Aug 7, 2023
by Reking Chen
Subway recently signed a deal that is expected to result in the opening of 4,000 new restaurants in China over the next two decades. The deal is a master franchise arrangement with its franchisee, Shanghai Fu-Rui-Shi Corporate Development Co., Ltd., who will have the exclusive rights to manage and develop all of Subway’s restaurants in China. This deal is not just the largest in Subway’s history – it is potentially one of the largest the food & beverage industry has ever seen.
With over 1.4 billion people and many high-profile deals, China certainly appears promising for franchises. However, success in this market is far from guaranteed, as many brands have learned. In addition to cultural differences and competition from local competitors, potential franchisors must navigate the legal and regulatory landscape as well. In this article, we will address some of the key legal issues to consider when setting up a franchise in China, with an emphasis on master franchise agreements.
I. Key Franchise Provisions Under Chinese Law
The definition of a franchise is somewhat broad under Chinese law. As defined by the Commercial Franchise Administration Regulations Ordinance No. 485 of 31 January 2007, a franchise must contain the following three elements:
Other significant regulations related to franchise setup in China include:
II. Basic Requirements for Franchises in China
To set up a franchise, franchisors must comply with the following requirements:
a) file certain information about the franchise with the competent commercial authorities within 15 days after signing the first franchise agreement with its franchisee;
b) report operational results to the competent commercial authorities on an annual basis; and
c) report material updates about the franchise business on an ongoing basis.
Finally, franchisors are also required to disclose certain information to prospective franchisees in writing in the form of a Franchise Disclosure Document (“FDD”) at least 30 days before the signing of the franchise agreement. Failure to complete and provide the FDD could give rise to a claim by the franchisee for termination or rescission of the agreement, and in certain cases monetary damages.
III. What is a Master Franchise Agreement?
Put simply, a master franchise agreement is a key component of a franchise model where a party that wishes to franchise its business concept/brand (“Master Franchisor”) bundles and grants a package of rights and resources (“System”) to another party that wishes to establish business units mirroring that of the Master Franchisor and develop the market (“Master Franchisee”). Usually, these rights are granted for a specific territory, and include the right to open and operate franchised units, as well as the right to sub-franchise the System to third parties who can open and operate units using the same business model and business resources.
This is one of the most popular franchise models for international businesses seeking to expand in China. This model allows a Master Franchisor to delegate the work of setting up and operating franchise units to a Master Franchisee who has clear advantages in navigating the various regulatory complexities and cultural differences that exist within the Chinese market, and who is often better suited to deal with staffing, supply chain, and management issues. In short, a reliable Master Franchisee can prevent the headaches – and in some cases, the potential regulatory issues – a Master Franchisor may otherwise face when seeking to increase its China presence on a large scale. McDonald’s is perhaps the most famous example of a master franchise arrangement in China. Papa John’s also has two master franchisees in China: one covering the northern portion of the country and another covering the south.
Of course, not all franchise models use master franchise agreements. But they are especially popular among companies looking to dramatically increase their presence in new markets, as the Master Franchisee (usually a well-established local partner) is often better suited to formulate a strategy and address local market conditions than the Master Franchisor. In practice, a Master Franchisee will normally be required to first open and successfully operate a number of pilot units in the territory before being permitted to sub-franchise to others.
IV. Risks Associated with Master Franchise Agreements
Although master franchise agreements offer several benefits for companies looking to expand rapidly, they also pose several risks, including:
Master franchise agreements, by their very nature, tend to stake the company’s success on a single partner. Thus, finding a suitable Master Franchisee is paramount to preventing the entire arrangement from failing and damaging the entire brand’s reputation. Furthermore, it is vital that the master franchise agreements are properly drafted and that they provide adequate protection to the Master Franchisor.
V. Other Common Franchise Arrangements in China
In addition to master franchise arrangements, the following approaches are also common in China:
There are two common methods for adopting a WFOE/JV arrangement:
In addition, some franchisors have chosen to establish a WFOE/JV to help supervise and provide services to the franchisor’s China franchisees who are otherwise engaged through a master franchise arrangement or a single-unit franchise arrangement.
In any event, a WFOE/JV will be subject to regulatory restrictions on foreign investment. In addition, these entities can be somewhat slow and costly to set up compared with single-unit franchise agreements and will have ongoing compliance obligations to meet.
Choosing the most suitable market entry option requires careful consideration and an in-depth analysis of various commercial and regulatory factors. Doing this legwork, however, will significantly increase the chances of a franchise’s success in China.
VI. The “2+1” Rule
As mentioned above, both local and foreign franchisors are required to have operated at least two company-owned units for at least one year before they can set up a franchise in China. Many foreign franchisors, particularly those who do not operate any of their own stores, find this to be the biggest challenge when planning to enter the Chinese market.
If prospective franchisors ignore this rule and enter the market anyways, they may be subject to, among other penalties, orders to adopt rectification measures, fines, asset seizures, and/or having their names publicized on lists of violating entities.
To ensure compliance with the “2+1” rule, franchisors should do the following:
VII. Takeaways & Tips for Potential Franchisors
Franchising in China presents many opportunities and challenges. We suggest businesses to take the following steps when setting up any franchise in China:
DaHui’s IP team has rich experience in franchising projects involving restaurants, hotels, theme parks, fitness clubs, training services, and many other types of businesses in the PRC and numerous other jurisdictions. Aside from the topics discussed in this article, there are many other points for franchisors to consider, and our team is available to discuss potential projects and answer any questions.
Sep 8, 2023