1. Development of Franchise in the Mainland

Expanding domestic demand and encouraging consumption are among the objectives of China's 11^th Five-Year Programme. In recent years, following the booming of the retail sector in the mainland, the number of retail shops and their sales have been on the rise, foreign investment has been flowing in, while operation modes have been maturing and becoming modernised and diversified. World leading retailers such as Wal-Mart, Carrefour, Metro and B&Q have been expanding in the mainland. With their strong bargaining power, brand effect and highly efficient management, these multinational retail giants have posed competitive pressure on domestic retailers. In response, domestic players have taken proactive measures including merger, cooperation and reforming management. According to the report Retail Revolution: A Look at M&As in China's Retail Industry compiled by Ernst & Young, the mainland's retail sector, which is dominated by small family workshops (80%), can generate better gains through merger and acquisition (M&A).

Today, the most common sales channels on the mainland retail scene include department stores, supermarkets, hypermarkets, professional stores (e.g. electrical appliances stores, cosmetics stores) and specialty stores (i.e. stores that sell products of a single brand). Among these, setting up own specialty stores is an important means employed by manufacturers in building their brands. In the face of intensifying competition in the mainland retail sector, resulting in squeezed profit margin and consolidation (M&As), diversifying into retail could mean high-cost and high-risk investment for manufacturers whose core business is production.

Retail Sales and Growth of Major Retail Channels, 2005

In order to reduce investment and risk, many Hong Kong companies choose to enter the mainland market by way of franchising. Successful examples include Esprit, Giordano, Baleno and Bossini in the garment industry; and Chow Tai Fook and 3D-GOLD in the jewellery industry. As for multinational companies making a foray into the mainland market in the form of franchising, they cover a great number of industries. Franchise operation has been expanding fast in the mainland, especially in commodities retailing such as convenience stores, foodstuffs, medicines and health food, niche products, sporting goods, cosmetics, clothing and accessories, computers and auto accessories. Franchising is also found in service sectors such as catering, beauty service, laundry, interior decoration, hotels and even education institutes.

Development of Franchising Business in the Mainland

It can be seen from the above table that the franchising business in the mainland has been developing in leaps and bounds. There are examples of franchisers which started from zero and expanded to several thousands of shops within a few years. At present, apart from foreign-invested enterprises which engage in franchise operation in the mainland, domestic enterprises are also jumping on the bandwagon. These domestic enterprises include domestic importers which import foreign goods and are granted exclusive distribution right. Many enterprises see franchising as a way to inter-province expansion, and two forms - direct franchise and sub-franchise - are used.

Generally speaking, franchisers sell branded/patented products. The brands can be proprietary, commissioned or licensed. Some successful franchisers have already set up thousands of retail outlets across the country. For the smaller franchisers, they may only have a few outlets and may sell other brands as well in order to enrich the variety of their products. Currently, in the mainland, the initial investment of the franchisee in joining a franchise (including franchise fee, shop decoration, stock order etc) ranges from RMB 50,000-100,000 on the low side to RMB 300,000 or more on the high side, with the majority falling into the RMB 100,000-plus bracket. The franchiser normally offers a number of investment plans (e.g. special counters or stores) for the franchisees to choose from. For stores opened in different locations/cities, the investment amount may vary. While some franchisers may collect a fixed or pro rata amount of "annual fee", most of them do not. In the general commodities retail sector, franchisers usually supply goods to the franchisees at a 40-60% discount on the suggested retail price. According to the optimistic estimates of franchisers, it normally takes about one to two months for a franchisee to open shop and the investment payback period ranges from several months to over a year.

The quality of mainland franchisers varies. Generally, the franchiser would provide a range of services to franchisees, such as opening shop, actual operation, goods delivery and training etc. But for those franchisers with a shorter history of operation and smaller scale, their ability in providing support and guidance is uncertain. Still, those that intend to cheat are few and far between. Rather, the most common problem with franchisers is that they cannot catch up with the expanding business by providing the right services. Mainland franchisers are often more lenient in selecting their franchisees. A franchise contract will be offered as long as the potential franchisee has enough capital to open shop, agrees with the business philosophy of the franchiser, and is willing to operate the stores according to the set format. Objective selection criteria such as commitment, experience and integrity are seldom taken into consideration.

Some franchisers view franchisees simply as their distributors. Such franchisers would collect the franchise fee but do not provide any corresponding guidance or service (e.g. opening shop, logistics and returned goods). They offer franchise contracts indiscriminately and some even claim that as long as the franchisees pay them money, they are free to do anything. There are also franchisers who choose to ignore the provisions in the existing administrative measures (e.g. they do not have enough number of directly owned stores, the period of the franchise contract is too short etc).

According to the trade, at present mainland franchisers mainly franchise their business in the form of direct franchise rather than sub-franchise. As for franchisees, some join a franchise for the sake of employment (i.e. with the hope of saving some money and starting one's own business), while the majority do so for the sake of investment. The latter includes wealthy individual investors, companies, or people who have experience in that particular industry. These investors normally entrust their close relatives or friends to take care of the accounts while they themselves do not do anything. As such, they tend to choose franchisers which are well-established and can take care of all day-to-day operational matters. In choosing to join a franchising business, mainland franchisees may not go for the most well-known brand. Instead, they would make their choice based on their own interest and experience as well as the business practices (e.g. operation mode) of the franchiser; some would also base their choice on the recommendations of relatives and friends.

2. Supervision of Franchising Business and Relevant Regulations

As part of its WTO commitment, China has opened its retail sector, including the franchising business, to foreign investment. It has also introduced the Measures for the Administration of Commercial Franchise and Regulations for the Administration of Commercial Franchise to regulate franchise operation¹. While the Measures are departmental rules, the Regulations, effective in May 2007, are administrative regulations with greater legal effect. In the words of a mainland official, the attitude adopted in regulating franchise operation is: "the civil rights of people involved in franchise operation will not be restrained so that the development of the franchising business will not be suffocated by excessive administrative interference."

Under the relevant rules and regulations in the mainland, commercial franchise refers to "a business activity whereby an enterprise (the franchiser) possessing its own business resources such as registered trademark, corporate logo, patent and proprietary technology, licenses its business resources in the form of contract to other operators (the franchisees) for use and the franchisees will run the business under a unified operation mode in accordance with the contract and pay franchise fee to the franchiser."

Based on the above Measures and Regulations, Hong Kong companies embarking on franchise operation in the mainland must meet the following requirements:

• The franchiser must be a profit-seeking enterprise with independent accounting system. It can be a sole proprietorship enterprise, partnership enterprise, limited company or foreign-invested company. Hong Kong businessmen are not allowed to engage in franchise operation in the form of individually-owned business.
  
  
• In developing the franchising business, it is not necessary to apply for a separate business licence. However, the franchiser must file the franchise contract for the record with the provincial-level commerce department or Ministry of Commerce (for inter-provincial operation) within 15 days after the contract is first signed. Thereafter, a report has to be made to the government annually on the progress of the contract.
  
  
• The franchiser must have at least two directly owned stores which have been in operation for one year or more.
  
  
• The obligations of the franchiser include (but not restricted to) providing support, guidance and training to the franchisees. The franchiser must not use the advertising and publicity fees collected for other purposes.
  
  
• The obligations of the franchisee include (but not restricted to) keeping commercial secrets. The franchisee must not transfer the operation right to other parties.
  
  

The Regulations also set out detailed requirements on the duration and content of the franchise contract, as well as on franchiser information disclosure (for details, please refer to the Regulations). The main reason for so doing is that the mainland market has not reached maturity and risks are relatively high. Where legal risks are concerned, Hong Kong companies should take note of the following:

• Contract dispute - mainly caused by unclear contract terms and conditions, breach of contract by one party or breach of contract by both parties.
  
  
• Trademark counterfeit - some people might open shop using the trademark of the franchiser without authorisation, or the franchisee might abuse the trademark (e.g. using the trademark on other products, companies or businesses, or even sub-franchise the trademark to other parties, without authorisation).
  
  
• Unfair competition - upon expiration of the contact, the franchisee may still continue to engage in the same business as the franchiser; or staff of the franchising business who have left service may make use of the commercial secrets to engage in a rival business.
  
  
• Legal liability of the behaviour of the franchisee - theoretically speaking, if there are any operational faults on the part of the franchisee (especially in the service sector) resulting in damages to the customer, the franchiser is not to be held liable; but in reality, some customers might still institute legal action against the franchiser.
  
  
• Franchise operation involves the transfer of operation right, purchase of products and payment of fees, it may also involve membership system. The franchiser must not engage in pyramid sales in disguise or unlicensed direct selling in order to avoid breaking the law.
  
  
• If the qualifications and capability of the franchiser do not meet the requirements of the Regulations, even if a contract has been signed, it might still be deemed invalid and compensation has to be made to the franchisees. The information in the promotion materials used by the franchiser in recruiting franchisees must not be false, or the contract may be invalidated.
  
  
• In order to protect oneself, the franchiser must record and keep all the evidence in connection with the franchising business, including bills, accounts, correspondences, information, legal documents etc.

A detailed franchise contract should include the following:

Franchising can be a win-win business for both the franchiser and franchisee if the operation is properly run with the advantages given full play and the disadvantages avoided. To the franchisee, the attraction of franchise operation is that one can set up one's own business at lower risk even though one is inexperienced. With the franchiser providing a well-known brand/trademark, guidance on all fronts, effective operation mode, logistics, publicity, business processes etc, the franchisee can focus on the operation and gain experience.

For those Hong Kong companies interested in developing the mainland market, the advantages of franchising include:

• Capital saving - one of the effective ways of building brands is setting up a large number of sales outlets. However, it requires huge capital to set up an extensive sales outlet network in the mainland or introduce a large amount of products into the mainland retail system. Franchising is an effective way of reducing capital outlay and generating revenue by means of collecting franchise fees.
  
  
• Brand building - even cash rich listed companies make use of franchising because it can save the management the trouble of opening shops and can thus capture the market quickly. Another reason is the franchisees may have better personal networks in the mainland which can facilitate the smooth development of business.
  
  
• Lower risks and costs - in franchise operation the economy of scale can be increased through centralised sourcing and unified distribution etc, which can help reduce costs. Advertising spending can also be shared with the franchisees. When expanding in an unknown territory, the franchiser can leverage on the local knowledge of the franchisees and test the market by opening franchise stores. On the part of the franchisees, since they are responsible for their own profit and loss, they have more incentive to operate the business.

Risks encountered in developing franchising in the mainland include:

• The improper behaviour of the franchisees may damage the image of or cause loss to the franchiser. Such improper behaviour includes: poor business practice/service, unauthorised price cuts, transfer of products to other retailers, selling other products, substandard store image, abusing the trademark etc. However, if an effective monitoring system is in place, the possibility of a serious crisis (e.g. theft of intellectual property) is low. The more common minor hiccups would only include: shop display not complying with the unified image of the brand, unauthorised production of packaging and promotional materials by the franchise stores.
  
  
• Manufacturers who are not familiar with the retail business may not be able to provide adequate guidance and support to the franchisees. While such franchisers may be capable of dealing with the situation at the beginning of the franchise operation, as the business grows, they just cannot cope.

4. Rights and Obligations

To the franchiser, his rights include collecting franchise fee (a non-refundable one-off payment), deposit (to be paid by the franchisee as soon as the franchise contract begins, it serves as a guarantee for the franchiser in the event of breach of contract by the franchisee and is normally refunded to the franchisee upon expiration of the contract), franchise right fee (a recurrent franchise usage fee paid by the franchisee), default penalty (a penalty to be paid by the franchisee in the event of breach of contract), and other fees (e.g. promotional charges). Whether these fees are collected or not is to be stipulated in the contract. Some mainland franchisers try to attract franchisees by collecting only a one-off franchise fee. Also, the franchiser has the right to supervise and the right to terminate the business. In other words, the franchiser has the right to have access to the operation data and details of the franchise stores. Should any serious problems occur, the franchiser has the right to terminate the business of the franchisee in accordance with the stipulations in the contract.

On the other hand, the franchiser must also have the ability to perform its obligations, the objectives of which are to protect the interests of the franchisee. As both parties are inter-dependent, by performing its obligations the franchiser can also benefit. Generally speaking, obligations may vary according to different companies and different industries. But it should be noted that some "professional" franchisees in the mainland join a franchise simply for the sake of investment. These franchisees only contribute capital and would not take care of the actual management or operation of the business. In order to attract the capital of such investors, some mature franchisers would take care of everything for these franchisees, such as which products should be sold, preparations for opening shop, market research, inventory control, personnel management etc.

Obligations of the franchiser include:

• Support and guidance for opening shop - since the success and failure of a business very often hinges on shop location, the franchiser may have strict requirements where the selection of shop location is concerned. The franchiser would normally assist the franchisee in selecting the shop location, such as specifying a particular section of the road or a particular floor in a mall, the supporting facilities nearby, the architectural structure of the shop, the shop sign and area (including warehouse), terms and conditions of the tenancy agreement, decoration plan of the shop, interior design and materials used etc. In addition, before the opening of the shop, the franchiser may carry out a field inspection of the shop and conduct market research, assist in the application for relevant documents and licences, and provide risk and return analyses with regard to the proposal of the franchisee.
  
  
• Training - this includes the recruitment of staff as well as training on service attitude and product knowledge, skills/technology/sales technique, company history and corporate culture, and rules and regulations. Such training may last several weeks. The staff training provided by successful franchisers covers many aspects. Detailed instructions given may include: when pouring water for the customer the water must not fill up to the brim, no more than one article should be taken out of the display counter at the same time, and product display. For franchisees which are inexperienced in doing business, training on accounting, goods ordering, inventory control and promotion and marketing is also offered. In such training, apart from the introduction of new products, all the other courses are one-off in nature. For sectors such as catering and beauty service which require technical skills, training may be continuing.
  
  
• Implementation and operation - this includes providing sales and operation analyses for the franchisee (to help the franchisee in making a decision on goods ordering), supplying manpower support, and providing instructions on day-to-day operation details and processes, e.g. sending staff on regular inspections of the franchise stores and making suggestions on the actual operation. After-sale service, repair and maintenance, and return of goods service will also be provided. If equipment is included in the contract, computer systems and related machinery would also have to be provided with or without compensation (especially in the catering, beauty service and laundry industries).
  
  
• Logistics and delivery - today most franchisers allow their franchisees to place orders online and provide them with free delivery service. For products with a limited life cycle (e.g. food), just-in-time and professional delivery is particularly important. Hence, the franchiser may consider setting up its own logistics department or outsourcing the logistics service to a third party. In running inter-provincial franchising business, the franchiser often sets up a branch company in each province to take care of logistics and other matters.
  
  
• Brand promotion - the head office of the franchiser (especially in the case of direct franchise) is often responsible for all the brand promotion campaigns on a national or regional basis (e.g. ads in the underground railway systems and magazines, outdoor ads, community event sponsorships etc). It may also opt to outsource the work of brand promotion and take care of the coordination work itself. Generally, seasonal promotional activities on a nationwide scale would be carried out and publicity collaterals, packaging materials and free giveaways would be produced (for instance, one Hong Kong-invested jewellery shop gives away magazines to its VIP customers in a move to educate them on product knowledge and fashion sense). In the case of sub-franchise, the franchisees may also be responsible for part of the regional publicity and promotion efforts.

5. Preparations for Launching Franchising Business

• In terms of staffing, if the Hong Kong company in question is already engaged in retail business, it is not necessary for it to employ additional training and retail staff; all it has to do is to set up a "development department" to take care of matters in connection with the franchise. Even if the company does not have too much experience in retail, it can outsource the "generic" part of the training (e.g. skills) to intermediary training companies, while the work of marketing can be outsourced to advertising companies. For instance, Chow Tai Fook now has over 500 directly owned and franchise stores on the mainland and the company plans to increase the number to 1,000 by 2010. As Chow Tai Fook is already well-equipped with staffing, logistics, management and marketing systems, when the company expands its franchising business, no additional substantial input is necessary.
  
  
• Where finance is concerned, since franchising business develops progressively, the initial additional capital required is not that large. However, as the business gradually expands, there might be needs from all fronts and the capital may not be enough. Therefore, it should be noted that a sound financial plan must be prepared in advance which should include input budget and forecast on break-even point.
  
  
• In internal management, to manage an extensive distribution network, it is necessary for the franchiser to buy new corporate management software or add new features to its webpage so that it can better communicate with the franchisees, take orders, monitor sales, and collect feedback from the franchisees.
  
  
• As for recruiting franchisees, as there is a shortage of investment channels in the mainland, the idea of being one's own boss is appealing. Moreover, many mainlanders like the idea of setting up their own business after having saved some money. The main channel in the mainland for recruiting franchisees is participating in franchise fairs or posting an ad on the web (either one's own web site or other people's sites). For Hong Kong brands which are rather well-known, basically no special promotion is required, potential franchisees would take the initiative in approaching these companies.

There are some franchisers on the mainland which claim to be Hong Kong companies in order to increase their attractiveness. There have been cases where these companies committed illegal acts or even disappeared suddenly. In order to win the confidence of the franchisees, Hong Kong companies planning to embark on the franchising business in the mainland should do their best to show their sincerity in their franchisee recruitment exercise. For example, they should produce some exquisite name cards and promotion materials; brief the potential franchisees on the concept, philosophy, characteristics and features of their products/brand/company; explain the investment plan and budget in great detail; arrange factory visits for the potential franchisees etc. All these should be done with great care to prove to the potential franchisees that they are serious. Also, detailed plans for supporting the franchisees should be prepared (such as training, new product launch etc) to give the potential franchisees an idea of the profits and prospects of the business and to show them that they are committed.

6. Selection Criteria for Franchisees

In view of the fact that the quality of franchisees varies, the franchiser should be careful in choosing the franchisees. In joining a franchise, the potential franchisee should supply information to the franchiser for evaluation (the evaluation could be tangible, such as the threshold for joining the franchise, or intangible, such as the qualities of the franchisee). The criteria for evaluating the franchisee may vary, such as: its commitment to the business, its experience and track record, its local knowledge, its financial strength, its expectations for joining the franchise. There has been a case where a well-known Hong Kong brand embarking on franchising in the mainland set out the following criteria for recruiting franchisees: the franchisee must have minimum capital of several millions yuan, it must have the strength and determination to make the business a success, it must have the ability to protect the brand in the mainland (i.e. cracking down on fakes), it must also have excellent business and other networks locally.

The franchisee could be a company, a shopping mall or an experienced business operator of a considerable scale. It should have certain financial strength and could expand from one or two franchise stores at the beginning to over 10 stores eventually. The intention of the franchisee in joining a franchise should be to leverage on the fame of the brand to enhance its own strength. For instance, a shopping mall operator may choose to open franchise stores in its mall in a move to upgrade the class of its mall and attract other famous brands to open shop there.

After a franchiser has established a firm foothold in the market, it can then consider regional expansion. The difference between direct franchise and sub-franchise is that direct franchise involves the transfer of the operation right of individual stores while sub-franchise involves the transfer of the operation right of a whole region. Under sub-franchise, the franchisees are normally larger in scale, have more local experience and stronger management capability (for instance, they may be able to help manage other franchise stores in neighbouring regions). When seeking expansion in unknown territory, Hong Kong companies may consider using sub-franchise. Otherwise, they may have to set up branch companies in every region to exercise central management of the franchise stores in that region.

7. Franchisee Management System

To ensure smooth operation of the stores, monitoring is of paramount importance. A sound monitoring system requires certain skills. For example, the franchiser can send brand protection teams and "mysterious customers" on inspection tours to the franchise stores regularly to inspect and prevent non-complaint acts (such as unauthorised price cuts and buying fakes from other sources) as well as other acts causing damage to the image of the brand. In the case where unauthorised price cuts are offered, the franchisee would be asked to give a reasonable explanation.

Many franchisers organise franchisees meetings every year to brief the franchisees on the action plans of the company, including advertising input and coverage, five-year plans on new product launch etc. Such annual meetings can increase the sense of belonging of the franchisees. Incentive system should also be set up to commend stores and staff with outstanding performance.

It is the hope of every responsible franchiser that all the franchisees could make a profit. In the case where the business result of a franchisee falls short of expectation, the franchiser should send someone to the store to find out the reason (e.g. whether there is something wrong with the product or the sales technique of the staff) and then provide the right solution, such as giving permission to the franchisee to offer a discount so that it can make a profit. Some franchisers may sign a short-term contract with the franchisees first and would only grant the franchisees a long-term contract upon they have completed the "trial period" with good performance.

In terms of hardware, many franchisers exercise computer control of every business process ranging from order placement, delivery, inventory, sale to expenditures undertaken by all the stores, whether they are directly owned or franchised. By using the computerised system, the head office would know about the price of every piece of goods sold and would find out about the operation of every store at a glance, with any problem or non-compliant act clearly recorded.

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