Joint ventures have long been a popular strategy for franchise expansion in certain markets. This strategy is used across all sectors, with the equal sharing of risk and reward between franchisor and franchisee and the joint decision-making process being the main difference to a vanilla franchise.

Below are seven key considerations for franchisors that are considering a joint venture project.

It is a “Vanchise” (a joint venture under franchise)

It needs to be understood that a joint venture between a franchisor and a potential franchisee is quite different from both a standard joint venture and a standard franchise relationship. In a franchise, the franchisor has extensive veto and approval rights. The franchisor does not contribute cash and it does not share in the losses of the franchised business. Contrast this with a joint venture, where each party shares in the profits and losses of the business and decision making occurs at board level. This means that the franchisor will have to make ongoing capital contributions. There is also a significant risk that the franchisee will expect decision making to take place at board level, thereby eroding franchise type veto and approval rights. Sometimes a joint venture can be the only route to enter a new market. However, franchisors need to be mindful that the level of control that they will be able to exercise is likely to be significantly eroded. Negotiating a franchise joint venture is a specialist skill. The dynamics of a franchise business model need to be balanced with the traditional joint venture mechanics. Care must be taken that the franchisor does not end up with less control and more risk than it would have had in a franchise.

Who should control the joint venture company?

In order to retain its veto and approval rights, the franchisor may wish to take a majority stake in the joint venture company. Alternatively, they may view the joint venture as a way to receive some additional profit without significant day-to-day involvement. In that case, the franchisor may want to use a subordinated equity model taking only a 10%-20% stake. Finally, we see a significant number of “vanchise” type joint ventures where both parties have equal shares. This can be particularly challenging as it is directly at odds with the franchise model, where the franchisor controls all the decisions affecting the brand. Accordingly, there are three basic options:

• Equal rights vanchise: 50/50: Here both parties have equal board representation, profit shares and capital.
• Franchisor-controlled JV 80/20: Here the franchisor has the majority control at all levels.
• Franchisee-controlled JV 20/80: Here the franchisor is a minority investor with a focus on profit participation and tag and drag rights/ call options.
• The choice impacts significantly the ability of the franchisor to maintain and control brand standards, the opening schedule, business plan, and pace of roll-out.

Subordinated equity model

In the subordinated equity model, the franchisee is the majority owner of the franchised business. The franchisor takes a golden share or minority stake, typically 10-20% in the franchised business. In this model the franchisor would seek to secure a right of first refusal over the shares in the joint venture company on any sale as well as a purchase option at a discount upon termination of the franchise agreement for breach or failure to meet target. The franchisor would have a board representative for transparency and information rights. It may also wish to secure a tag and drag right upon a sale of the franchisor’s business. This model is specific to the franchise industry and has been used by well-known F&B brands advised by Dentons.

Equal rights joint venture

A 50/50 joint venture is particularly challenging in a franchise context. The franchisee will expect to receive equal treatment with the franchisor when it comes to the decision-making process. The franchisee may expect that brand standard changes and the development schedule are subject to voting at board level. This can result in a deadlock over matters that the franchisor would expect to fully control in a vanilla franchise. If the parties are able to agree and attach a business plan that cannot be deviated from without mutual consent, this may go some way towards preventing early deadlock. Other challenges in an equal rights scenario include the renegotiation of the franchise agreement in a manner that eliminates franchisor checks and balances.

Minority shareholder protection

Any shareholders' agreement needs to include carefully drafted voting provisions which strike a fine balance between preventing a difficult minority shareholder from frustrating the business and ensuring an oppressive majority shareholder does not subject the other shareholder to unfair conduct. A minority investor typically also has certain protections provided by law such as the right to prevent the passing of certain resolutions and the right to bring a claim for unfairly prejudicial conduct.

In UK companies, there is a statutory duty imposed on directors to act in the best interests of the company. Franchisors need to verify if the same applies in the target country of their joint venture. In addition, veto rights are commonly added at both board and shareholder level. In the UK, it is common to see various reserved matters decided at shareholder level. There can be different thresholds of approval needed for different categories of decision e.g. greater than 50%, 75% or 100% of shares in issue. The higher the percentage, the more care is required to ensure that veto rights, and therefore undue influence, are not given to minority investors.

Reserved matters and business plan

Reserved matters are often the most heavily negotiated part of a joint venture agreement. For a franchisor, it is key to ensure that it does not end up with less control than it would have had if there had been no joint venture. Where the franchisor is the majority owner, this means that the franchisee should have very few veto rights. The franchisee should not be able to veto actions that they would have been obligated to perform under the franchise agreement. Conversely, where the franchisor is the minority shareholder, they will want to ensure that they have at least the same veto and approval rights that they would have had, if the relationship had been a vanilla franchise.  The debate tends to focus on the extent to which the roles of the parties in a joint venture differ from the roles and responsibilities in a franchise.

One solution would be to link approvals to an approved business plan. The relevant reserved matter should not require further approval at shareholder level to the extent (i) it has been approved in the business plan, or (ii) it relates to an obligation of the franchisor or the franchisee under the franchise agreement. When coupled with a franchise agreement drafted with sufficient control rights for the franchisor, this should ensure that the franchisor only needs to come back to the company/joint venture partner for approvals in limited circumstances.

Exit rights

A franchise agreement would typically be for an agreed period of time, for example 20 years. A joint venture can also be time limited. The parties may wish to be able to sell the company after a certain period of time or upon the occurrence of a trigger event. Breach of the franchise or joint venture agreement by the franchisee is a common area of debate. In those cases, the franchisee cannot be free to sell its shares in the company to any third-party buyer. The buyer needs to be a party acceptable to the franchisor. The same logic applies that would apply if the franchisee owned 100% of the business and wanted to sell the franchised business. Here the franchise agreement would contain a buyer approval process and ROFR in favor of the franchisor. Franchisors should ensure that they do not concede this position in a joint venture scenario. The price is often dependent on whether the franchisee is a good leaver or a bad leaver.

A franchisee may seek its own exit mechanism in addition to any mutual right to sell interests after a certain trigger event. This could arise, say, five years after the joint venture is signed or upon the opening of an agreed number of units. If so, the franchisor should negotiate the right to acquire the interest being sold for a price not less than and on no less favorable terms than those offered by a third party. The franchisor should have sufficient time to respond as to whether it wants to accept the offer. If the offer is rejected by the franchisor, the franchisee might argue that it should be able to move ahead with the sale to the third party that made the offer at a price not less than that offered to the franchisor. However, the franchisor may not want to have any third party as a new franchisee. Franchisors would therefore typically require the change of control process under the franchise agreement to apply. Franchisors should take care to insist that they control who acquires an interest in their brand. Without those controls, the new franchisee could be a competitor or someone without the required expertise and resources.

Funding

The business plan for the joint venture will envisage funding from both franchisor and franchisee. The parties will need to agree to what extend funding is in cash or by way of shareholders loan. Additional funding may be needed if there are opening delays or where some adjustments to the system are required to reflect local preferences. The franchisor would typically have a stronger interest in funding the roll-out plan than the franchisee. However, the franchisor should be careful not to agree to provide unlimited cheap funding to the joint venture. There should be a cap on the amount a franchisor is obliged to invest in a joint venture. To the extent further funding is needed, there should be the ability for that to be satisfied by way of a loan. If a party wishes to fund such an amount, it should be entitled to make a shortfall loan, which will attract a higher rate of interest and be repaid ahead of other sums in the waterfall. The equity of the franchisee should be diluted if they are unwilling to provide additional funding.

How we can help

It is crucial that the franchisor’s negotiation team has solid experience of joint venture franchising. The team needs to be fully aligned to avoid franchisor rights being given up at the corporate/joint venture level, thereby undermining the rights of the franchisor set out in the franchise agreement. At Dentons, we have an integrated team consisting of corporate and franchise lawyers, who have negotiated high profile franchise joint ventures involving leading international brands. We have significant experience of joint-venture franchising in countries such as India China the Middle East, Europe and Hong Kong.