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Franchising first began in China in the late 1980s and today China has the greatest franchise market in the world.
The growth of franchises in China has in part been fuelled by a change in local attitudes as the Chinese have increased their desire for a faster and more convenient lifestyle. The growth of franchises has also been due to the fact that an increasing number of Chinese entrepreneurs want to be franchisees for foreign brands. The franchise model is therefore being adopted by an increasing number of entrepreneurs in China.
With the rapidly expanding Chinese economy, franchising offers easy access to the growing consumer market and to second-tier cities. Furthermore, franchising is relatively low cost and allows for rapid growth. The franchising model attracts a large number of consumers, as a larger brand name and faster brand recognition enable increased reliance.
In the past, franchising in China was generally avoided by many companies. The principle reason behind this was that good partners were hard to find and other reasons included a general lack of local management skills and local franchisees often choosing not to follow franchise standards and sacrificing the brand image for short-term profits. Furthermore there were challenges with intellectual property, a lack of control concerning the recruitment process, difficulties in securing locations, and an unpredictable legal and regulatory framework.
Companies therefore chose to enter the Chinese market and expand throughout the country via direct ownership with wholly foreign-owned enterprises (WFOEs) or joint ventures (JVs), through which branches were opened up in a number of locations.
Through direct ownership, companies have total control over business operations. For example, Yum! Brands Inc., the parent company of KFC and Pizza Hut, still owns and manages 90% of its stores in China. Furthermore, direct ownership means that companies have the opportunity to receive 100 percent of the potential profits from the rapidly growing disposable income of the middle class.
Franchising first started in China within the food and drinks sector, however, the majority of the franchisors in this sector are domestic firms. Within the clothing industry, franchising has been used mainly within the second and third tier cities. Franchising is also common within the fitness industry, but several larger gym chains have now started to use WFOEs or JVs as an alternative method for expansion.
There are generally two methods through which foreign enterprises will establish a franchise in China, either cross-border franchising or foreign direct investment, whereby local legal entities may be established to serve as franchisors. Both of these models are outlined below:
Cross-border franchising:
Due to the change in China’s franchise law, which occurred in 2007, a franchise contract may now be signed between a foreign investor, without a local presence in China, and a master franchisee. This contractual relationship means that the foreign enterprise outside of China can operate a local network of franchisees.
The cross-border franchising model has opened up the opportunities for mid-sized international franchisors that do not have the resources or do not wish to establish a legal presence in China. This franchise method is both the easiest and cheapest way to franchise in China, however it may lead to a loss of control over the franchise.
Foreign direct investment:
This model includes the establishment of either a wholly-foreign owned enterprise (WFOE) or joint venture (JV) and then later expansion into a franchise. This method requires a larger amount of capital investment than cross-border franchising, however it allows the foreign franchisor to build brand awareness and establish supply chain networks prior to expanding.
Furthermore, the local legal entity, either the WFOE or the JV, is able to serve as the franchisor to local Chinese franchisees. From a legal point of view, this method will simplify things, however in order to serve as a franchisor the WFOE or JV must have operated two direct-owned stores (any location globally) for at least one year before it can have franchisees. This is known as the “2+1” rule.
This franchising model will give the foreign company greater control over the Chinese franchisees. The franchise agreement must have a minimum term of three years, however this can be shortened if the franchisee agrees. In the case of an extension or a renewal this requirement does not apply.
