Launch Your Chinese Franchising Business: 5 Points to Consider

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Today, as many in the global market are aware, China is becoming the land of opportunity. China’s economic growth led to an increase in personal incomes, especially in larger cities. The emergence of a large middle class, often consisting of well-educated professionals, added to the consumer demand for globally recognized, quality products. While the fast developing market is driving the demand for franchising, franchising became a very popular business model in China after the Chinese government opened the door to foreign franchising investors in the 1980’s. A number of well-known foreign franchisers such as McDonalds, KFC have entered the Chinese market during the past 20 years and are operating very successfully in terms of market shares and profitability. However, Chinese franchising business is not without risks, so understanding the following 5 points before starting your Chinese franchising business is essentially important for foreign franchisers.

1. Franchising Models

Generally, Chinese franchising business is most likely to be engaged in the following three models:

Joint Venture: A limited liability corporation in which both partners invest in and manage operation through a Board of Directors. In this arrangement the partners share in the profits/losses in proportion to their investment. For example, McDonald’s. Although this form may be suitable for some franchisers, it is often problematic in that a well-know international franchiser may be unwilling to share profits with a local partner. Conversely, a strong local partner may be unwilling to work with a weak international franchiser.

Wholly Foreign Owned Enterprises: All capital is provided by the foreign investor who has full control over the operations of the enterprise. This form has become an increasingly popular entry vehicle into China. For example, Yum! Brands, which owns KFC and Pizza Hut. This option, through using a foreign direct invested enterprise, can be an ideal way to build and manage a franchise network in China. Having local presence and staff will benefit the management of business resources, the supervision of the uniform business format and the brand awareness leading to later expansion. This construction can under certain circumstances moreover be strongly advisable from a tax perspective.

Master Franchising: Many international franchisers sell master franchising rights to interested Chinese companies. This leaves the international franchiser the critical decision of finding the right local partner, and using the appropriate entry structure. In many ways, successful market entry depends upon the quality of the local partner. Local knowledge and connections are extremely valuable for both short-term and long-term success. For example, Century 21 China Real Estate.

2. Franchise Registration

According to the the Regulation on Administration of Commercial Franchises (Regulation), a franchisor must, within 15 days after signing a franchise agreement for the first franchised location in China, file an application with the appropriate commercial authority in the Ministry of Commerce (COM) to register its franchise. The registration requirement of Chinese franchising business is an administrative measure to regulate franchise activities, and also provides potential franchisees with public access to more information regarding the franchisor and its business. Although the failure to register does not impact the effectiveness of the franchise agreement, a franchisor that fails to timely file the franchise registration could face a fine from the commercial authority ranging from 10,000 to 50,000 Chinese Yuan (CNY) (approximately US$1,600-8,000). In connection with the franchise registration application, the following documents must be submitted for Chinese franchising business:

• Business registration certificate of the franchisor.
• Registration certificate of the franchised IP right: Where the franchised trademark is not owned by, but instead is licensed to, the franchisor, the trademark license must first be recorded with the Chinese Trademark Office, and the franchisor must submit the certificate of trademark license issued by the Chinese Trademark Office with the franchise registration application.
• Franchise agreement: To comply with the requirements of the Regulation and relevant laws, the franchise agreement must include certain language regarding consumer protection, quality guarantee, and training, as well as several other matters. In addition, the agreement must also grant the franchisee a “cooling-off period” during which the franchisee can end the relationship without penalty. The term of the agreement must be at least three years; however, the franchisee can waive this requirement.
• Certification for the 2+1 Requirement: To meet this requirement, the franchisor must submit a certification from a competent commercial authority or franchising association (such as the International Franchise Association). The certification must contain information about the franchised brand; the opening date, address, and business scope of the two stores; and the relationship between the franchisor and the stores, all of which demonstrate that the franchisor (or, if applicable, its parent or subsidiary) has directly operated two stores operating the franchised concept under the franchise brand/marks for more than one year.
• Marketing plan for the franchised operation.
• Other documents required by the Regulation.

If there are any major changes to the original filing (e.g., changes concerning the business registration of the franchisor, business resource, and distribution of the Chinese franchisees), the franchisor must, within 30 days, file a notice and supporting documents with the MOC for modification of its franchise registration. An annual update regarding new franchise agreements and those terminated in the past year also must be filed with the MOC by March 31.

All certificates or documents generated outside of China must be notarized by a local notary public, legalized by a Chinese Embassy or Consulate and submitted to the MOC with a Chinese translation.

3. Opportunities for Chinese Franchising Business

Many trends indicate that the China market is ripe for franchises.

The consumer class is expanding fast. The large group of middle- and upper-class consumers can afford to buy more than basic necessities, and many members want to show their wealth through what they buy — for example, by purchasing a cup of expensive foreign-branded coffee and walking around with it. They are purchasing big-ticket, branded items — often on their credit cards.

Western brands are highly regarded. Many consumers perceive Western brands as providing quality, convenience, and customer service. This is true especially in the retail and food sectors, where most major food franchises are either already present or are entering China.

Western franchises bring new and modern business systems. Successful US franchises bring a complete business system, management processes, job training, and the potential for healthy and reproducible bottom line margins. So franchises like US ones in China thus have high potential to succeed.

Second- and third-tier cities in China are open to foreign companies for Chinese franchising business. First-tier cities offer developed infrastructure, business-friendly governments, and a multitude of services and internationally standard amenities. These cities are generally “easy” for newcomers to enter, but labor and real estate prices have risen and competition has intensified in recent years. Second-tier cities have millions of potential consumers and often have lower labor and real estate costs and local governments that encourage the creation of new businesses. In addition, US food franchisors are increasingly allowing small companies to own franchises — a trend that KFC and Papa John’s started in second- and third-tier cities in the last few years.

4. Challenges for Chinese Franchising Business

Foreign franchises must also overcome problems that are specific to the China market.

Intellectual property protection is uneven. Weak intellectual property enforcement and an inadequate legal framework are key reasons early foreign brands opened as company-owned stores or JVs, instead of franchises, in China. Many US brands have seen local companies take their name and logo and open fake, unapproved outlets. For example, after a local coffee store chain violated Starbucks’s trademark by nearly duplicating its name and logo, Starbucks took the company to court and won the dispute in 2006. China has a range of intellectual property laws, and landmark court cases have defined the right of foreign brands to protect their trademarks and business systems. Intellectual property laws, however, are not uniformly enforced throughout the country.

Local managers lack strong management skills. Franchises in China often experience difficulties finding local managers who understand how to run a business. Training costs are high and so is the rate at which good employees quit to take higher paying jobs after they receive Western business training.

Finding and evaluating licensee candidates is tough. The most important part of Chinese franchising business is finding, evaluating, and signing a qualified company as the local, regional, or country franchisee. Due diligence resources to fully check on a local company are improving, but it is still difficult to find companies with the management skills, business track record, and capital to acquire and properly develop a US franchise business. To help find appropriate licensees, companies can check with various organizations, such as US Commercial Service offices in China, legal firms with US ties, consulting firms, or American Chamber of Commerce offices.

China has many markets. The sheer size of China, and its diversity of business and food culture, makes franchise development difficult. Companies that function well in one region seldom function as well elsewhere in China. Accordingly, franchisors rarely grant companies a country franchise for China. More typically, franchisors grant regional franchises (for a province or group of provinces) or first-tier city franchises (such as for Shanghai). This means the foreign franchisor must manage multiple licenses in China, requiring more time and energy.

Franchises must adapt their products to new markets. Some franchises face difficulties in China when they do not adapt — or are slow to adapt — to the needs and tastes of Chinese consumers. For example, restaurants should conduct appropriate research before planning their menu and offerings. Sales may increase simply by adding chicken dishes and rice to the menu, or by changing a spice or bread. Adding a trendy “foreign” item to the menu, such as coffee or ice cream, may also increase sales. In addition, foreign companies should take care when translating their brand names into Chinese. Ideally, the Chinese name should convey what the brand is and sound similar to the English pronunciation.

5. Suggestions to Foreign Enterprises

Despite the great economic potential, doing business in China can be difficult for many foreign companies, evident by the many failures of multinational companies. The following suggestions might be helpful for foreign franchisers to start Chinese franchising business:

Register the brand when entering the China market at inception. Without the official registration, even a well-known company can find itself in a difficult position when someone else has registered their brand name. Starbucks filed a trademark infringement suit against a Shanghai coffee chain in 2004. But lawyers and industry executives say things are moving in the right direction.

Carefully seek local partners who can help them navigate the local business environment. Needless to say how important it is to choose a partner in the same industry with channels of distribution, industrial connections and good relationship with government organizations.

Understand the cultural difference and adjust market access strategy accordingly. For those franchisers that can navigate China’s way, the prizes can be big. Unlike in other countries, where KFC helps franchisees set up stores, KFC is taking a different approach by selling well-established profit-making stores to Chinese franchisees in order to effectively reduce the risk of damaging brand names. Of course, minor modifications will be required to adapt to local habits, if they want to earn more chances of success.

Minimize the price of the final products and the franchising fee to achieve rapid expansion. The Chinese are price-conscious because their income is substantially lower than that of Westerners. It is the same for Chinese investors. Actually there are not so many Chinese people who have one million USD and are interested in franchise business. So it is important to the new-to-China foreign franchisers to lower the franchise fee.

Conclusion

Many signs indicate that Chinese franchising business will become easier over the next few years. China’s regulatory and investment environment is developing and becoming more transparent. Lower-tier cities are becoming ripe markets for franchises, and China’s rapidly rising middle- and upper-class consumer base desires Western brands with their well-known name and association with convenience, quality, and service. In addition, more Chinese are reaching an income and savings level that will allow them to invest in a franchise. Despite the challenges of the China market, the opportunities are too great to ignore, and foreign franchisors are entering China in great numbers.

Related reading: 9 Keys to Successfully Sell Your Product to China