A case for due diligence

As with other forms of commerce, franchising has now become truly international. However, unlike other forms of commerce, the emphasis on uniformity in franchising sometimes makes some franchise concepts less recognisable as having their roots abroad. The converse is also true in that there are a number of franchise concepts that may give the impression of being American, but which, in fact, originated in the UK, for example Nice-N-Stripy. On the other hand, Wimpy emanates from a Chicago-based fast food operation.

To complicate matters further, a series of mergers and acquisitions and the evolution of multi-nationals means that franchises which were previously thought of as being, and which in fact were, foreign, became owned by UK companies such as Burger King and Holiday Inn.

At the end of the day, it does not really matter providing the concept is right, the system works and there is a demand for the goods and or services offered by a particular franchise. Whilst the consumer may not care about the origins of a particular franchise, anyone proposing to invest in a franchise, should, whether they are acquiring the rights for the whole or a part of the United Kingdom or simply to operate a single outlet in the high street. This article is concerned with the pitfalls of acquiring rights to a foreign franchise concept for use in the United Kingdom.

The two principal vehicles for acquiring such rights are the development franchise and the master franchise.

In a development franchise, the foreign franchisor grants rights to the UK investor for the whole or a part of the United Kingdom enabling that investor to open company-owned outlets under the terms of a franchise agreement direct with the foreign franchisor. This makes the investor a direct franchisee of the foreign franchisor. Where development rights are granted only for a part of the United Kingdom, this is usually referred to as an area development agreement. It is common for the grant of such rights to be exclusive to the UK investor, and it is common for such agreements to contain a development schedule which both parties agree. This development schedule specifies the number of outlets which the UK investor must open within a given period of time.

In the writer's experience, the negotiation of a development schedule is often the most fraught when dealing with US franchisors. US companies almost invariably fail to appreciate the difficulties which face businesses in the United Kingdom in terms of acquiring the right sites for retail premises. Even where US companies enter the UK market themselves, they have been wildly over-optimistic.

Not surprisingly, there is a tendency for their expectations to be based upon the rate of growth they have achieved in the United States. In these circumstances, the UK investor has to be resilient in resisting unrealistic development schedules and the writer would go so far as to say that unless the US franchisor is willing to accept a reasonable (in UK property terms) development schedule, the UK investor should walk away. It is probably true to say that there have been more failures than successes of US franchisors trying to enter the UK retail market. Indeed, in one particular case, one of the largest and most successful (in their market sector) US retailers who attempted to enter the UK market themselves, as opposed to via a developer or master franchisee, failed.

Their internal development plans called for the opening of 300 retail outlets in the UK within two years! They shunned all advice to the contrary and insisted that they had done it before elsewhere and could do it in the UK. However, with the exception of US companies, there appears to be little difficulty in agreeing, with other foreign franchisors, development schedules which are reasonable.

With regard to a master franchise, this is the same as a development franchise but with an additional right for the UK investor to sell franchises. In a development franchise the UK investor must open all the outlets itself, whereas under a master franchise arrangement it is common for the UK investor to not only operate outlets itself, but also to franchise others to do so. In these circumstances the UK investor would not only be a franchisee of the foreign franchisor but would also become the franchisor of that particular concept within the territory allocated to it by the foreign franchisor.

Although franchising has enjoyed an explosion of growth internationally in recent years, there are nevertheless very few franchisors whose system and reputation are so well established that a UK investor could be forgiven for feeling that it can proceed without undertaking a due diligence exercise.

So what should a due diligence exercise involve? There are three golden rules.

1. Never accept anything at face value.
2. Never make assumptions (the fact that it is so hugely successful in Holland does not mean that it will work in the UK).
3. Never be afraid to ask searching questions.

In the last few years there has been a marked increase in US franchisors seeking to expand internationally. Some have a sound base from which to launch their franchise internationally whereas others have an eye to the main chance. They come in all shapes and sizes and a would-be UK investor is likely to encounter a greater sales pitch. We are constantly being reminded that one of the most valued possessions of franchisors is their reputation and so far it has generally been safe to assume that franchisors will not do anything to damage their reputation.

However, in terms of international franchising, different rules apply. When it comes to franchising abroad, franchisors are generally less affected by adverse publicity. To take the example of a US or Australian franchisor - if it's proposed entry into the UK market fails, it's US or Australian operations and reputation are unlikely to be affected. The United Kingdom is too far away for any failure to directly affect their reputation in their country. It is therefore tempting for foreign franchisors to be less particular with regard to whom they sell rights to in the UK than they would in their home market.

This naturally leads to a less fastidious franchisor making optimistic claims about the chances of success for its concept in the UK market. Providing the franchise fee is sufficient to make it worth its while, a foreign franchisor may be more willing to take a chance that if it fails, it will be able to sustain the failure and who knows, after a year or so it could always have a second crack at the same market!

Master franchisees and franchise developers tend, by nature, to be more able to look after themselves than individual franchisees running a retail outlet. Nevertheless, that is no reason why they should be more trusting of a foreign franchisor than they would be of someone in the UK with whom they are contemplating a joint venture. Indeed, there is a great deal to be said for a UK investor to seek greater safeguards when dealing with somebody who has no UK presence. There is no substitute for taking the same sort of precautions that any prudent investor would take when considering investing in a UK venture.