency in which the payment is to be made (typically U.S. dollars). And, consistent- with the notion that international development is a long-term proposition, the franchisor should always retain flexibility to require payment in currency other than U.S. dollars. This is particularly important as revenue from outside the U.S. becomes significant or should the value of the U.S. dollar in a particular country become less stable than another currency.

4) Economic vulnerability. As noted above, the global recession has taken an uneven toll, hitting some countries harder and longer than others. Just as an astute financial planner can spread risks across a financial portfolio, a franchisor can take advantage of this unevenness of impact and the opportunities it creates by seizing opportunities in countries that have been less affected while allowing other markets time to recover. It is, of course, impossible to predict what will happen to any particular country's economy, especially given the length of the relationship between the franchisor and franchisee, the interdependence of various countries' economies, and the impact of political and social unrest.

Franchisors interested in seizing the opportunities created by the unevenness of the recent global recession must make sure that their contracts are sufficiently flexible and their development plans and initiatives are sufficiently agile to enable them to deal with situations where what now is an opportunity becomes a liability in the years to come.

5) Franchisee selection. In international development, arguably more so than in domestic development, the selection of the franchise or "partner" will be critical. A franchisee or master franchisee who is politically connected is generally thought to be desirable. But, as events in the Middle East are revealing, the political connections that were once an asset might become a liability if the regime is toppled and replaced by a new one. Depending on the franchisor's development strategy, the franchisor should focus on selecting franchisees or master franchisees who ideally are financially sound, experienced in bringing U.S. brands to market, have appropriate real estate and other local contacts, have (or are capable of building) appropriate infrastructure, and who are philosophically aligned with the franchisor when it comes to brand expansion and protection.

Events like the recent global recession and the political unrest in the Middle East cannot always be predicted, particularly over the typically long life of the franchisor's relationship with its international franchisees. And it cannot be argued that international development doesn't add layers of risk and challenge to those experienced by domestic franchisors. But with proper planning, appropriate expectations and a long-term vision and strategy, international development is an important step in the evolution of a­ franchise brand. There's no time like the present to explore the opportunities created by these unprecedented world events.

Michael Daigle, a partner with Cheng Cohen LLC in Chicago, has served as chief development and chief legal officer for some of the world's most rapidly growing franchise systems and has been advising franchise clients in transactions around the world for more than 25 years. Email michael.daigle@chengcohen.com or call 312-957-8366.