China – The New Franchise Frontier

Franchising was only introduced to China in the early “90’s, but according to Rod Young, Executive Director of DC Strategy , “China is emerging as one of the fastest growing areas of franchised retail brand development in the world”.

Western franchises may have started the trend but Chinese entrepreneurialism has been quick to grasp the significance of the franchised business model to harness local, small business zeal to large-scale business brands, distribution and processes.

Jeans West was an Australian-owned clothing retailer that was acquired by its Chinese supplier. The business model and name has expanded throughout China.

While we all think about McDonalds and KFC being franchising trailblazers consider this:- Jeans West has over 1000 stores in China and about one third are franchised including 3 franchised stores in Tibet. They are all displaying the distinctive Jeans West signage that originated in Perth, Western Australia in the ‘80’s.

The business has more utilitarian fashion to meet the practical needs of the local market and the significantly lower labour costs are reflected in the staffing structure. For example, in Australia, a typical Jeans West store has 2 to 4 staff where in China from 10 to 20 employees will assist you to make your purchase. However the brand is what binds these stores together and the business format that the franchise model is built on has allowed even the largest company-owned networks to expand into areas where the branch model is challenged.

Young says “This highlights a trend that will continue in China in the same way that franchising has been adopted in many other world markets. The foreign majors may establish the concept of franchising but as China grasps the significants of branding a business (which, unlike a product, cannot be as easily counterfeited), home grown Chinese businesses will develop to represent 90% of franchise systems in China.”

The China Chainstore and Franchise Association is a quasi-government organisation that is responsible for mandating rules and codes of conduct for franchise operations and promoting franchise development. It represents the franchising industry in China and reports there are currently over 1900 separate franchise chains operating in China engaged in over 50 business sectors with 87,000 individual franchised outlets. Many of these organisations are locally established Chinese businesses.

This development has been pioneered by the successful entry of foreign franchisors like McDonald’s, KFC and Pizza Hut (although to date the operations of these companies in China is primarily through a company owned and managed structure rather than through a traditional franchise network), and more recently many other western brands such as Starbucks with 150 stores in 6 years and Subway with 27 locations.

Local franchisors such as the Hulian Supermarket Chain have used franchising to drive growth and have led the way for the development of domestic Chinese businesses to grow through franchising.

Liberalisation

Ian McCubbin, Leader – China Business group at Deacons says ”The future development of franchising in China has been stimulated by two significant government initiatives – the liberalisation of foreign investment pursuant to its WTO accession obligations and the introduction of a comprehensive franchise law subjecting domestic and foreign franchisors to a common regulatory regime.”

The ongoing development of franchising in China will also be supported by significant social factors including factors such as changing consumer attitudes, an expanding urban middle class with increasing income, and a growing breed of Chinese entrepreneurs who have the business acumen to run and the financial capital to invest in a franchise.

The fast food/restaurant and retail industries are generally regarded as providing the greatest potential for foreign franchisors. A number of multinational fast food chains are already operating in China, and department stores, chain stores, supermarkets and hypermarkets are some of the fastest growing retail sectors in China. Franchises in the services sector are developing quickly. Increasing affluence in the major cities such as Shanghai, Beijing, Guangzhou and Shenzhen has been accompanied by increasing demands on time which is creating a demand for services, increasingly met by franchise systems.

Market Entry for Franchisors

Despite the recent history of China being one of increasing liberalisation in terms of market entry, participation in formerly restricted business sectors and in modes of business operation, foreign participation in the domestic franchise sector has been a complex and difficult process. However, under the protocol governing its membership of the WTO in 2001, China agreed to open its markets to foreign enterprises in wholesale, retail, services and franchise sectors, with certain restrictions, by the end of 2004. In June 2004 Measures for the Administration of Foreign Investment in the Commercial Sector which repealed previous foreign investment Measures came into effect. The 2004 Measures remove many of the restrictive requirements for establishing commercial foreign investment enterprises and open foreign investment in retail and franchising operations to foreign enterprises operating through a sino-foreign equity or co-operative joint venture or a wholly owned foreign enterprise.

Franchise Regulation

In November 1997 the then Ministry of Internal Trade issued Interim Measures on the Administration of Commercial Franchise Operations (Trial Implementation) which created the first regulatory framework for franchising in China.

From a Western perspective the 1997 Interim Franchise Measures were not particularly sophisticated. In effect they described how franchising works rather than setting out a comprehensive regulatory regime for franchising. But, in the context of a system in which activity which is not expressly authorised is, by implication, prohibited the Measures, despite being administrative rules of a general nature, had a significant role in the official recognition and, by implication, encouragement of franchising as a distinct method of business operation.

In February 2005 Measures for the Administration of Commercial Franchise Operations that subject both domestic and foreign franchisors to a uniform regulatory regime replaced the 1997 Measures. These new Measures cover both direct and sub/regional franchising and require all franchising to be conducted pursuant to the principles “of voluntariness, fair dealing, honesty, and credibility”. The Measures prescribe the necessary qualifications of the parties to be a franchisor or franchisee (which include, in the case of franchisors, that at least two direct sale stores have been in operation for more than one year within China). Prior disclosure, rights and obligations of the parties, and the content of franchise agreement are provided for. Foreign franchisors are subject to an application and approval regime and must apply for approval to “engage in commercial activities by franchising” by submitting documentation including the business licence, FIE approval certificate, proof of qualifications to be a franchisor, prior disclosure information, the standard franchise agreement and the Franchise Operations Manual.

The Franchising Measures require franchising to be conducted “under the laws and regulations of the People’s Republic of China”. China is currently modernising its legal system and its business laws. But although advances in developing commercial laws on western models and implementing reforms designed to establish a more transparent and predictable regime for business dealings and legal certainty are impressive, the reform process is not complete.

According to Mr McCubbin, the two key areas for consideration by foreign franchisors are intellectual property law and contract law.

China’s IP laws are becoming increasingly sophisticated and familiar but enforcement remains a real problem. China grants trademarks on a “first-to-register” basis. Therefore, it is imperative that a franchisor considering establishing a franchise in China registers its trademark with the relevant Chinese authority as the first step in any franchising plans for China. A failure to do so can have devastating consequences. Similarly, it is important for a franchisor to take steps to protect its copyright in operations manuals and other written material by educating its franchisees (and all employees of the franchise operation) on the need to keep copyrighted material that contains trade secrets confidential. Franchisors should also register their trademarks and trade names as domain names.

China has recently introduced a new uniform Contract Law on the civil law model based on internationally recognised commercial contract principles. Contracts are nevertheless not accorded the sanctity they enjoy in the west and are frequently regarded as a preliminary understanding rather than a final agreement.

Who will be your franchisee?

Finding a solid reliable and compatible partner is one of the greatest challenges for a foreign franchisor expanding into China just as finding the right single unit franchisee once the pilot operation launches its domestic franchise network. Without a local partner / master franchisee, business operations for foreign franchisors is extremely difficult in China. The complexity of negotiations with a potential business partner and concerns as to loss of control in a venture with a party who does not necessarily understand western business and franchising norms is a common problem.

As the reader may know, China is not “one country” but is characterised by significant regional differences not only in consumer tastes and preferences but also in relation to bureaucratic administration of law at a local level.

Rod Young says “Much of the domestic franchising activity in China is still quite basic in the application of franchising as a management and marketing technique and as a vehicle to grow a significant network and brand. The opportunity to develop some of the worlds largest franchised networks will come from the application of the more sophisticated franchising know-how held by western franchisors and practitioners that have learned to apply franchising in more mature markets.”

DC Strategy (www.dcstrategy.com) is using its substantial franchising and network development experience in western markets to advise not only foreign based franchisors on franchise entry strategy into China but domestic Chinese businesses on franchise development processes that will provide them with the competitive edge over the many home-grown franchise systems that are climbing onto the franchising bandwagon.

China is undoubtedly a market with massive potential for franchising driven by rapidly developing legal, commercial and social factors. Its massive franchising potential is nevertheless tempered by substantial, but not unsurmountable, challenges.