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3

Master Franchising

1. What is Master Franchising?

In any negotiation with a “franchisor,” it is important to determine the relationship between all the players. Who are you contracting with? If it’s not a well-known franchisor with a recognizable world-wide brand, then who are you dealing with, and what rights does this person have?

Some franchisees will not acquire their franchise rights from the franchisor (or who they expect the “franchisor” to be). In some cases, their franchise contract will be with the franchisor’s Canadian branch or subsidiary, or one of its affiliated Canadian corporations. This is because many franchisors will not franchise directly out of the worldwide head office in the United States or the UK, but instead will create a Canadian subsidiary or affiliate that will run the franchisor’s franchised and corporate operations in Canada. This structure is adopted in other countries as well.

In Canada, this is done for a variety of reasons (including tax planning) and helps deal with Canadians withholding taxes. Where the US-based franchisor has created a Canadian subsidiary, that subsidiary may have a Canadian office and hire Canadian management personnel, although this is not, strictly speaking, necessary. Certainly in larger and more established franchise systems, it is normal to have a “Canadian” office that Canadian franchisees can deal with, as opposed to dealing with someone in Fort Lauderdale, Edinburgh, or Melbourne, who might lack knowledge of the Canadian marketplace, not appreciate the size of the Canadian market (let alone the weather), and be many time zones and long plane flights away.

In other instances, franchisees will be contracting with a “master franchisee” for its franchise rights. (Sometimes the term “master franchisor” is used to denote the area franchisor granting franchise rights in a territory. More often the term “master franchisee” is used.) A “master franchisee” is similar to a franchisee, only the master franchisee will have additional rights and responsibilities and a much larger territory. Instead of the franchisor granting the master franchisee the right to establish one franchised outlet in one mall in a city with 12 other franchised outlets from the same system, the franchisor is normally granting the locally based master franchisee the right to —

• establish numerous outlets on its own account throughout a large territory (say for example, all of Ontario or all of Canada); and

• sub-franchise the franchisor’s system and enter into individual franchise agreements with other entities (called sub-franchises or unit franchises).

The concept works well. Many US- or Canadian-based franchisors may lack the financial resources to expand to other territories and into other countries. Contracting with a locally based territorial master franchisee allows the “head franchisor” to expand the brand in the new territory using the “local knowledge” of the master franchisee, as well as the master franchisee’s risk capital and the master franchisee’s infrastructure (i.e., employees, offices, etc.). Risk is spread to the master franchisee. The locally based master franchisee will usually have some experience of the local market that the franchisor might not possess (i.e., they’re Canadian), and the master franchisee will often be situated in the territory, as opposed to being in Fort Lauderdale, Melbourne, or Los Angeles.

In Canada, some franchisors will divide up the country on a provincial or regional basis and grant master franchise rights to a master franchisee in respect of “Western Canada” or the “Maritimes” and that master franchisee will be charged with franchising the “XYZ concept” in those provinces while the franchisor retains the right to develop its own stores and to franchise in Ontario, Quebec, and indeed, the rest of the world.

There may be overriding reasons why a franchisor (even a Canadian one) may wish to master franchise the province of Quebec; certainly language, culture, and other distinct nuances of Quebec’s society might lead a franchisor to contract with a Quebec company, with principals and employees fluent in French, to enter unit franchise agreements in that province (in French) and service the franchise network (again, in French).

Not only does it make sense for franchisor to master franchise a territory where it may well need specialized local knowledge with respect to the territory (again, the example of Quebec comes to mind with its civil law system and language), but master franchising is also an appropriate means of expanding the brand when the franchisor does not have the financial or human resources to adequately do so. For example, a Vancouver-based franchisor may want to expand into the Ontario marketplace but understands that Toronto is a five-hour plane flight, 3,366 kilometres, and three time zones from the West Coast. Besides, Vancouver is just too nice to have to leave it in February and March when all the flowers are blooming and there’s still snow on the ground everywhere else in the country!

From the franchisor’s perspective, it may be difficult to solicit new franchisees let alone service existing ones very well if there is no presence in the “faraway territory.” Although travelling between BC and Ontario may be good for someone’s frequent flyer points, distance makes it difficult to promptly service an existing territory or expand into a new one. (You just can’t drive there in an hour for a meeting or a surprise visit, so out of sight can truly be out of mind.) Master franchising allows the franchisor to rely upon the skills, acumen, risk capital, infrastructure, and local knowledge of someone within the territory to solicit for new franchisees, open stores on its own account, and service existing franchisees.

Unit franchisees should be aware that their contract will normally be with the master franchisee and not with the so called “head franchisor.” Accordingly, the master franchisee is the only party the unit franchisee can obtain a legal remedy from because the franchisor in the US or the UK isn’t a party to that agreement. The franchisor in Fort Lauderdale does not want a phone call from a disgruntled unit franchisee in Winnipeg. It’s the master franchisee’s franchisee; it’s the master franchisee’s problem. Unit franchise agreements that contemplate the existence of a master franchisee will normally contain a provision that provides that if the master franchisee should ever be terminated, the franchisor will step into the shoes of the master franchisee. All royalties and other monies due and owing to the master franchisee will then be payable to the franchisor and not the master franchisee.

2. Cost of Becoming a Master Franchisee

It is beyond the scope of this book to advise on master franchise agreements or to analyze a master franchise agreement in the same detail that we are analyzing the unit franchise agreement in Part 2. Suffice to say, however, that the cost to acquire master franchise rights for a province or a group of provinces (or for that matter a part of a province or the boundaries of a large city) will be larger than what would be charged to acquire the franchise rights for one location only. The franchisor may do an analysis of the territory and determine that the master franchised territory will be able to support 40 outlets over a ten-year period.

Perhaps the price to acquire master franchise rights will be a product of the franchisor’s forgone income in not exploiting the territory itself. The price might be some factor of 40 initial franchise fees and 40 royalty streams.

From practical experience, when a master franchisee is franchising individual locations to the “unit franchisees” or “sub-franchisees,” the initial franchise fee and royalties may well be higher than if the franchisor was doing this on its own account. For example, a US-based franchisor may charge $25,000 USD for the rights to open a XYZ bagel emporium in the city of Seattle. If the US franchisor has entered into a master franchise agreement with a British Columbia-based company to master franchise the same concept in BC, the initial franchise fee may in fact be the equivalent of $30,000 USD; the $5,000 differential being paid to the franchisor on the signing of each unit franchise agreement.

The royalties may also be slightly higher for Canadian unit franchisees when compared to their US counterparts who franchise directly from the “head franchisor.” This is because the Canadian master franchisee will normally have to pay a percentage of the royalty it collects from individual franchisees to the franchisor.

3. Performance and Development Obligations of the Master Franchisee

The master franchisee will normally have “development obligations” under its agreement with the head franchisor. Such development obligations will often prescribe that “so many” stores will be opened in the first year followed by a higher number in the second and a still higher number in the third year. Failure to meet these performance obligations might well lead to the termination of the master franchise agreement (and the master franchisee’s rights) or the franchisor could reduce the size of the master’s territory or make the territory “non-exclusive,” entering into other master franchise agreements with other entities.

In order to meet such performance obligations (or because it wishes to reserve the best locations for itself), the master franchisee in the territory may decide to open up its own “corporate” locations that will also be subject to a sub-franchise or unit franchise agreement in each case. It is desirable that the master franchisee have some corporate stores, if for any other reason, to have day-to-day familiarity with the business just like the franchisees.

4. Negotiating a unit franchise agreement with a Master Franchisee

It may be difficult, if not impossible, to negotiate the unit franchise agreement with a master franchisee, not because master franchisees are inherently difficult and unaccommodating people, but because their contract with the franchisor may prohibit or severely restrict the master franchisee’s rights to modify the unit franchise agreement. Normally, the form of unit franchise agreement the franchisor requires its master franchisee to use (with the master’s unit franchisees) is appended to the master’s contract with a requirement not to modify the form without the franchisor’s prior written consent. US-based franchisors are very reluctant to agree to change any part of their agreements for the following four main reasons:

1. They don’t want wacky, one-off side deals floating around the known world.

2. “This is my contract, and if you don’t like it, find another franchise.”

3. They don’t want franchisees comparing who got the better deal and coming back to the franchisor to negotiate different deals.

4. Separate deals may adversely effect their own disclosure obligations under US franchise laws.

There are variations on this agreement, such as in cases in which an individual or corporation is not granted master franchise rights, per se, but rather is granted the right to find prospects, sign up franchisees who sign an agreement with the franchisor, and service existing franchisees within the territory in exchange for a portion of the initial franchise fee and a portion of the ongoing royalties, or on some other financial arrangement. This might be called a multi-unit area franchise.