The Challenges of Franchising in China

Categories: Business In China, Foreign Direct Investments | By Peter Pang

The franchising concept is relatively new to China. In fact, as recently as the mid-1990s, the Chinese language didn’t even include a direct translation of the word “franchise.” Nevertheless, in recent decades, Western franchises have been proliferating in China like flowers after a spring shower. Although fast-food chains such as McDonald’s, KFC, and Starbucks have been particularly successful, franchises in other industries have also experienced success.

The market certainly looks inviting since China’s middle class has exploded to over 400 million people in recent years – more than the entire population of the US. Indeed, China is one of the largest franchise markets in the world, with franchises operating in the food and beverage, retail, car rental, catering, education, beauty, health and fitness, and hospitality industries. The challenges of operating a franchise in China, however, should not be underestimated.

Trademark Infringement

The old saying “imitation is the sincerest form of flattery” might not have been first penned in China, but the Chinese certainly seem to have taken it to heart. If your brand name is already well-known in China before you start doing business there, you’re likely going to be dealing with trademark infringement whether you set up shop in China or not.

If your brand is not well-known in China by the time you arrive, this problem will surface gradually as your brand reputation grows. Of course, you have legal recourse to the courts and, at least in Shanghai and Beijing, the IP courts enjoy a reputation of being relatively free of local bias. Litigation is expensive, however, and many foreign investors complain that, even in victory, damage awards are sometimes insufficient to deter future infringement.

Trademark Squatting

In China, trademark rights cannot be acquired by “use in commerce,” even on a local basis. A trademark must be registered to be enforceable. This state of affairs opens the door to trademark squatting, a practice whereby a Chinese party registers your trademark in China before you do, thereby gaining full rights to it, and demands an exorbitant price to transfer those rights. Fortunately, however, there is an exception for internationally “famous” trademarks

Differences Between the Chinese Franchise Model and Western Models

In the West, franchisors anticipate most of their income from royalties. In China, sources of income are typically more varied, with revenue more oriented towards the supply side of the business. Chinese franchisors also generate income by owning property that they rent to the franchisee at a premium as well as many other ways..

Finding Suitable Franchisees

Locating and attracting appropriate franchisee candidates in China can be challenging, especially outside of the rich coastal provinces. Candidates with the proper experience who possess the understanding and flexibility to bridge the cultural gap can be difficult to find. For linguistic and cultural reasons, it may also prove challenging (or at least expensive) to research the reputations and business history of franchisee candidates.

Help is available, however. The US Commercial Service, or its equivalent in your home country, can be quite useful if they maintain offices in China. You might also seek assistance from law firms with ties to your home country (such as IPO Pang Xingpu) or your country’s Chamber of Commerce operating in China.

Cultural Differences

The cultural differences of operating in China should not be ignored. Differing consumer tastes (relevant to restaurant chains) are only one dimension of this challenge. Large international franchises have greatly modified their menus by adding local flavors such as rice, chicken, and homegrown spices, although traditional favorites such as the Big Mac remain popular, even in China.

Cultural differences run deeper than palates, however. Even when dealing with franchisees, you are likely to run into differences in various ways of doing business that reflect different attitudes towards debt, investment, regulatory compliance, contracts, and personal relationships that are simply too numerous to list here. The most harmonious relationships are likely to be formed with franchisees with Western educations who have experience doing business in China.

Employee Turnover

The staff turnover rate in China is rather high. While the turnover rate is high even in Western countries among minimum-wage workers, in China, even highly trained management staff tend to leave their positions so frequently that it leaves management wondering whether the investment in training these employees was justified. The problem is particularly acute due to the shortage of well-trained franchise managers that results from the youth of China’s franchise industry.

Regional and Provincial Differences

China is a vast continental nation where every province speaks its own dialect (in addition to Mandarin in most cases). In addition to linguistic differences, there are differences in tastes, disposable income, licensing regulations, and business practices. Operating in Shanghai, for example, is a lot different than operating in Henan. The fact that franchises are locally rather than nationally licensed greatly complicates the operations of nationwide franchises.

Unstable Regulatory Environment

The youth of China’s franchise industry means that regulations are changing quickly. Not all that long ago, foreign franchises needed to partner with a local entity in a joint venture to operate in China. After China joined the WTO, however, wholly foreign-owned enterprises were allowed to operate franchises on the condition that they operated their stores themselves for one year before granting any franchises. This requirement has proven costly for many foreign franchises. It is likely that future regulatory changes are in store, but they are hard to predict.

Putting It All into Perspective

The long-term outlook for franchising in China looks bright, despite the existence of political and economic uncertainty. Western products remain popular throughout China, particularly if the brand is well-recognized. China’s franchise consumer market tends to be young, adaptable, and willing to spend money. Assuming no major regulatory or political disruptions, China’s franchise market looks to continue growing at a healthy rate for the foreseeable future.

Peter Pang serves as the founder and Managing Partner of IPO Pang Xing, an international commercial law firm that has been serving foreign investors for more than 25 years now. Mr. Pang is recognized among both clients and peers for his expertise and decades of experience in FDI-related legal issues such as intellectual property protection, corporate governance, joint ventures, labor law, and M&A.
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