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Franchising a foreign business model in China

Franchising a foreign business model in China

Introduction
China is one of the thirty-three countries worldwide explicitly regulating franchising. Over the years, franchising has become increasingly popular and widely used by international brands in an attempt to reach Chinese consumers.

Chinese legislation introduced this legal concept relatively late, in 1997, with the implementation of the “Administrative Procedures for Commercial Franchising.” This regulation was updated in 2005 by the implementation of the “Measures for the Administration of Commercial Franchise”, now also specifically addressing foreign investors. Today the franchise law is much clearer by virtue of revisions, which were implemented in the year 2007.

Franchising structures
Before the introduction of this legislation, franchises generally took the form of a Joint Venture. Examples are KFC, McDonald’s, Pizza Hut, Wall-mart and Starbucks.

The current applicable legislation however broadens the scope and allows the franchisor to be either a domestic subsidiary – including a foreign invested enterprise such as a Wholly Foreign Owned Enterprise (WFOE) or a Joint Venture – or a foreign company without presence in the PRC. The latter, also referred to as “cross-border franchising”, avoids the establishment of a domestic enterprise. It does carry however certain risks as the local absence of the franchisor can lead to a lack of control over the franchisee.

The first option, through using a foreign direct invested enterprise, or FIE, can be an ideal way to build and manage a franchise network in China. Having local presence and staff will benefit the management of business resources, the supervision of the uniform business format and the brand awareness leading to later expansion. This construction can under certain circumstances moreover be strongly advisable from a tax perspective.

Franchisor requirements
Chinese legislation protects franchisees rather than franchisors. A franchisee is hardly required to satisfy any requirements, whereas some specific qualification requirements are imposed on the franchisor. Below we will discuss some of these requirements.

The franchisor must have operated at least two directly managed franchises (either in China or abroad), for more than one year. This is also known as the “two shops for one year” rule.

The franchisor has an extensive information disclosure obligation towards a prospective franchisee. It needs to provide, amongst others, a sample franchise agreement, information on its business, its business resources, including its registered intellectual property, its investment and budget plan, and its business model. Failure to disclose such information, or the providing of inaccurate information, gives the franchisee legal grounds to terminate the franchise agreement and to claim for damages.

Franchise Agreement
The Franchise Agreement forms the heart of a franchise and provides the basis of the cooperation between the franchisor and the franchisee. Amongst others, the Agreement will include clauses on the contents of the franchise, the franchise term and fee; operation guidance, technical support or other business training courses; quality, standard and warrant of the products or services; advertisement and promotions of the products or services; after sales and product liability; and liability for breach of contract.

The Agreement moreover needs to provide a “calm-down” period, during which the franchisee is entitled to unilaterally terminate the agreement without giving any reason.

Protection of Intellectual Property
Franchising is a common source of intellectual property (“IP”) rights infringements. Before entering the Chinese market, franchisors must be cautious. They should ensure that their IP is established under Chinese law, and that the franchise agreement contains clear clauses on how their brand name, designs and trade secrets such as production techniques should be applied. Above all, breach of these clauses should be punishable by penalties and the immediate termination of the franchise by the franchisor.

Franchising vs retail chain stores
Internationally well-known brands with a wish to implement their business model in the Chinese market might be confronted with the choice between franchising and setting up one or multiple retail chain stores. It is generally believed that in most circumstances, franchise is the best way forward. Reasons can vary: Franchising can avoid the opening of multiple retail stores all over the country, which can be quite cumbersome. It moreover avoids the investments and liability of a chain. The franchisee is believed to have a greater incentive than a direct employee of a chain store because he or she has a direct stake in the business.

Compared to establishing retail chain stores, franchising allows foreign companies to expand into the Chinese market rapidly, at a relatively low cost. It should be taken into account however that setting up and implementing a franchise in China has its own hurdles, which will need to be taken into account as well.

Franchising vs Licensing
Under certain conditions, one way to avoid these hurdles would be to opt for a licensing construction. This allows the foreign company to, by way of a license agreement, license its intellectual property such as trademarks, logos and images to a Chinese party. The license agreement has to be filed to the Chinese authorities at the conclusion of the agreement and the rights and obligations laid by law for the two respective parties to the agreement are relatively balanced, if not more inclined to the owner of the IP (i.e. the licensor). Therefore, compared to franchising, the foreign party will in this construction be subject to more favorable applicable legislation, less government control, and will not have to comply with the “two shops for one year” rule and the disclosure obligations as mentioned above.

Note however that the foreign company will, compared to the franchise model, have limited control on the use of its IP and no supervision whatsoever on management of the licensor. Therefore, if there is an intention to be active in local management and have control of the key business elements such as brand building, marketing campaign, supply and resourcing, staff training, finance compliance, etc., setting up a franchise would be the preferred option.

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