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Testing the Waters

A pilot franchise works in theory, but not really in practice


Philip F. Zeidman

Dateline: New Orleans

A couple of intriguing questions were posed during two of the many programs focusing on international franchising at the recent International Franchise Association Convention. They didn’t get much response at the time, but they deserve some thoughtful consideration. Let’s address one of them here, and reserve the second one for a later column.

There’s a lot of talk about “test franchises” and “testing the waters” in cross-border franchising. Are they really feasible?

Unless they are arrogant or careless or foolish, when businesses venture into unfamiliar territory, they do so with great care and as much planning as is feasible and affordable. And, even with all that preparation, because they know they will encounter the unexpected, they try to limit their risk by limiting their commitment. If they find that any of the myriad unknowns—the competition, the sources for product, the culture—threaten to render the venture unviable, they want to be able to cut their losses.

Franchising is no different.  Franchisors want to be able to commit no more than necessary to a planned expansion—in time, cost and personnel—until they can make an informed assessment of the prospects for success.

The questioner was certainly correct: At almost every one of these gatherings, the notion of “testing the waters” is aired, as an apparently sensible way of proceeding just as one would do in any other commercial venture. Prudent business people recognize what works at home may not work elsewhere, or at least not without substantial adaptation, and what works in one market may not in another. They would like to do abroad what they wisely do at home: test the waters in a new market.

But that does not take into account the almost unique characteristics of franchising, where the franchise laws may make it impractical. The heavily front-loaded process of international franchise expansion and compliance requires a franchisor to take all the steps required to franchise, with the attendant costs, even if the transaction contemplates only a single unit in a single foreign country.  

Since that is virtually never an economically viable step, too many franchisors decide not to go forward; opt not to comply with the laws, sometimes by using questionable techniques to avoid them; or enter into a transaction that entails a greater commitment than can be justified, simply because the cost of doing so differs little from a much smaller transaction.

The franchise laws in effect act to nudge franchisors toward non-economic decisions, or to violate the laws. Thus, one of the more frustrating impediments to international franchising arises at the very outset of a company’s consideration of embarking on a cross-border strategy.

I believe those who speak in an off-handed way of “test markets” may have not adequately taken into consideration the true cost of such an undertaking. As a realistic matter, a franchisor who wants to enter a market on a “test” basis must do so either as a franchisor (with legal and regulatory costs which are difficult to justify if the initial step fails to demonstrate promise) or on a company-owned basis (which only a small percentage of franchisors are financially or psychologically prepared to undertake).

Responding to the difficulties this imposes, some jurisdictions have sought to alleviate the burden. The concept of an “isolated sale” exemption is one such response.  In New York a franchisor can avoid the obligation to register its franchise offer with the state if its offer is directed to no more than two persons (a way of testing the waters).  But this exemption alone does not shield the franchisor from the requirement to produce a disclosure document and deliver it to a prospective franchisee.  

A similar limited exemption exists elsewhere; see, for example, Minnesota’s exemption for no more than one sale during any period of 12 consecutive months.  An indirect way of opening the door to testing the waters allows franchisors to terminate franchisees on the basis of “withdrawal from the market,” by expanding the definition of “good cause.”

But this early enlightened approach is conspicuous by its absence once one leaves these shores.  Indeed, so strong is the prohibition against “testing the waters” that some jurisdictions will not permit a company to franchise until it has first entered the country with company-owned units, sometimes more than one, and in some cases has operated them for a minimum period of time.  

Variations of this approach exist in Italy, Vietnam and China. The latter two are the most fully developed. In Vietnam, a foreign franchisor’s system must have been in operation for at least one year before a franchise can be granted. China requires a franchisor to establish and operate at least two company-owned units for at least one year before it grants franchises. (The earlier regulation specified the pilot organizations be in China, but the current law has removed that requirement.) 

Since this increases the amount of capital that must be committed, as a practical matter it bars all but well capitalized companies. Indeed, it can bar even some very large companies whose business model calls for an entirely franchised network.

“Testing the waters” or establishing a “pilot operation” is, in theory, a manageable way to determine in an affordable fashion whether a small or medium-sized franchisor can sensibly undertake a venture into the swamp of international regulation.  In practice, given the state of the franchise laws and the cost of both entry and compliance, it may be a mirage.

I recognize this position runs counter to the approach advanced by the proponents of test markets. Let the games begin. 

•   •   •   •   •

In a future column we will address another interesting question raised at the IFA Convention. 

Aren’t some of these franchise laws overkill? Do prospective franchises need or even want those protections? Isn’t there some way to target them to reach only those who most need the protection they’re designed to provide?

Philip F. Zeidman is a senior partner in the Washington, D.C. office of DLA Piper. He can be reached at Philip.Zeidman@dlapiper.com.

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