FRANCHISING AND GOVERNANCE
by Callum Floyd and Win Robinson


Introduction
Franchising has had an unquestionable impact on many countries economies and is widely acclaimed for its contribution to GDP, job creation and training. With estimates of franchisors and franchisees currently exceeding 350 and 15,000 respectively, New Zealand is perhaps the most franchised country in the world, ahead of Australia, Canada, the US and the UK, respectively.

Franchising is an organizational form employed by multi-site organizations large and small, profit and non-profit. Global franchising examples include McDonald’s, Subway, 7-Eleven, InterContinental Hotels Group, RE/MAX, UPS Store/Mail Boxes Etc and Curves. Local well-known companies employing franchising include Fonterra, Flethcer Building, Fisher & Paykel, Harcourts, Mike Pero Mortgages, Fastway Couriers, and the New Zealand Herald.

In its most basic form franchising involves the franchisor granting franchisees the right to operate the business format in different locations. The franchisor normally charges an initial fee for this right as well as ongoing royalties, typically a percentage of sales. Key franchisor advantages include faster growth (through access to franchisee capital) and more motivated management (through franchisee owner-involvement). Franchisee advantages include a better business start based on a proven trademark and business formula, compared with building a new business and brand from nothing. In addition, franchisees often receive comprehensive training and ongoing support.

Yet, while simple in concept, franchising comprises countless combinations of forms, structures, process and restrictions. Franchising forms vary from requiring owner-involvement at the unit level to allowing multiple franchise ownership, sometimes involving 10s or even 100s of units. Franchising forms also contrast from the franchisor managing unit-level franchisees directly, to master franchising involving delegation to master franchisees. In turn, there are multiple forms of master franchising configurations. Each form has attendant advantages and disadvantages. Yet another variation is the plural form of organization, which comprises both franchised and company-owned outlets. Worldwide franchise systems average between 20% and 30% company-owned units.

Every franchise system encompasses a number of key structural components, each of which require configuring with the utmost care. Examples of eight key structural components include the design and distribution of franchisor and franchisee functions, franchise support office structure, performance management framework, information framework, systems and training, franchise fees, territory structures and the term of the relationship.

Guiding Frameworks
To date, New Zealand has no franchising-specific legislation. This is in contrast to countries like Australia, the United States, Italy, Belgium, Malaysia and China. Instead, New Zealand, like the UK and Singapore, has a voluntary, self-regulatory regime promoted and governed by the Franchise Association of New Zealand (FANZ). The FANZ requires members to comply with a set of Rules, Code of Ethics and Code of Practice. Practically member franchisors must comply with certain franchise agreement stipulations, pre-sale (for prospective franchisees) disclosure and, downstream, dispute resolution processes.

The Complexity of Managing a Franchise Network
While providing many strategic advantages franchise systems also provide a layer of complexity to the governance and chain management role. The additional challenge is primarily due to the addition of franchisees, a new set of stakeholders vital to the reputation, development and long-term success of the franchisor and network.

The introduction of franchisees gives rise to two key sources of challenge. The first key challenge relates attracting and retaining franchisees. Unlike traditional companies, franchisors compete in two markets rather than one. One is the market for the end-users of the product/service. Second is the market for high performing franchisees, which are limited in number and have increasing career choices.

The second key challenge relates to the ongoing management of the relationship with franchisees. While franchisees take responsibility for employing and managing unit-level staff, they are themselves challenging for the franchisor to manage.

While having an interdependent relationship, franchisee and franchisor goals are never totally aligned. The franchisor is understandably interested in the development (and protection) of the brand and system wide sales. Meanwhile the franchisee is understandably driven by profitability (and return on investment) and gaining the best possible foothold in their particular territory. As a consequence franchisors are often challenged with managing compliance, franchisees focusing on short-term profitability and seeking to over-adapt the model to their market, and resistance toward implementing initiatives intended for system wide benefit. By contrast franchisees see the franchisor as more interested in system growth than their [franchisee] profitability and being out of touch with their territory requirements. In addition, there is a value issue and franchisors always demands royalties on time.

Governance is further complicated by changes in the franchise relationship overtime. Following recruitment, the franchisor and the new franchisee embark on a relationship journey with changing dynamics requiring careful management. A franchisee’s basic needs, attitudes and [subsequent] actions, change overtime as they gain knowledge, operating experience and confidence. Successful management requires understanding franchise relationship foundations, dynamics overtime and, in turn, an active and changing approach to managing the relationship through each stage. A win-win approach must pervade all stages.

The nature of the franchise relationship means key chain management challenges must be approached with greater planning and empathy. Crucial challenges include managing uniformity (standardization), levels of adaptation within territories, and implementing system-wide changes for system-wide benefit. Not surprisingly, franchisees are sensitive to each area. Clearly the above challenges can be more easily approached in a company-owned chain. Indeed, employees can be ‘told’ whereas franchisees must be ‘sold’ on new initiatives. That said, research shows how a well managed plural form of organization (comprising both franchised and company-owned units) can overcome each task better than either a purely company-owned or franchised network.

Governance Implications
Franchising provides many unique challenges and requirements to the governance role, when compared with many other forms of organization. Directors and management who learn about franchising, their franchise structure and franchise management, will be well positioned to reap the advantages franchising can provide.

Good governance stems back to the decision to franchise the business. The first responsibility is to a) evaluate whether franchising is appropriate and, if so, b) ensure that the franchising form and structure implemented is appropriate and optimal for the business. Too often systems are developed with fatal flaws for the franchisor and/or franchisee. The ability to govern well will depend fundamentally on the quality of initial development, as fundamental changes to franchise structure are very difficult to implement mid-term. Expert advice from management consultants and lawyers specialising in franchising is vital.

Going forward, the board and management must have a good working knowledge of franchising. They must understand the rationale for their own franchising form and structure, how it differs from competitors, and its relationship to best practice. The challenges of franchise system management are so unique that neither role can function effectively without specialist knowledge.

The board must understand the unique challenges and requirements of franchise system management in order to plan effectively and review the performance of management. The board composition, and allocation of duties should, in turn, reflect the unique knowledge and requirements of managing a franchise system (compared to managing company units).

The board and management must at all times promote and practice ethical and responsible decision-making. Franchisees are especially sensitive to the integrity of the franchisor and their history of decision-making. In addition, the board and management must be sensitive to the public positioning of franchisees as vital stakeholders to the business. Consider McDonald’s annual report which refers continually to committed franchisees as the first of three vital legs to their system.

Directors must also know and understand the financial and non-financial indicators unique to measuring and monitoring franchise system performance. As examples, directors should know the level of franchisee satisfaction, distribution of franchisee sales and profitability, whether franchisees are paying full royalties, refurbishment program status, the proportion of units for sale, whether territories are fully exploited, level of changes implemented, level of compliance to the brand etc. Note, the franchise system must be designed to provide this information.

Public companies employing franchising also clearly have unique considerations if they are to respect shareholder rights and provide true timely and balanced disclosure. The health of the franchise system is key here. Consider a franchise network with static sales, 50% unprofitable franchisees, declining audit scores, low franchisee satisfaction, a high proportion of franchisees seeking to sell their business etc. In addition to shareholders, the franchisor also has specific and unique disclosure requirements to prospective and existing franchisees in order to conform to best practice, FANZ and/or overseas requirements.

A sound system must be established to recognize and manage risk. This is very important because franchise networks have unique risks. Specialist knowledge is required to recognize and manage key risk areas. Examples include market changes leading to an outdated franchise structure, low franchisee satisfaction, inability to implement required changes, low brand compliance, channel conflict, etc. Regular full franchise system management reviews should be employed by independent specialists to help here.

The ability to fairly review and encourage enhanced board and management effectiveness is vital for both franchisor and franchisee growth. This again stems back to initial franchise structuring decisions, whereby the franchise system must be structured to a) provide information (preferably automatically) vital to reviewing management and franchisee performance, and b) provide both management and franchisees with the franchising infrastructure and framework to effectively develop franchisee performance. Unfortunately, many franchise systems, including some public companies, were not originally structured to achieve this.

Finally, the need to remunerate fairly and responsibly applies beyond the board, key executives and other employees to franchisees. Accordingly, franchisee remuneration (long-term) must be addressed when designing the franchise structure. It also needs to be reviewed regularly. Franchisees clearly need to earn a fair return on investment after making necessary refurbishments and upgrades. Furthermore, franchisees need to feel that remuneration and fees (including the balance of royalties and rebate distributions) are fair in the light of the roles and obligations of the parties. Transparency is becoming increasingly important and even mandatory (in some overseas jurisdictions).

Conclusion
Franchising is a organizational form providing advantages to many chain businesses. Compared with other forms of organization, including company-owned expansion, franchising provides many unique challenges and requirements to the management and governance roles. As highlighted above, the ability to derive the powerful advantages franchising can provide requires a) good initial development of the franchising form and infrastructure, and b) directors and management who are knowledgeable and capable of maximizing the potential of both markets and franchisees long-term.

This article first appeared in boardroom, The Journal of the Institute of Directors (New Zealand) May 2008.

> Return to complete article list