Franchising your brand in China: Should it be part of your long-term plan?
The benefits of choosing the franchise model as part of your long-term
business plan in China can often be compelling. From raising capital without
surrendering equity to supercharging your brand, it can give you the
chance to grow your business quickly in the knowledge that your customers
will receive reliably consistent levels of service and quality from your franchise
And its contribution to economies worldwide would seem to underline the potential for franchising your business: in 2017, according to the International Franchise Association (IFA), franchising in the US accounted for more than USD 670 bn of economic output and 2.5% of GDP. And in the UK, the British Franchise Association found that in 2015, 97% of franchise businesses reported profitability, with commercial failures standing at lower than 1%. And with figures like that, you’d be forgiven for thinking that your venture could replicate home-grown success stories from here in China like McDonalds, which now boasts more than 2000 franchise outlets in China alone.
But life isn’t exclusively rosy in the franchise world and here we look at a few of the pros and cons of the franchising model to see whether it might be right for your business here in China.
1. Raising capital by franchising:
Because franchisees invest based on the proven success of your business model, as well as access to suppliers and marketing, you can expand your business and raise capital at the same time without surrendering any ownership, a luxury that’s not available if you seek investment from more traditional venture capitalists or angel investors. In short, you can expand without the risk of debt or the cost of equity.
Therefore, because you’re selling your business concept and not your business, franchising is an attractive means of raising capital, both through the up-front initial franchise fee (IFF) and on-going royalties in the form of a percentage of a franchisee’s monthly gross revenues. And with finance one of the biggest hurdles to growth, the franchising model is a good way of expanding your business with minimal investment. Indeed, many franchisors use both the company-owned and franchised models in combination – for example, one model for domestic markets, another for foreign – therefore offering an even more flexible approach to running multi-unit ventures.
But there are some downsides worth considering here, too: firstly, your reduced risk in the form of franchisee investment brings with it reduced returns at unit level. The chance for much faster growth offsets those reduced returns, but you would potentially have to sell five franchises to achieve the same profitability as one company-owned outlet with 25% margins.
In addition, you’ll be liable for the up-front investment needed to set up an organized franchise company. Franchising your existing business requires you to set up a separate business entity and franchise business plans which typically form part of your Franchise Disclosure Document (FDD). Several steps in the process also need investment: from drafting operations manuals and legal documents to creating franchisee training programs and marketing strategies, creating a franchise system will need a certain amount of capital investment long before you begin to see the royalties roll in – if your model’s successful and profitable, that is – and, as with any capital investment, it carries some risk.
And part of that risk includes damage to your brand capital incurred by a franchisee’s actions. Because even though, by definition, you’re not running a corporate business model, your customers aren’t likely to make that distinction in the event of a PR disaster. Take the Dunkin Donut’s Thai franchise, which created a ruckus in the US when it aired a TV ad in Thailand depicting racial stereotypes to promote a new charcoal donut. And to show how hard it can be to exercise any control over independent franchisees, the head of Dunkin’ Donuts Thai franchisee group dismissed US criticism of the ad as ‘paranoid American thinking’.
2. Attracting talent:
According to Harold Kestenbaum, author of So You Want To Franchise Your Business? experience among franchise systems has shown that employees who join a brand or a company through a franchise system are more likely to stay than those who join as a company employee. This seems to suggest that as you grow your franchise network, the rising demand for employees means that talented individuals have a greater opportunity to progress up the ladder, either at outlet level or within the franchisor’s management team.
Perhaps that’s not surprising: after all, franchise employees, often starting at ground level, are more motivated and incentivized to see the business succeed. And the franchisee has quite literally bought in to your business model and concept, so the tendency for the most talented, motivated and hardest working people to invest in running a franchise business can only bolster your revenues and profits. As Professor Scott Shane, author of Using Franchising to Drive the Growth and Profits of Your Company notes, ‘by franchising, you are going to get better talent that will work harder to build the business than you would by hiring someone to work for you’. Remember, if your franchisees succeed, so will you.
But there are some dangers, too: relinquishing and delegating the responsibility for hiring and managing employees can be attractive for you as a business owner, but generally speaking you’ll also be relinquishing control over those employees. According to Kestenbaum, in most cases franchisors don’t have unilateral authority over decisions such as removing under-performing managers and they must rely on the franchise owner’s discretion.
But it’s not just the employees you lose control of: franchises are independent ventures run by franchisees, and you can’t tell franchisees what and what not to do in the same way you can employees. As Professor Scott Shane points out, ‘franchisees make money from the outlet’s profits. Anything that boosts sales but not profits will create conflict between you and the franchisee’. So, with franchisors generally making their money by collecting a percentage of sales from a franchise outlet, not a percentage of its profits, trying to persuade franchisees to undertake promotions, for example, that will drive sales but not necessarily profits in the short term can emerge as a potential danger area for poor franchisor-franchisee relations.
3. Rapid growth and increased brand recognition:
The relative ease of raising capital through the franchise model, as I’ve mentioned above, brings with it an opportunity to grow your business in China without having to tap into more traditional sources of capital, and with growth comes much wider brand recognition. After all, the requirement for franchisees to use your company name and branding, among other things, is the cornerstone of the franchise model.
Going down the franchise route allows business owners to grow their venture in China and expand their market share and their brand much faster than would otherwise occur if you simply added more company-owned units, even if you’ll be accepting reduced unit returns to do so.
But beware some of the dangers of rapid expansion. With a much wider franchise network, you’ll take on much more responsibility, as franchisor, for managing that growth within the terms of your franchise agreement: from ensuring demand for supplies is met to bolstering your franchisee training and support team, too rapid an expansion could see your own management resources stretched too thin.
Indeed, according to Harold Kestenbaum, one of the many challenges experienced by rapidly expanding franchise networks is that franchise support staff can often be ill-equipped or under-resourced to manage that rapid expansion, and you’re too busy with your own responsibilities to manage the growth of your support staff. In extreme cases, this could lead to poorly trained franchisees in China who, instead of helping to build positive brand capital for your business, end up inflicting long-term damage to your brand by creating brand saboteurs.
And there’s also a danger that expansion can limit and hinder innovation: the faster the expansion, the quicker that ability to innovate disappears. This might seem an obvious point, but the franchise model is predicated on consistency across the board in all company outlets, a fact that can make it harder and more complex to create and implement new products or services and roll them out across your network.
With company-owned units, you as the business owner make a decision and implement it network-wide. With a franchise, however, any innovation can involve lengthy negotiations with franchisees to persuade them to accept any innovations. And remember, the downside here is that lengthy negotiations can contribute to your venture’s inability to react quickly according to the Chinese business environment. As the Franchise Institute notes, if you can’t adapt quickly enough in a competitive market, this drastically limits the flexibility of your business.
Assessing your model
It’s clear from the above points that, for the right ventures, franchising can offer tangible benefits if your business model proves successful and scalable in the Chinese market. It can be a fantastic way to expand your business in China with minimized risk, but you’d be wise to weigh up the downsides before those downsides get to weigh you down.
To read the PDF version click here
DISCLAIMER: All information in this article is verified to the best of our ability and is assumed to be correct at time of release; however, Woodburn Accountants & Advisors does not accept responsibility for any losses arising from reliance on the information provided within. The information provided is for general guidance and does not replace specialized advice.