Encroachment – Managing Market Expansion
QUESTION: When we began our franchise system, our lawyers advised us that the simplest and best method for establishing protected territories for our franchise system was to establish a radius around each location in which we could not open new franchised or company-owned locations. We are a retail business and, based upon the advice of our lawyers, we selected a three mile radius for our franchise system. Can you address whether this selection was right for my company?
ANSWER: Without conducting an analysis of your retail locations and getting an understanding of what draws customers to your stores, I really can’t provide you with a specific answer. However, for me, if providing a franchisee with a protected area around their location is the right decision for a franchisor, using radii as the determining factor is the least appealing method to use.
Generally, without the constraints of franchise sales and the potential impact on franchisee relations, franchisors would select sites based upon market conditions existing at the time they choose to expand. Defining, often decades in advance, territorial protection is unique to third-party distribution strategies such as franchising, and generally it is a constraint not faced by non-franchisors in selecting sites for new locations. The establishment of protected or exclusive territories is one of the inelastic restraints that is problematic to the competitiveness of franchise systems.
In franchising, what a radius generally means is that a franchisor cannot establish either a company-owned or franchised location within a certain distance from another location measured in miles in all directions. The likely reason that a radius is often found in franchise agreements is that it is easy for the franchisor’s attorney to define in the franchise agreements, and takes little or no effort on the part of franchisor to use when approving location. It also provides comfort to the potential franchisee, who is frequently looking for some protection against intra-brand competition.
If you have granted your franchisees a three-mile protected radius, then the horizontal line above shows the minimum distance from one location to another. However, systems that use a radius as their approach in spacing locations often find that their ability to logically place locations in a market is diminished. Using a radius ignores major elements of what constitutes a proper site selection process, which includes evaluating the location in the context of a neighborhood shopping area, roads, bridges, natural barriers, driving patterns, brand identification, marketing methods, competition, and draws, which are just a few of the variables that affect traffic to any location. They are also generally a measurement made globally for a franchise system and, as every businessperson knows, there are vast and important differences from one market to another when assessing where locations should optimally be established.
Equally problematic is that many franchisees equate having a protected territory as the same as having an exclusive territory from which only their location can draw customers. In the example above, while the locations are separated by the agreed three-mile radius, neither location has an exclusive territory in the overlapping area and, in reality, likely share from the same potential pool of customers. Achieving a three-mile exclusive territory in which there is no overlapping territory would require a six-mile distance between locations, as shown below. Except in very rural areas and in industries that do not require multiple locations in a market, this distance rarely makes any market sense.
Rarely do we find that a radius provide a proper market development strategy for either the franchisor or the franchisee.
For these reasons, when we are developing a market strategy for a client, if it is appropriate to provide franchisees with any territorial protection in order to achieve competitive market penetration, we avoid the simplicity of defining a protected area using a radius measurement. Besides not having any scientific or true business basis, using radii tends to leave gaps in the market which may not be able to be exploited by either the franchisor or the franchisee, but can be developed by competitors that do not use such arbitrary measurements.
In determining markets for their franchisees, many franchisors which grant territorial protection use customer-based measurements such as population, number of businesses, traffic counts, or other market measurements that meet some predetermined measure at the time they were developed. Franchisors will then grant territories of sufficient size to provide an adequate quantity of the projected customer base to their franchisees. However, as time passes and the market dynamics change, often so does the underlying validity of the measurements used.
Markets expand and contract, customer focus changes, new competition emerges, traffic patterns alter, and the measurements over time may no longer meet the market dynamics set when the market was first established. Modifications of these measurements in a dynamic, practical, and legal sense are difficult to implement within an established franchise system. But at the outset of the business, for franchisees and franchisors which are fixed-base operations, defining a protected or exclusive territory by actual analysis of market factors and then providing the franchisee with an area defined by metes and bounds at least looks at the reality of the market in which they will be doing business. Nothing, though, requires the protected territory to be permanent, and nothing precludes other business or marketing activity unless that is what is decided upon.
Further complicating the issue of exclusive or protected territories are alternative distribution strategies and dual branding opportunities which are available today. Consideration needs to include what impact, if any, alternative sites have on traditional locations. Frequently it is found that increased brand awareness achieved through alternative sites or alternative methods of meeting consumer demand (i.e. supermarkets, internet sales, etc.) actually provides benefit to what on the surface looks like an impacted location.
Both franchisors and franchisees we work with have similar concerns:
- How do you balance the competitive benefits for the overall system against potential impact on the individual location?
- How do you develop an adequate number of locations to meet competition, when the only constraint on the non-franchised competitor of the franchisor that does not provide any market protection is available customers, franchisees, capital, and real estate?
- Is it better to allow a competitor to take a high-volume location rather than face the potential claim of encroachment by a franchisee?
- Should franchisees sacrifice potential high-volume locations in order to protect their other locations?
- Should franchisees be able to block additional market expansion or be compensated when new expansion impacts their businesses?
These are some of the business issues that are most important to evaluate in setting your market protection policy.
Many franchisors today are simply not providing for any protected or exclusive market exclusivity at all in their franchise agreements, and are selecting locations based upon the needs of the consumers. Good franchisors make new location decisions with care, based upon current market conditions, and factor in the impact new locations have on existing locations. Generally, where there is a solid basis of trust within a franchise system, this method of market expansion works well.
A handful of franchisors have created impact policies which may be useful tools that provide additional rights to franchisees that feel a new location may have a negative impact on their businesses. Those impact policies may also provide a safe harbor for franchisors when accepted by franchisees. While not broadly used, well developed impact policies can be used by franchisors and franchisees to maintain a beneficial relationship and provide some protection to the needs of both the franchisor and the franchisee.