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Fighting shy of the franchise route in China

If a country already has 1,500 foreign and domestic franchise companies, over 70,000 franchisees and another 300 foreign companies waiting to enter the market, then it has to be an attractive franchisor destination, right? Not if the country is China, which already has several global franchisors operating on its soil. These include McDonald’s, Kentucky Fried Chicken (KFC), Dairy Queen, 7-Eleven, Pizza Hut, Days Inn and Sign-A-Rama. KFC alone has over 1,000 outlets, while McDonald’s has 560, Pizza Hut 110 and Starbucks 70.

KFC’s late Colonel Sanders may be a commercially revered icon in China, but McDonald’s has upped the ante in the intensifying competition by recently hiring Chinese basketball star Yao Ming of the Houston Rockets, USA, as its official spokesperson. To further improve brand recall and steal a march on its competitors, the hamburger chain also signed a contract to sponsor the 2008 Summer Olympics in Beijing.

 

Yet, major franchisors did not start up in China via the franchise format but through joint ventures (JVs) with local partners.

“Several companies with very high-profile franchising operations internationally have entered the Chinese market with a standard foreign-investment model. This involves [forming] a limited-liability joint venture with a strong domestic company, followed by the opening of branches in [various] locations,” says Fraser Mendel, known IPR (intellectual-property rights) expert and Beijing-based senior associate, corporate department, Morrison & Foerster.
KFC, which entered China in 1987 and became one of its best-known foreign brands, is an example. Although it is currently in almost 1,000 locations (it opened over 200 outlets in 2002 and another 200 in 2003), the brand started franchising only recently and with a limited scope.

McDonald’s, which opened its first store in 1992 and now has over 560 outlets, also started looking at franchising opportunities only last year.

Understandably, 2003’s sales from franchised stores increased 44% from 2002 but they still accounted for only 2% of all retail sales.

Today, foreign franchisors entering China are not limited to JVs. “Since June 1 of this year, foreign entities have been allowed to establish fully-owned companies in the commercial and retailing areas. JV is not a must for foreign franchisors (except in special areas where there are still prohibitions),” says James Liu, chief partner of FranChina, a leading consultancy in China focusing on franchising issues. FranChina also operates two leading franchising-related websites — the www.franchising.cn and www.chainstore.cn.

Why then do foreign franchisors still shy away from their core format in China? The answer lies in the country’s laws and related problems linked to trademark piracy, underdeveloped infrastructure, uncertainties relating to the enforcement of contracts and the weak dispute-settlement mechanism.

Besides, the franchising concept is new to the Chinese market. Although foreign franchisors like KFC entered the country nearly 20 years ago, cross-border franchising has not been explicitly provided for under Chinese law. Hence, cross-border franchising is often perceived to be illegal, although there is nothing barring it.

To explain the situation, Phil Zeidman, international franchise and distribution expert, and senior partner at Piper Rudnick LLP, cites the Chinese government’s first effort to address franchising through a regulation adopted in 1997.

Being administered by the China Chainstore and Franchise Association, a quasi-governmental organisation, and adopted by a ministry without jurisdiction over foreign trade and investment, the “Measures on the Management of Commercial Franchise Operations” regulation was little more than a form of agency ruling that did not cover cross-border franchising. “A new and more comprehensive regulation is expected before the end of the year,” says Zeidman.

The franchise business model’s success in many other countries has been ascribed by Mendel to those countries’ stable and predictable legal frameworks. This stability not only reduces business costs but also creates a system that assures franchisors of their rights against franchisees, and which values and protects IPR such as trademarks, copyrights, know-how as trade secrets and patents — all key elements of franchising.

China’s modern legal system is less than 20 years old. Committed to transforming the country into a modern economy, the Chinese government has undertaken a monumental task to create a legal system to support that economy. The result is a new legal infrastructure of laws, enforcement mechanisms and dispute-resolution process that has been undergoing a seemingly endless changes since the economy first opened to foreign investment.

“As this system has quickly developed, the protection of IPR has lagged behind. [Thus], until recently, the fundamental legal environment in China has not been reassuring for foreign franchisors,” observes Mendel.

Moreover, market entry has been made more difficult by the country’s foreign-investment regulatory regime restricting domestic franchisees’ ability to remit payments out of the country solely for the provision of IPR. Further, a comprehensive franchise law proposed by the government several years ago has remained in draft form.

“[All] this has created additional uncertainty for many foreign franchisors, which have been reluctant to invest in China, where there is a distinct possibility that the overall rules of engagement will change when the draft franchise law is promulgated,” says Mendel.

 

Domestic competition:

The legal system aside, a foreign entrant also has to contend with domestic competition. Several local franchisors, including Beijing Quanjude Roast Duck, Tianjin Goubuli Steamed Bun, Shanghai Ronghua Fried Chicken and Lanzhou Jinding Beef Noodles, are emulating foreign models.

Not only do these local operators have local understanding and relations — important to doing business in China — they also have local laws working to their advantage. Existing regulations that provide guidance for domestic franchise activities are not applicable to foreign franchisors. “This gives domestic franchisors regulatory stability while foreign franchisors are still waiting to see what the new regulations governing their operations will involve,” says Mendel.

 

Why the China rush:

If things are so unattractive for franchisors, how does one explain the China rush? “How could [foreign franchisors] not be interested?” counters Zeidman.

China’s juggernaut economy has spawned a rapidly-growing middle-class with ample disposable income and a pent-up desire for faster, trendier and more convenient lifestyles.

This booming trend is evidenced by retail sales growing annually at an average of 10%, with retail food and clothing sales growing at higher rates.

Although China’s average disposable income is low by developed countries’ standards, the typical franchisor is not trying to reach all its 1.3 billion consumers, nor finding it necessary to do so, Zeidman maintains. “The buying power of this country is concentrated in urban centres (there are more than 100 of them), each having a population of more than one million,” he says.

He notes that the advent of TV has raised the level of Chinese buyers’ awareness of the consumption patterns of the West, and the cachet of modernity has created a demand for the products and services of mostly American, and some European, franchises. “A growing number of indigenous franchise companies are also tapping these new consumers,” says Zeidman.

Adds Prof Chen Ye-Sho, associate director of International Franchise Forum and professor of management information systems at the EJ Ourso College of Business Administration, Louisiana State University, USA: “Although there is room for improving China’s IPR law, the fact that China has become the world’s second-largest FDI recipient, after the US, implies that prudent investors have found the opportunities of making profits in the country outweighing the fear of IPR infractions.”

Early entrants are waiting for the day China’s norms will be eased and aligned with those practised internationally. The country’s World Trade Organisation (WTO) commitments for franchise operations include removing restrictions on geographical location, number, equity ratio and form of establishment for foreign investment by December 2004.

Foreign franchisors can also expect IPR issues to be resolved soon — as well as a more level playing field. Although they recognise the limitations of the standard JV model, many companies find it “the best way to protect their key assets and build their brands in China while waiting for the legal system to reach a state of development that supports full-fledged franchising operations”, says Mendel.

 

Precautions:

Some precautions remain essential in a market where the norms are still evolving and the legal framework is fluid. FranChina recommends its overseas clients to consider four basic criteria when choosing local partners and franchisees: Experience, funds, public resources and credibility.

“Usually, we don’t suggest a foreign franchise system develop a franchising arrangement with individuals directly in the beginning. Master or area franchising is a more secure approach for a new entrant to this market,” says Liu of FranChina.

Prof Chen also warns against market entry without being aware of pre-existing laws. He identifies “finding good partners, adaptation to local needs, enforcing uniformity standards” and dealing effectively with copycats as some of the issues new entrants will have to tackle.

 

The path ahead:

Experts are convinced that IPR will be a top issue facing franchising in China. “The fundamental issue of how to structure a franchise relationship remains,” says Zeidman. “Many franchisors have cobbled together a set of various cross-border licensing arrangements to deal with this problem. Whether the Chinese government will recognise and address this wasteful and convoluted process, perhaps as part of the package of reforms adopted in the accession to the WTO, remains to be seen. Western franchise companies are cautiously optimistic,” he says.

Liu foresees that the right mechanism for the exit of incompetent franchisees will become more important than merely knowing how to develop more local franchisees.

“By the end of this year, a new franchising regulation will replace the current one. We believe that will be more complete in protecting the rights of both franchisors and franchisees,” he says.