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Franchising in China:Overview and OpportunitiesBy Thomas Leclercq & Guillaume Smitsmans, Third Place Ltd

This paper aims to provide an overview of franchising in China to help franchisors understand the key pitfalls to avoid and how to successfully expand into this market. Guidelines for franchise companies will be provided in order to help them to successfully tap into the opportunities in China.

During the past 30 years, there has been a dramatic economic growth in China. Thanks to the tremendous growth of the country’s economy, franchising has become a popular business model. First of all, this paper will start with a short introduction on general principles of franchising in China. Secondly, this paper will elaborate on the different market entries into China and the future perspective of the franchise industry. Last but not least, recommendations and challenges facing International Franchisors will be discussed.

But first and foremost, what is franchising? A franchise is a business model that defines the relationship between a franchisor and one or multiple franchisee(s). On the one hand, a franchisor is a company that owns strategic

resources such as registered trademarks, a company logo, patents and specific know-how. The f ranchisor should be an economic organization that is incorporated by law and must have the ability to provide franchisees with long-term business guidance, technical support and training services (Beshel, 2001). By means of contract, they license to another business operator (the franchisee) the use of the operational resources owned by the franchisor, and the franchisee conducts its business activities under a uniform business system and pays franchise fees, entrance fees and ongoing royalties to the franchisor in accordance with the contractual obligations. The franchisee does not always require any specific qualifications or skills while however most franchisors will have detailed selection criteria for their ideal prospective franchisees profile.

FRANCHISING IN CHINA

The Middle Kingdom offers amazing opportunities for franchising. However, it is best to be prepared to win in this competitive environment.

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Franchising first emerged in China in the late 1980s but it was definitely lacking a proper legal environment, which led to an uncontrolled and unfavorable climate for its development. Initially, many companies with high-profile franchise operations chose to avoid franchising in China because of the difficulty of finding partners, their lack of specific skills, the regulation requirements, difficulty acquiring locations and problems with fraud (Hughes, 2011). Many cases of fraud from both Franchisors (using fake support systems, defraudment, etc...) and franchisees (infringements of intellectual property, non-respect of product sourcing guidelines, etc...) were observed in the early days of the industry. Furthermore, and to give a bit more of perspective to the readers, there was not even a proper translation for the word in Chinese; it was then referred to as 连锁经营店, which means chains of stores. Today, even the Chinese language has been adapted: there is a proper word for franchising which is 加盟.

Franchising as it is known in the most developed franchise countries, like the USA or United Kingdom, has yet to be developed in China but changes are underway and can happen rapidly in the Middle Kingdom. Also the Chinese Government is well aware of the potential of such business model to create jobs, sustain the local economy while the countries business model shifts from an export focus to a development of its own domestic market. In 2009, China's franchise industry experienced rapid development, the number of franchise systems broke the 4,000 threshold, up nearly 15% over 2008. The total number of franchised stores exceeded 330,000, and each franchise system had on average 83 franchised stores according to the China Franchise Market Report (2011). By industry, franchise systems were mainly concentrated in retailing 44%, catering 30%, and service industries 26%. Service franchises witnessed the fastest growth according to the China Franchise Market Report.

According to statistics released by the end of 2010, there were more than 4,500 franchise systems in China, c o v e r i n g 7 0 i n d u s t r i e s a n d the total number of franchise stores has reached 400,000 (Yigi, 2011). The number of franchised outlets in China is likely to reach 800.000 over the next five to 10 years, creating more than 10 million jobs (Mark, 2011). It’s also stated that the top 120 franchisers had a total sales revenue of 338.7 billion Chinese Yuan (36,4 billion Euros) in 2010, an 8.9 percent increase from 2009 and that the 120 franchisers own 131,413 stores which is 12,5 percent more than in 2009 (Yigi, 2011).

Today, KFC is still the largest brand in China concerning fast food. Yum Group reported a turnover of 12.6 billion dollars in 2011 of which the Chinese market contributed roughly 45% (Feng, 2012). Yum's success in China has resulted in large part from its ability to create a menu that combines its traditional Western fast food with dishes that appeal to Chinese tastes.

Furthermore, given the rapid economic development of the past few years, capital is readily available in China, and many Chinese entrepreneurs are looking for opportunities to bring into China. The Chinese are certainly getting richer fast: the per-household disposable income of urban consumers is expected to double between 2010 and 2020, from about $4,000 to about $8,000 (Atsmon & Magni, 2012). That will be close to South Korea’s current standard of living but still a long way from the level of some developed

countries, such as the United States, which reaches about $35,000 and Japan for about $26,000 (Atsmon & Magni, 2012). However, these entrepreneurs might be lacking the necessary experience and management skills to successfully launch a brand or concept. That’s where the support of a franchisor is most welcome and needed.

The Chinese economy has been growing tremendously over the last decade and with an estimated annual GDP growth of 7.6 per cent in 2012, they are still performing well (Branigan, 2012).

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Franchise N° of outlets in China

Mc Donald’s 1750

Starbucks 700

Pizza Hut 700

KFC 4000

Figure 1: # of outlets per major franchise

Figure 2: A dramatic increase in Middle Class

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Because the wealth of many consumers is rising so rapidly, many people in the value category will have joined the m a i n s t r e a m o n e b y 2 0 2 0 a n d mainstream consumers will then account for 51 percent of the urban population (Atsmon & Magni, 2012). According to figure 3, a new consumer base belonging to the mainstream revenue category is about to boom in the coming 10 years. This will have an impact on companies targeting this segment, especially those selling a product in a discretionary or non essential categories will show the strongest overall growth (13.4 percent) between 2010 and 2020, as these goods become affordable to growing numbers of consumers (Atsmon & Magni, 2012).

It goes without saying that this economic growth will lead to an increase in the Chinese middle class. As showed by figures 3 and 5 hereunder, the Chinese middle class has a bright future and will increase its consumption tremendously in the next 10-20 years. It is expected that the Chinese middle class will grow to more than 600 million people in the year 2020 (Fox, 2012). As a result, more people in China will be able afford more expensive products on a regular basis. Chinese value many foreign brands very highly, which makes it attractive for franchise concepts from all over the world to come to China.

International Franchises specifically appeal to what we call the New Chinese Consumer. This New Consumer is a young (or young at heart) and

modern person, extremely mobile and demanding and also has huge aspirations for the future. If they are married, these new Chinese consumers have typically a double income and have seen their discretionary income increase greatly over the past few years. Combining the large and growing middle class in China, the acceptance of franchise systems by entrepreneurs and the improvement in China’s regulatory environment leads to huge business opportunities for franchisors.The Chinese market values foreign brands higher than their domestic brands which makes international franchise business model very attractive to many investors.

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Figure 5: 300 Mio people expected to enter Middle Class within the coming 10 years

Figure 3: Disparities among Cities in evolution of Middle Class Consumers

Figure 4: A growing appetite for Foreign Brands

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Which Corporate structure to use to enter the China market?As been showed by Figure 9, there are different possibilities in terms of corporate structures to enter the Chinese market. If an international franchisor wants to conduct franchise activities in China other than by way of a cross-border franchise agreement, it must establish a legal entity in China, which is called a Foreign Invested Commercial Enterprise or FICE. Franchisers in China are most likely to be engaged in franchising models like a Wholly Foreign Owned Enterprise WFOE, a Joint Venture or a Master Franchise. A Joint Venture is a limited liability corporation in which both partners invest in and manage operations through a Board of Directors (Beshel, 2001). In this arrangement the partners share the profits and losses in proportion to their investment. In a Wholly Foreign Owned Enterprise WFOE, all capital is provided by the foreign investor who has full control over the operations of the enterprise (Beshel, 2001). Master Franchising is another possibility in which the international franchiser sells master franchising rights to interested Chinese companies.

The future perspectives of the franchise industry.Needless to say that China has a bright future when it comes to franchising. First of all, the Chinese economy is still increasing with an annual GDP growth of 7,6% in 2012 (Branigan, 2012). The increasing wealth that had been amassed over the years is of course an opportunity for franchising. The growth of the economy has created a massive Chinese middle-class, which is expected to be over 600 million people in the year 2020 (Fox, 2012). This tremendous growth of the Chinese population means more people are able to buy “luxurious” products (Atsmon et all, 2012). Furthermore the variety of franchise industries are increasing, which means that not only the food & beverage industry is establishing in China but also a variety of financial, real estate and educational franchise systems are starting to establish their concepts in China.

Another important aspect for the future of the franchising industry is the opening of the so-called Tier 2 and Tier 3 cities. The Chinese government allocates an important part of its resources to develop the country’s cities (many of which have more than 1 million citizen!) and sustain their economy. They do this by constructing and developing Tier 2 and Tier 3 cities, with massive investment in infrastructure for instance. Tier 1 cities are for example Shanghai and Beijing and have the highest household income, a large population base and the largest GDP scale. Tier 2 are cities like Hangzhou and Nanjing and have growing populations, incomes and GDP. Tier 3 are cities like Nanchang and Xuzhou and are growing markets with a lot of potential but are a little bit behind in terms of development, while catching up really fast as being showed in figure 10. Though the total population of the Tier 2 cities accounts for only 8 percent of China's overall population, these markets receive more than 59 percent of total US imports according to the US Commercial Service, and Global Trade Atlas statistics show that the cities with the highest year-on-year growth in US imports as of June 2010 where Hefei, Anhui (164 percent), Ningbo (90 percent), Chengdu (75 percent), and Hangzhou (63 percent)—far outpacing the 19 percent and 21 percent growth rates in Beijing and Guangzhou (Craig & Qiang, 2011). As living standards and the business environment improve, these cities have enormous market potential like for example Suzhou's population that was roughly 6.3 million and its gross domestic product (GDP) was $774 billion in 2009

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Figure 6: Types of company structure to enter China

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In comparison New York, the largest US city had a population of about 8.4 million and GDP of nearly $1.5 trillion in 2009 (Craig & Qiang, 2011). China's 12th Five-Year Plan for 2011-2015 which lays out national policies in major social and economic areas for the next five years, is currently being executed and is expected to continue funneling major investments into Tier 2 cities. All these positive numbers could transformed into opportunities for the franchise industry. Opportunities for western franchisors also lies in the relatively under developed competitive landscape in those Tier 2 and Tier 3 cities. If foreign franchisors are willing to adapt slightly their offering to local Chinese consumers and are prepare to venture into these cities, the payback can be huge!

To describe the future of franchising in China, you need to differentiate between domestic and foreign franchised concepts and we will refer here to an excellent research done by JLJ consulting (2008). The domestic franchise brands clearly outnumber foreign franchise systems in China but their success are also quite different. For instance, domestic outlets suffer from poor standardization and consistency across their network (Joseph, 2007), which is something that they will have to improve in the future to be able to attract local investors faced with many more highly standardized foreign franchise systems. Foreign brands are valued highly by the Chinese population and have the widest presence in Tier 1 cities, where a large brand can have a lot of outlets per city, compared to 1-4 outlets for each Tier 2 city (Joseph, 2007). In the future, Chinese franchise systems will reinforce their foothold in their motherland while standardizing and developing more processes. Some of the best franchise systems are already looking at expanding in selected countries overseas.

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Figure 7: The hierarchy of cities in China

Figure 7: Differences between Domestic and Foreign Franchise systems

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In the previous chapters, we have proven there are still tremendous franchise opportunities to seize in the Chinese market. However, International franchisors need to be careful when addressing these opportunities. Success in China comes at a certain price and focus. In this section, we provide a few recommendations to those willing to tap into the growth of the Chinese franchise industry:

- IP protection: first and foremost, protect your intellectual property! There are still today IP infringements in China even though the situation has slightly improved over the years in major cities. However, if you venture into Tier 2 or Tier 3 cities, the risk of your concept being copied is a reality. Therefore the first step is to protect yourself. To really avoid this situation, we always recommend to our partners, to develop rapidly in a given territory to seize the full potential of the market by themselves.

- Partner selection, due diligence and quality of management: this is a crucial element for successful franchise development in any market but it is even more important in China. Education levels in China are rising for sure, but most of today’s successful entrepreneurs are self-made men or women. Due diligence is not always easy to conduct from overseas, having a local partner to help you conduct these background checks is really a must since general information is not readily available in China. Given the amount of wealth created over the past 2 or 3 decades, finding investment is not a problem. However, finding partners with the right management skills is not as easy. Therefore, you need to assess thoroughly your partner’s ability to understand and blend into your franchise model but also its ability to manage it the way you expect.

- There is no such thing as one China: Many international franchisors make the mistake of considering China as one single market. China is so vast and its regions so diverse that it should be treated almost as a collection of separate countries. Companies should redefine the roles of their regional divisions and headquarters, delegating more decision-making power to the former (Atsmon & Magni, 2012). And it is no surprise for a country that is in the end larger than Europe. Especially for Food and Beverage, local tastes and preferences vary greatly from province to province. And major franchisors, which have been working in China for a while, have well understood this phenomenon. For instance, Starbucks has recently announced (http://online.wsj.com/article/SB10001424127887324784404578142931427720970.html) to move away from the one-size-fits-all model that prevailed in China. And that strategy will surely pay to allow them to tap into a wider consumer base. Consumer needs could become so varied across China’s regions that local insights and strategic decision-making power will be vital. We recommend to international franchisors to be humble when entering the China Market and be willing to learn and adapt to the local culture.

- Pricing and Volume: One last recommendation concerns the positioning of international franchise systems in the marketplace. Many international franchisors tend to go for a premium positioning given the foreign credentials of their brand. While it might be logical for some brands, it might be beneficial for others to reconsider another type of positioning, especially for those concepts suited for Tier 2 or Tier 3 cities. To succeed and reach the masses, international franchise should consider adopting a “value-for-money” approach. In many industries, there is still room for mid range pricing positioning, and in China, reducing your average price by a few cents might mean an increase of you target group of a few dozen million people!

Recommendations and challenges to international Franchisors

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About us Thomas Leclercq is the CEO and founder of Third Place Ltd, a franchise Development and Management company established in Shanghai, China. Guillaume Smitsmans is a Business Development Associate and has joined Third Place in 2012 to reinforce the Business Development Team. You can contact them at info@third-place.be,

Third Place Limited is a China-based franchise consulting firm specialized in developing and managing franchises in Asia with a focus on China. We offer a multicultural team that can easily bridge the gaps between Western and Asian culture to ensure a successful franchise development. The value we bring to our clients resides in the externalization of your international development while variabilizing their investment to grow.

We provide among others the following services: China Franchise Compliance, Franchise Health checks, China and Asia Franchise packages development, Franchise Manuals Development, Franchise Market research in China and Asia, China Franchise Partner evaluation, China Franchise partner recruitment, Franchise business plan evaluation, Franchise Coaching, Franchise Training, Franchise Network Management.

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ReferencesAtsmon, Y., Magni, M., (2012). Meet the Chinese consumer of 2020. McKinsey Quarterly. Mckinsey&Company.

Atsmon, Y., Magni, M., Jin, A. & Li, L., (2012). From mass to mainstream: Keeping pace with China’s rapidly growing consumers. 2012 Annual Chinese consumer report. Mckinsey Insights China.

Beshel, B., (2001). An introduction to franchising. IFA Educational Foundation. The money Institute.

Branigan, T., (2012). China’s economic growth slows to 7.6%. The Guardian. Retrieved from the internet; http://www.guardian.co.uk/business/2012/jul/13/china-economic-growth-slows-gdp

Craig, R., Qiang, J., (2011). China’s emerging tier 2 cities: Opportunities for US companies. China Business Review.

Edwards, W., (2011). The pros and cons of franchising in China. China Business Review.

Feng, J., (2012). The turnover of Yum Group exceeds 12.6Billion Dollars. Jing Hua Newsletter.

Hughes, N., (2011). FICE Franchising in China: A flourishing business model. China briefing magazine. Retrieved from the internet; http://www.china-briefing.com/

JLJ Group (2008). Franchising; The way to go in China. JLJ Group. Retrieved from the internet; http://www.chinaprimer.com/franchising-in-china/china-franchising-market-entry.html

Joseph, F., (2007). China: Franchise Industry; Access dynamic and emerging markets. U.S. Department of Commerce.

Mark, J., (2011). China to have 800000 franchised outlets in 5 years. China Chain Store & Franchise Association,

Yigi, Y., (2011). Franchise heat. China Daily. Retrieved from the internet; http://www.chinadaily.com.cn/business/2011-06/24/content_12772247.htm

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