Contributor article: A Survey of International Retail Franchising
In some key markets there are regulatory barriers to corporate expansion. Retailers therefore generally use a variety of third party structures. However there is a marked lack of data available about the financial models generally used and the overall “health” of these businesses. Field Fisher Waterhouse therefore decided to carry out this survey with its consultancy arm, FFW Consultancy (FFWC) into the fees and other revenue streams charged by retailers expanding into the international markets.
Not surprisingly the majority of retailers charge initial “territory development fees” for the grant of rights to do the business in a particular country or regional market. Unsurprisingly the initial territory fee in almost all cases varies according to the market Clearly the market potential affects what people are prepared to pay. A very few do not charge upfront fees at all, taking the view that they would rather have their operators investing the money in developing the business.
The vast majority of franchisors charge a percentage of sales as royalties. Those who do not tend to have a product margin-based revenue model. The practice with joint ventures varies, and we have come across a surprising number of cases where the tax structuring has been neglected in such arrangements (arms length “transfer pricing” issues in relation to the value of the trademarks/system being made available), causing potential problems in the future.
Although provision for a central international advertising and marketing fund is made in most franchise agreements, the results suggest that very few international retailers establish one to which they require contributions. The majority sensibly require a significant commitment to a local advertising and marketing spend in the local market – where it should be spent and will support and raise the local profile of the brand and therefore sales.
The charging of a mark-up on tied products supplied is critical to most of the business models of retailers involved in dealing with third party operators. Those who do not charge a mark-up are typically passing on at cost, usually with a handling fee and always, in our experience, with royalty unless there is a JV situation. An issue which was not addressed in the survey, but which in our experience greatly impacts upon the quality and sustainability of the relationship, is whether there is transparency with regard to the mark-ups and the size of those mark-ups.
It was notable that a good number of retailers have adjusted their financial model recently. We suspect that this is due both to inadequate financial modelling when structuring the franchise initially and wonder whether others may do so as a result of this benchmarking exercise (which was one reason for our doing the survey). Over time those who charge store opening fees must increase them if they are designed to partially cover the franchisor’s costs in assisting with the development of the market, since those costs inexorably rise during the life of the relationship.
As well as surveying the financial structures used we also asked questions about problems with the third party relationships, and whether respondents had taken equity stakes in their local partners.
In recent years, there has been a significant trend to build such exit structure arrangements into even arm’s length franchise deals as a key part of the market entry strategy. There are advantages in doing so for well-funded companies, approaching saturation in the home market.
Particularly those who have to deliver inexorable growth to the public markets. It puts the levers in place to turn an arrangement producing arm’s length royalty and/or product margin on merchandise sales into a share of the operating profits from the local operations as well.
However joint ventures are, in our experience, often commercially inappropriate to effectively implement those strategies and sometimes more subtle structures such as subordinated equity arrangements are used to better effect.
In recent years, with the emergence of the major BRIC markets, more Western brands are realising that there is significant local profit potential to be taken by including purchase options in the deal, and then exercising them at some point. Those without such options tend to be firmly of the view that they will simply never invest the company’s money overseas. The difficulty with conventional approaches to purchase options such as enforceability and a range of exercise issues has traditionally been a barrier. However more creative and innovative approaches, such as subordinated equity arrangements have enabled a more finely tuned and strategically appropriate way of dealing with this issue.
Franchising continues to be a key part of the internationalisation strategy of many UK retailers ranging from the very large to the fairly small. Traditional approaches seem to be changing in favour of more sophisticated structures. A wide range of financial arrangements are used, very often depending upon retailer specific issues. Unfortunately disputes are not uncommon and one wonders if this is at least in part due to the current economic slowdown.
Dr Mark Abell will be speaking at the Retail Bulletin’s 2nd International Expansion Summit 2013. He will explore the structural options for the internationalisation of retail businesses and how to select the most appropriate structure for each markets with particular focus on markets such as India, South East Asia, China, the Middle East and Russia. Click here for programme details and to register.
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