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Exclusive Territories and Franchise System Design

Exclusive Territories and Franchise System Design

 The Dilemma

One of the most contentious issues in franchising, and a core area of focus in designing a franchise system, is the question of territorial “rights” in favor of individual franchisees and what provisions (if any) regarding territorial protections should be included in the Franchise Agreement and other documents used by the system.

On the face of it, it may appear that Franchisor’s and Franchisees’ interests are inherently opposed, with at least some commentators assuming that Franchisors will (and should) universally oppose granting such rights to Franchisees and want to retain unlimited freedom to establish competing units (whether company-owned or franchised) in proximity to franchised units.

On the other hand, some Franchisee advocates claim that:

• Franchisors are only interested in receiving initial franchise fees and are therefore motivated to open as many units as possible notwithstanding any impact on existing units;

• Since Franchisors are commonly paid a percentage of gross sales, they will be indifferent to the impact of competing units on a Franchisee’s bottom line, so long as total system sales trend upward; and that

• Franchisees should therefore demand and receive territorial protection from both additional brick-and-mortar units and competition from other channels of distribution (internet sales, mail order, etc.) affiliated with the Franchisor or using the same brand.

When viewed this way, franchising is seen as a zero-sum game, with enhanced market presence for the Franchisor inevitably reducing opportunities for Franchisees, and territorial protection for Franchisees precluding growth of the brand presence in relevant markets.  The size of the economic “pie” is limited, a win for one party is a loss for the other and compromise is either impossible or merely a disguised form of surrender.

A More Complex Reality

In fact, the realities are far more complex than either side may be willing to admit.

It is true that, in some situations, establishment of a directly competitive physical unit in close proximity to an existing unit may, in some situations, affect sales at the first unit.  And it’s even possible (although perhaps less likely) that the availability of other channels of distribution might also adversely affect sales of traditional brick-and-mortar units.

But it’s also the case that few (at least in my experience), if any, Franchisors are truly indifferent to bottom-line results at franchised units, if for no other reason than it’s difficult to sell franchises in a system where most units fail to validate positive retail results and respond to an inquiry by a prospective Franchisee with a sad tale regarding their own experiences in the system.  At the end of the day, the easiest franchise to sell is probably the one where most of the Franchisees are delighted with their results and are demanding additional units.

At the same time, it’s true that poorly designed territorial arrangements may negatively impact the growth of the system and its performance against potential or existing competitors, even if they were originally conceived as an attempt to benefit Franchisees.

Here’s how that can happen:

Assume that a new chain, Carla’s Coffee Shops, is being rolled out on a nation-wide or regional basis.  In order to facilitate franchise sales, Carla’s agrees to give Franchisee’s extensive exclusive territories, for the full term of the Franchise Agreement, as well as to protect them against sales of Carla’s ground coffee in supermarkets in their area, by mail order or through the internet.

With these rights in hand, Johnny Jones opens his franchised Carla’s Coffee Shop in Costa Mesa, California, with rights covering that city, along with the nearby communities of Newport Beach, Balboa, Huntington Beach and Fountain Valley, secure in the knowledge that he will not be subject to competition from other Carla’s Coffee Shops in those areas, or any sales of Carla’s ground coffee in local supermarkets or through other venues.

Within a few years, however, Johnny has found that his business has stagnated, due to three factors, among others:

First, while other Carla’s Coffee Shops have certainly been kept out of his territory and he has lost no business to them, Starbucks, Peets and other competitors have remained entirely free to enter the local market, have done so and have secured all of the best possible remaining sites in the area, including ones very close to Johnny’s.

Second, since Carla’s made the strategic choice to grant expensive territories, it has been able to open only a limited number of units.  In fact, after 3 years, there are only 21 Carla’s units nationwide.  This has had the effect of severely limiting funds available for national advertising and Johnny receives none of the benefits of a healthy national marketing strategy, while his competitors have the benefit of huge levels of funding available for national ad campaigns.

Third, due to the lack of any meaningful national marketing strategy, surveys show that consumer awareness of the Carla’s Coffee Shop brand is miniscule, and that relatively little goodwill attaches to the brand on a national basis as compared to its direct competitors.

In addition, the limited number of available locations (due to the granting of broad territorial rights) has limited franchise sales, reducing royalty and other income at the Franchisor level and making the providing of extensive services to Franchisees by the Franchisor problematic at best.  And that lack of services has created dissension and dissatisfaction among the Carla’s Franchisees, further impacting franchise sales.

In short, the attempt to “protect” local Franchisees by granting territorial rights has, it can be plausibly argued, actually wounded those same Franchisees in terms of their long-term investment in the brand and their chances for future expansion and success.

Potential Solutions

While the lessons of the (hypothetical) Carla’s Coffee Shops case may or may not apply to all business models or franchise systems, it does make clear that we cannot assume that a “one-size-fits-all” approach to site location will actually work to the benefit of individual Franchisees or the franchise system as a whole.  In fact, an unsophisticated approach may end up hurting the very people it was designed to protect.

A franchise system that develops a reputation for “cannibalizing” its existing Franchisees will probably have a difficult time selling franchises, while a system precluded from responding to real-life competitive challenges or opportunities will be unlikely to succeed in the long run.

Perhaps a way out of the dilemma is to recognize that both the Franchisee and the Franchisor have legitimate interests:

One the one hand, the Franchisee wants to have a reasonable chance to become established in his business.  So, a limited term of territorial protection (perhaps by means of a right-of-first-refusal) may be appropriate to give him a fair chance to get his business off the ground.

On the other hand, the Franchisor has a justifiable interest in responding to market demand and opening units, securing locations and possibly using alternative channels of distribution when it benefits the brand.  These considerations will probably drive an approach whereby long-term and broad territorial restrictions on the Franchisor will not be built into the system and that individual cases will be dealt with on an individual basis.

What seems clear is that no single, universal approach to territories will always work for every system and that a strategy which takes into consideration the legitimate long-term interests of all the parties involved will nearly always be appropriate from a business standpoint.

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