Joint Ventures in International Franchising
A joint venture company (JVC) is a company participated in by the franchisor and a foreign partner, and this company could operate as a franchisee, a developer or a master franchisee; for practical purposes this party will be referred to as ‘the franchisee’ in this chapter, unless otherwise explicitly said.
A franchising company wishing to enter into a joint venture with a foreign partner for its international expansion may want to do so for one or more of the following reasons:
The complexity of the local market, which would make it advisable to incorporate a local partner instead of the franchising company setting up a wholly owned subsidiary in the foreign country.
The size of the local market or the amount of initial investment required to adapt and test the business model before starting to franchise it in the foreign market, which could make it advisable to incorporate a local partner with sound financial resources instead of the franchising company acting alone in the foreign country.
The franchising company wishing to have control of the use of its know-how that will be transferred to the foreign franchisee. Except when the franchisee is a wholly owned subsidiary of the franchising company, in all other cases when a foreign franchisee is appointed, the franchisor’s know-how is transferred to such third party, and notwithstanding the measures that the legal agreements could include and the controls that the franchisor effectively could develop, it could become challenging to monitor the use of the know-how by the franchisee.
The franchising company having a good candidate to be appointed as franchisee but this person not having enough financial resources as to develop the franchised business, in which case the franchising company decides to participate and provide financial support to the JVC that will act as franchisee.
The franchising company wishing to have a close relationship with the franchisee at the beginning of the relationship to assure the successful implementation of its business model and the initial development of the franchise network.
That is, in all these cases, to set up a joint venture with a local partner could be the best solution, compared with other alternatives: the franchising company appointing an independent franchisee, master franchisee or developer or the franchising company setting up a wholly owned subsidiary in the foreign country to develop the franchised activities. Many CEOs are reluctant to set up a joint venture for franchising purposes in a foreign country because of the legal complexities; however, if the structure of the deal and the legal agreements are carefully negotiated and drafted, the disadvantages could be overcome.
To summarise, in a JVC for international franchising the partners will be the franchising company and the local partner. The JVC will act as franchisee, master franchisee or developer of the franchising company. Ideally the JVC should start operating one or more outlets, to test and fully adapt the franchise system to the specialities of the foreign country, before starting the appointment of local franchisees in the foreign country.
When a franchising company decides to start its international expansion and chooses one or more countries, it is necessary, before taking any investment decision, to dedicate some time and resources to obtain professional advice on the following issues:
The market situation. Marketing issues are out of the scope of this book, but it is needless to say that in the complex, volatile and each day more competitive scenarios that companies face, any investment decision should be preceded by thorough market research. This research should not only include the consumers’ trends and the competitors’ situation in the foreign territory, but also the financial parameters under which the JVC and its future franchisees would have to operate in that country. It is essential in any franchise system that franchisees who manage the business reasonably well are able to obtain profits from that business, otherwise the essence of franchising is not fulfilled. Quite often, the combination of the amount of local costs (leases, salaries, supplies, etc) and the franchise costs (franchise fees, royalties, supply of goods or services, etc) imply that the franchised products or services have to be supplied to the foreign market at a price much higher than other local competitors, and in this case, unless the quality or other characteristics of the franchised products or services are much different and better than the competitive products, it will be very difficult for the franchisees to run the business in a profitable way.
Regulations applicable to the products or services that constitute the core business of the franchise. EU franchisors are used to being able to develop international expansion within EU countries without having to face regulations that are very different to those in force in their own country, however, many countries do have some degree of regulations (harder or softer) regarding many business sectors where franchising operates; for example, regarding the importation of food or the provision of educational services.
Regulations applicable to foreign investment. As the JVC will be participated in by the franchising company and the local partner, it is necessary to check potential limitations to the ownership of shares by foreign companies, the requirements to distribute dividends to foreign shareholders or to pay them royalties or technical assistance fees, and the reimbursement to the foreign shareholder of the proceedings from the sale of its shares. Taxation should be checked as well as the corporate and regulatory aspects.
Labour regulations. It is quite common for the franchising company to want to expatriate one or more of its employees to the JVC, therefore it is important to check the requirements for them to obtain residency and work permits.
Regulations regarding franchising itself. In no country are these regulations so complex as to prevent any prospective franchisors from developing their activity there, but it is always advisable to check what the requirements applicable to franchising are; for example, registration, delivery of a disclosure document, and the obligation to operate one or more franchisors’ own units during certain period before franchising.
Experts in companies’ internationalisation agree that there is at least one valid principle for all kinds of activities and all kinds of territories: never assume anything. That is, the factors that could have made a company successful in one country could be similar in another country, but if only one of these factors, which the company could have taken for granted because it was too obvious as to be seen as a possible hindrance, is different, this could cause the failure of the new product or service if such small different factor is not properly analysed.
Election of the right foreign partner
Much has been written about the election of the right franchisee or master franchisee, and most of the following characteristics that are desirable in a master franchisee could be applied to a partner in a JVC for developing franchising activities abroad:
Deep knowledge of the local market. As pointed out above, one of the reasons of pursuing a joint venture with a foreign partner is the complexity of the local market, therefore the franchising company should check the foreign partner’s knowledge of the local market. Many people will consider it enough that the foreign partner is a native and has been raised in the foreign country, but other requirements should be sought.
Experience in the same business sector. Nowadays any business is complex in terms of management, regulations and being competitive, therefore having previous experience in the same business sector is a valuable quality. However, it is not essential, as this experience can be acquired.
Management skills. Apart from in the case that the foreign partner is going to be just a financial partner and delegate the tasks in the JVC to an employee or collaborator, the foreign partner should prove to have management skills, or at least to be business-oriented.
Ability to act as a cultural bridge. The foreign partner will have to help the franchising company understand the peculiarities of the local market and adapt the business model, and to do this successfully it is necessary not only to know the local market but to know the business culture in the country of origin of the franchising company. Speaking the language of the country of origin of the franchising company is a must, and it is a plus to have lived, studied or done business there.
Financial soundness. When the purpose of the JVC includes a substantial financial contribution by the local partner, it is necessary to check the availability of such resources by the local partner.
Undoubtful background. Especially when doing business in countries with a very different cultural background from the original country, it is important to hire the necessary professional services to check the business background and reputation of the prospective partner.
Usually it is not possible to meet a candidate that fulfils each and every requirement to a high degree, therefore it will be necessary to evaluate all the candidate’s qualities and ascertain which ones are more or less relevant for each case: for example, depending on the franchising company’s activity, the foreign partner’s experience in the business sector could be essential, or the key element could be his or her financial soundness if the JVC’s development plan implies a lot of investment. In any case, the knowledge of the local market, the skills to act as a cultural bridge and an undoubtful background are a must.
The contributions of each party
One of the main characteristic of a JVC is that each of its partners make contributions to it, in the form of direct contributions to its share capital or other types of contributions such as services or supply agreements. The contributions may be in material or immaterial assets and may include the commitment to work for the JVC.
At the first stage, the parties of the JVC will have to agree on what will be the contributions of each of them and on a second stage they will negotiate what value is given to such contributions. This value is relevant, as it will have a direct impact on the valuation of each partner’s share in the JVC. Finally, the parties – or more likely its legal and tax advisers – will agree on how the contributions are formalised.
The franchising company will contribute with the assets related to its activity: the trademarks and other IP rights and the know-how (all considered as immaterial assets), plus the material assets necessary to develop the activity, which vary depending on each different type of business: in many cases it will include furniture and decoration (as the uniform presentation of the premises is one of the main features of a franchise network); and it could also include the machinery and tools (eg, in restaurant franchises) or the first stock for the JVC (eg, in retail franchises).
The contributions to be provided by the local partner will depend on the purpose of the JVC. For example, if the purpose of the JVC is to have a financially sound local partner, the local partner’s financial contribution will be essential, or if the franchising company is interested in providing financial support to the foreign franchisee as part of its internationalisation strategy, the local partner would normally be expected to provide working or consulting hours. In other cases, there could be an interest in the foreign partner providing some kind of material assets to which it has easy access: for example, locations and premises, raw materials, or products that will be branded with the franchisor’s trademarks.
In any type of JVC for franchising activities, knowledge of the local market by the foreign partner is essential, and therefore the parties must negotiate and agree in the most clear and detailed way possible how this immaterial contribution will be provided. It is needless to say that the description of the contributions in material assets is easier to do than the description of the knowledge to be provided by the local partner. The know-how to be provided by the franchising company is also an immaterial asset, but the franchising company, through its manuals and the experience of having assigned such know-how to its franchisees, already has a description of the know-how and how it should be assigned to and used by the franchisees. The description of the know-how to be provided by the local partner can be done in terms of working dedication, staff allocation, consultancy hours, contacts to be introduced or goals to be achieved. These goals can be of many different types: starting the JVC’s activities within a certain time frame; opening franchised or owned units in accordance with the development plan; or achieving the smooth supply of certain goods. It is necessary to point out that when the foreign partner offers contacts with the authorities to obtain the necessary permits, the franchising company should be diligent to avoid becoming involved in activities that could be considered as corruption.
As mentioned above, the first stage consists of defining what will be the material and immaterial contributions of each party; once defined it is necessary to negotiate what value will be assigned to each of them.
With regard to the contributions of the franchising company, it is easy to ascertain its market value (the value accepted by independent parties in a similar transaction, for example, in any franchise or master franchise agreement entered before by the franchising company), and based on this value, negotiate what value is given to it when contributing to the JVC.
The contributions by the local partner may be more difficult to value, but in any case, the starting point should be the market value – that is, the value that would be agreed by independent parties in a normal market situation, and based on this value, the parties should negotiate the precise value that will be given to such contributions when made to the JVC.
The financial contributions to the JVC can be agreed to be an obligation of either of the parties or both, in the same or different amounts. For a smooth development of the relationship between the parties it is necessary to have a carefully drafted business plan, which should include, after the necessary professional analysis, what will be the amount necessary to invest in the first stage and what will be the amounts needed for the development of the business plan, until the company is able to finance its growth and activities with its own financial resources. It is especially important to have a sound commitment from the party that is to provide the amounts necessary for the JVC’s second stage. The JVC agreements should include the possibility of terminating them if the party who must provide the financial resources fails to do so.
The non-disclosure or confidentiality agreement
During the negotiations regarding the contributions of each party to the JVC, it is normal to enter into a non-disclosure agreement (NDA) – also known as a confidentiality agreement. Normally, the initiative to enter into a NDA comes from the franchising company, which has a great interest in protecting its know-how and confidential information.
To be effective, this type of agreement should first identify which parts of the information that will be disclosed to the other party are confidential. It would be advisable not to use a standard form of NDA, but use NDAs adapted to each specific case. For example, the effectiveness of the NDA is weakened if we include as ‘confidential information’ documents or information that appear in the company’s website or that is usually delivered to people interested in the franchise, or that has become public for whatever reason.
Once the confidential information has been identified, the persons to whom it will be disclosed should be listed, considering that these persons may have an interest in sharing such information with their partners or professional advisers, in which case such persons should also be requested to sign the NDA, directly or after a request by the prospective partner in the JVC.
Other usual clauses in an NDA are those referring to: whether the confidential information could be copied or reproduced by any means; when the confidential information and its copies will have to be returned (usually at the end of the negotiations if no final agreement is reached); the duration of the agreement (usually for an indefinite period of time, meanwhile the information continues to be confidential); penalties in case of breach; and applicable law and jurisdiction.
With regard to the penalties, it is quite usual in an NDA to include severe penalties in case of a breach. The calculation of the amount of the damages caused by the breach of the NDA is very complex, therefore it is advisable to mention a figure or an objective method to calculate such figure, which could be based on an estimation of the damages caused or calculated as a penalty with dissuasive character, or both.
However, most cases of breach of an NDA are very difficult to prove, and consequently so is the liability of the party who has allegedly breached it. This means that many breaches of the confidentiality commitment remain unpunished, but in any case, it is better to have an NDA carefully drafted and signed than to not have it at all.
The letter of intent or memorandum of understanding
Like the NDA, at a certain stage during the negotiations between parties, one or both may feel that it is necessary to enter into a letter of intent (LOI) or memorandum of understanding. The purpose of this type of document is to state the intention of both parties to negotiate in good faith the terms for entering into a JV agreement, so that each party feels comfortable that the other one has the same intention and that there are no misunderstandings to date. An LOI does not oblige the parties to reach a final agreement, but could include an exclusivity clause, which aims to assure that one or both parties are not negotiating a similar JV agreement with a third party, and in this case, the LOI, or at least the exclusivity clause, should have an expiry date.
Some LOIs are very complete and include all the main agreements reached by the parties, leaving only the drafting of the contracts to be completed, while others are less detailed and, for example, do not include the valuation of each party’s contributions because they should be calculated after an appraisal or due diligence process.
Sometimes, when the franchising company has a strong position in the market and several prospective candidates to become its partner in the JVC, it may request such candidates to make a deposit as proof of their seriousness in the negotiations. In these cases, it is necessary to check if any mandatory provision regarding franchising could be applicable, in the sense of prohibiting the franchising company to receive any amount from a prospective franchisee before the delivery of the disclosure document. The partner in the JVC is not an ordinary franchisee but, as the provisions on this subject are usually mandatory, it is better to avoid the risk of breaching such rules.
An LOI normally includes a confidentiality agreement as well, when it has not been agreed in a separate document, and the usual clauses regarding applicable law and jurisdiction.
The shareholders’ agreement and other agreements
The agreements for a JV would normally include the main agreement or ‘frame agreement’, which rules the obligations of each party to take actions (ie, to incorporate the JVC and make the agreed contributions in kind or in cash) and subscribe the agreements that have been agreed to make the JV fully effective: the franchise, master franchise or development agreement between the franchisor and the JVC; the licence and supply agreements between the franchisor and the JVC; and the supply, financing, consultancy, professional services or work agreements between the foreign partner and the JVC. Of course, when we say the ‘foreign partner’ we refer to an individual person or the company or companies through which this person acts. The foreign partner could use different companies, for example to provide the financing and consultancy services, in the same way that many franchisors have different companies to provide the know-how, the licence for the IP rights and the supply of material assets or merchandise. If the foreign partner’s obligation is to provide working hours to the JVC, the frame agreement will include a clause according to which the parties undertake that the JVC will enter into a labour agreement with the individual foreign partner. Needless to say, the salary, tasks and responsibilities, working hours, holidays, termination notice and its consequences should have been previously negotiated between the parties, and usually they should be written in the LOI.
It is important to distinguish between the frame agreement and the agreements that the franchisor usually enters into with a foreign franchisee. Often, franchisors just enter into a franchise (or master franchise or development) agreement with the JVC, adding some special clauses pertaining to the fact that it is a JVC or a side letter, but in this author’s opinion the frame agreement allows better regulation of the relationships between the parties and the fact that the JVC will be a franchisee of the franchisor.
Another matter is whether there should be a frame agreement plus a shareholders’ agreement (SHA). The SHA regulates the relationships of the parties with regard to their position as shareholders of the JVC. In this author’s opinion the frame agreement could many times include all the clauses of an SHA, making it unnecessary to have it in a separate document, but it will have to be analysed for each case if it is advisable to have a frame agreement as well as an SHA, or just a SHA.
Some important clauses to be included in the frame agreement or the SHA are those that refer to the contributions of the parties that should be materialised during a period after the incorporation of the JVC, and the termination clauses, which specify the causes of termination and its consequences. Other typical clauses are those regarding notifications between the parties, severability, non-competition, applicable law and jurisdiction. As in any international JV, submitting the disputes to international arbitration, especially when the arbitration institution is specialised in franchising and distribution, could imply substantial advantages in terms of speed, cost, accuracy and fairness of the arbitral award.
The clauses that are typical of an SHA agreement are those referring to the functioning of the JVC, which are not included in the articles or association, or imply special rules: for example, regarding the calling of the shareholders’ meeting and the voting rights, the appointment of the sole director or the members of the board of directors and the functioning of this management body, the distribution of dividends, share capital increases or decreases, accounting and auditing, or the liquidation of the JVC. Clauses regarding the sale of its shares by any or all the partners in the JVC deserve special attention and are analysed below in the section titled ‘Exit clauses’. As mentioned above, these clauses could be contained in the frame agreement if there is no reason to have two different agreements.
The incorporation of the joint company
While the signing of the agreements discussed above does not usually require any special formality, apart from, in most jurisdictions, being written, the incorporation of a company does require some degree of formality in many countries, such as being signed in a public deed granted before a notary public and entered into the companies’ registry or chamber of commerce.
Both partners or shareholders of the JVC will have to personally appear or be duly represented before the notary public. The franchisor company will therefore have to grant a power of attorney (POA) in favour of an individual person who will represent it before the foreign notary who will incorporate the company. The POA will need to be legalised and apostilled in its country of origin (or legalised by the correspondent government authority if the country of origin or destination is not a party to the 1961 Hague Convention on the Apostille). There will also have to be a sworn translation of the POA into the official language of the foreign country, but some notaries do accept POAs drafted in two languages (the language of the country or origin, namely, the franchisor company’s country; and the language of the country of destination, namely, the country of the JVC). Notaries in many countries will also request that the franchising company provides a good standing certificate; that is, a certificate issued by the companies’ registry or the chamber of commerce, stating the legal existence and main characteristics of such company, and this certificate will have to be legalised, apostilled and legally translated.
At the incorporation moment the contributions of each party should be given to the JVC, and in exchange each party will receive a certain percentage of the JVC’s shares. During the negotiation period the parties will have agreed on the type of contribution to be made by each of them and the value that should be allocated. In case of immaterial contributions, the party’s advisers should have checked what corporate rules are applicable to them for being incorporated to a JVC. With regard to the contributions in cash, nowadays many countries request the foreign company making such contributions to prove the legal origin of its funds to fulfil the anti-money laundering regulations by means of providing, for example, certified copies of their corporate income tax, bank excerpts or a statement of who is the last beneficial owner.
Also, at the incorporation moment the first director or board of directors of the JVC is appointed. The corporate laws of some countries request that these persons personally accept such appointment, therefore the appointees should appear before the notary or should have granted a POA in favour of another person who will represent them for this purpose.
Normally, other agreements are signed by the parties simultaneously to the incorporation or just after it: for example, the franchise, master franchise or development agreement, the financing agreements, and the supply agreements.
The development of the network
Once the JVC is incorporated and fully operative (normally after being entered into the companies’ registry, having obtained its tax number, being registered before the labour or social security authorities, and having its bank account activated) it could start the development of its own activities as they have been agreed by the partners in the frame agreement or the SHA, based on the previously approved business plan.
Normally the main activity of the JVC after incorporation will be to look for a suitable location and open the franchised outlet as soon as possible, following the terms and conditions of the franchise, master franchise or development agreement. The franchisor company will have to provide the necessary training to the JVC’s staff and provide the manuals and know-how as it has been agreed by the parties.
In a second stage, if the purpose of the JVC is to act as master franchisee, it will start to commercialise the franchise in the foreign country and enter into franchise agreements with local franchisees. The frame agreement or the SHA should include a clause regarding the possibility of the local partner being appointed franchisee for one or more outlets, apart from the outlet or outlets operated by the JVC. If this possibility is included, the local partner will have two kinds of relationship with the franchisor: on one hand he or she will be partner in the JVC and on the other hand he or she will be an ordinary franchisee of the JVC.
It is advisable that the franchise agreements do include the usual clauses regarding assignment of such agreements to a new master franchisee, or directly to the franchisor if the master franchise agreement between the franchisor and the JVC is terminated.
The term ‘exit clauses’ here includes both the termination clauses and the clauses under which one of the parties would sell its shares in the JVC to the other party.
The termination clauses should operate at two levels. On one level, the franchise, master franchise or development agreement should include the usual termination clauses in case of breach of the agreement. The fact that the franchisee is a JVC participated in by the franchisor does make a difference, but considering that the franchisor is not the sole shareholder of the JVC, nor does it have an absolute control of it, it is advisable to have clear termination clauses. Of course, the local partner will have an interest in being protected against unfair termination by the franchisor, but the usual clauses regarding this matter should be valid in this situation. The fact of the franchisor being a partner of the franchisee company (the JVC) should imply, in principle, that it will have a bigger interest in maintaining the relationship than terminating it.
On the other level, termination clauses should be included in the frame agreement or the SHA. While the consequences of the termination of the franchise agreement are easy to draft (the usual ones would be suitable), the consequences of the termination of the frame agreement or the SHA are more difficult to establish: it could be that for any reason one or both partners of the JVC wish to terminate their relationship as partners, but if the franchised business is developing well, both parties could have an interest in continuing with such business: should then the local partner continue as the sole shareholder of the JVC? If such local partner is performing well as franchisee, there should not be any reason to put an end to this situation, provided fair compensation is paid to the franchisor company for its contribution to the JVC. If the situation is the opposite – that is, the local partner wants to finish its involvement in the JVC, and the franchising company is interested in continuing – the necessary clauses in the frame agreement or the SHA should allow the purchase of the local partner’s shares in the JVC at a fair price.
Normally a JV agreement includes clauses regarding the ‘drag along’ and ‘tag along’ rights. In the case of a JVC dedicated to franchising activities, the sales of its shares to a third party is not usual, but not impossible either. Therefore, it is advisable to include the clauses regarding when a party is entitled to buy the shares of the other party or when a party could oblige the other one to purchase or to sell its shares, and how the price will be calculated in each circumstance and how it will be paid. These types of clause, even though complex to negotiate, normally save a lot of argumentation and litigation when any of the parties in the JVC does not feel comfortable enough to continue with it. They provide a fast and affordable solution when there are serious misunderstandings, and the final consequence is the preservation of the brand’s value.
Reproduced with permission from Law Business Research Ltd. This article was first published in Getting the Deal Through –Practice Guides: Franchise 2019 (Published: May 2019). For further information please visit www.gettingthedealthrough.com