STOCKHOLM SCHOOL OF ECONOMICS IN RIGA



Paper to be presented at the EMNet-Conference on

"Economics and Management of Franchising Networks"

Vienna, Austria, June 26 – 28, 2003

univie.ac.at/EMNET

Choice of Foreign Entry Mode by Franchisor:

Case Studies of Lithuanian Franchisors Entering Latvia

Regina Jarmalaite, Irina Sekundo

Stockholm School of Economics in Riga

Strelnieku 4a

LV-1010 Riga

Latvia

Tel: 00371-7015800

Fax: 00371- 7830249

E-mail: jarmalaite@

E-mail: sekundo@

Abstract

This paper is the first attempt in the Baltic market to find reasons and explain the strategic motives and decision-making factors for the franchising companies to expand internationally via either ownership or contractual entry modes. The authors on the basis of two Lithuanian franchisor case study companies, that have entered Latvian market in order to create the franchising network, exploit the motivating factors and their influences on the choice of entry mode. The authors have identified and critically evaluated twelve factors and put forward the following five hypotheses:

Hypothesis 1. The franchisor, which has enough resources, high level of motivation to learn abroad, is alert to the rival firm’s activities but is not striving for fast penetration of market chooses the ownership mode of entry into foreign country.

Hypothesis 2. For a franchisor entering a culturally similar market with a low degree of country risk, international experience does not influence the choice of entry mode.

Hypothesis 3. For a franchisor when choosing an entry mode into foreign market existence of highly powerful players in market to be entered does not necessarily result in equity mode being chosen.

Hypothesis 4. For a franchisor that plans entering foreign market the absence of differentiation specifics of products or services is not an obstacle to choose the equity mode of entry.

Hypothesis 5. For a franchisor the perceived importance of brand and control over quality are not crucial factors for choice between contractual and equity mode of entry into foreign country.

Keywords

Franchising, Foreign Entry, Ownership Entry Mode, Contractual Entry Mode

Acknowledgements

As the authors of this Thesis we would like to express gratitude to many people and certain organisations that have helped and endowed with special knowledge and support necessary for the successful completion of the paper. First of all, we would like to thank Andris Strazds for the immeasurable support for providing insights into the topic. Also the assistance of Leona Achtenhagen and professor Roberts Ķīlis in the idea generation and clear direction finding were of great importance.

Our major thankfulness for their input into the success of this work belongs to Renaldas Gineika and Vilmantas Šimoniūtis, who were ready to give us all the necessary information on their companies and provide us with very valuable and abundant advice for our Thesis writing. It was of high value to have their support and instantaneous replies to our questions, especially when the deadlines were so close. As well we thank the expert of car repair business and the person who despite new restaurant opening rush was ready to meet us and tell his view. Moreover, we deeply appreciate the time and efforts spent by Diana, Indre and Tom to help us.

None of this would have been possible without the never-ending optimism, understanding and encouragement of our dear parents, family members and friends, especially Ivars and Katri.

Table of Contents

I. Introduction 1

A. Purpose and Research Questions. 1

B. Relevance 1

II. Definitions 2

III. Theoretical Background 3

A. Franchising 3

B. Internationalisation 3

C. Reasons for Choice of Entry Modes 3

1) Firm and Industry Specific Factors 4

2) Country Characteristics 5

3) Firm Strategic Intent and Preferences 6

IV. Methodology 8

A. Choice of Research Strategy 8

B. Selection of Case Companies 9

C. Data Generation 9

D. Constraints and Delimitations 9

V. Empirical part 10

A. Case study – Kemi entering Latvia 10

1) Background of the Company 10

2) Firm and Industry Specific Factors 10

3) Country Characteristics 12

4) Firm Strategic Intent and Preferences 14

B. Case Study – Pizza Jazz Entering Latvia 15

1) Background of the Company 15

2) Firm and Industry Specific Factors 16

3) Country Characteristics 18

4) Firm Strategic Intent and Preferences 20

VI. Interpretations of Research Findings 23

VII. Conclusion 26

VIII. References 29

IX. Appendix 31

Introduction

Throughout the United States and Western Europe, the countries of the world that could be called mature in their economic development, the concept of franchising is an integral part of the entrepreneurial environment. Nevertheless, the Baltic countries still portray rather undeveloped local company franchising practices.

The factors that would foster the growth of franchise business in the Baltics were already explored by Brennere and Petrova (2002). They focused their research on the situation in Latvia. Considering that the economic, demographic and historical conditions are rather similar also for Lithuania, in this research the authors will not go into detailed analysis of the critical aspects that could promote the franchise development in Lithuania. However, the authors will look from a fundamentally different perspective – international expansion of franchising companies. In this research the choice of the entry mode to Latvian market by Lithuanian franchisors will be explored.

Purpose and Research Questions.

The primary aim of this Thesis is to recognise and evaluate the critical motives for the choice of entry mode of Lithuanian franchisors when entering Latvian market. Critical motives for the choice of entry mode hereinafter are defined as issues considered before and during the entrance phase to the foreign market. This paper is an attempt to answer the following questions:

What are the factors influencing the choice of a franchisor when selecting the mode of entry into a foreign market? How have the aforementioned factors influenced the choice of entry mode in case of Lithuanian franchisors entering Latvia?

Relevance

From the practical point of view the strategic motives, choices, and development of the company – franchisor via two different modes for entering a foreign market are of extreme importance for the new entrants into the Latvian market. The analysed topic thus is valuable source for consideration for the SME – franchisor management that pursues a possible foreign market entry strategy to Latvia. Even though the paper does not provide the general recipe for entrance strategy, the authors consider the Thesis to set the guidelines for the SME – franchisors that are contemplating the growth to other countries’ markets.

The compliance of the actual entry motives and choice of entry mode when expanding to the Latvian market with the considerations or practices in the other markets revealed in the theories will be studied. Hence, the paper would be of utmost interest for those that are considering Latvia as a potential market for entry.

Definitions

Contractual entry mode is the entry mode when the owner of the service concept (principal) enters into a contract with an unrelated party (agent) to use a specific business formatted service concept to sell services or goods under the principal’s trademark. However, the principal does not invest funds of its own in the local service unit as the agent takes responsibility for the construction, maintenance, and management of the local operation (Fladmoe-Lindquist and Jacque, 1995, p.1238).

Franchisee is an agent that acquires the right to own a business representing or selling a proven product line or service, a respected trademark, and an established operating system that has been fully “debugged” to achieve maximum profit (Purvin, 1994, p.3).

Franchisor is a person or a company that grants for a fee and other considerations the right to use its name and system of business operations; a person or a company who has come into franchising contract with at least one franchisee. (Jucevicius and Smitas, 1999, p.81).

Ownership entry mode is the entry mode into the foreign market when a parent firm either wholly owns or manages the foreign unit or relies on some type of joint venture agreement (Fladmoe-Lindquist and Jacque, 1995, p.1238).

Theoretical Background

Franchising

Franchising is a form of entrepreneurial activity in which an agreement defines that “the owner of protected trademark grants to another person or firm, for some consideration the right to operate under this trademark for the purpose of producing or distributing a product or service” (Caves and Murphy, 1976, p.572). Apart from a trademark that creates the value for franchisor, there is also competitive uniqueness in business methods, procedures and services offered to customers (Contractor and Kundu, 1998, p.29). Franchisor and franchisee must be viewed as indivisible parts in successful business formation.

Internationalisation

Franchising ventures are especially useful tools when foreign market must be entered, this is known as international franchising. International franchisees have been greatly regarded as market seekers that exploit their firm-specific capabilities abroad (Pak, 2002, p.28). Indeed, franchising is one of the fastest ways to expand in foreign countries with the least capital expenditures and management time. It would seem obvious that franchisors then without hesitation would enter a new market by franchising agreement, the contractual mode, still there are some that choose another way, ownership mode.

The reasoning and approach of these two different entry modes suggests that companies which invest their own capital into foreign branches assess the local market conditions more critically than those entering via contractual mode. This could possibly lead to a less effective market potential recognition by franchising mode entrants.

Reasons for Choice of Entry Modes

As recognised by Contractor and Kundu (1998), the decision of a franchisor which foreign entry mode to choose can be based on three general criteria: firm and industry specific factors, country characteristics and firm strategic intent and preferences. Evaluation of each of these would then lead the franchisor to the best-fit entry mode.

Firm and Industry Specific Factors

The firm and industry specific factors are those that differentiate firstly the company from its competitors and secondly the power distribution in the exact industry from other industries. Primarily, these factors are company advantages of resource particularity and capabilities, and the ability to cope with tension and form alliances, successful combination of which can result in company’s internationalisation. However, not all these advantages are mobile; often a sophisticated adaptation to the local market must be made to make them usable also abroad.

Many previous pieces of research have identified firm and industry specific factors that have impact on choice of entry mode. The firm specific factors are the size of the company, product specifics, and international experience. The industry specific factors are in this case the distribution of rivalry power in the particular industry.

Size of the Company. The size of the company represents the amount of resources the company has at its disposal and the capabilities it has developed, which can be considered as the knowledge resources of the company. Firms with greater resource availability have greater possibility to make an ownership mode entry into foreign market (Brouthers and Nakos, 2002, p.49).

Product Differentiation Specifics. Ownership of a unique product or advantages of production or service creation technology makes the company search for the balance between the possibility to maximise its profits and need to protect unique advantage from the competitors (Brouthers and Nakos, 2002, p.50). Companies that have differentiated products usually prefer equity modes of entry as, firstly, “the unique nature of their technology makes a priori evaluation of market benefits difficult” (Klein, Frazier, and Roth, 1990, as cited by Brouthers and Nakos, 2002, p.50). Secondly, if the company has once exploited the benefits of differentiated product in home country, it will have advantage in replicating this success abroad due to developed marketing and delivery system.

Industry Specifics. Commonly contractual mode is chosen by service industries while ownership mode is chosen by production industries, who open in foreign country their owned production outlet and afterwards create in this country a network of franchised sales offices.

Depending on the risks affecting the company, either entry mode can be chosen. Usually companies operating in intensive competition industries would choose the ownership mode of entry, which allows for fast reaction and possibility of forming a stable relationship with other key players. Forming such relationship would be harder for franchisees, as they are perceived as less reliable partners. (Fladmoe - Lindquist and Jacque, 1995, p.1241).

International Experience. Two contrasting views exist regarding international experience impact on decision making. The traditional view is that gradually while growing in size companies change their organisational choice and channels of distribution from contractual licensing and distributorship to company’s own operations (Johnson and Vahlne, 1977, p.18).

The opposite view expressed by Fladmoe - Lindquist and Jacque (1995, p.1240) in service industry analysis is that “as a service firm gains international experience, it develops a knowledge base about management of global business, thereby becoming more confident about engagement in long term international franchising.” In the early stage novice international firms have a tendency to rely on contractual relationship, letting the internal and market risks of foreign entity to be monitored by a local partner (Root, 1987 as cited by Fladmoe - Lindquist and Jacque 1995, p.1240).

Country Characteristics

According to Ramcharran (2000, as cited by Brouthers and Nakos, 2002, p.51) firms entering foreign markets can be confronted with unstable political, economic, foreign exchange, and/or social environments. Contractor and Kundu (1998) identify three factors affecting the propensity of company to choose franchising entry mode: country risk, cultural distance, and the host country’s openness to global business.

Country Risk. The country risk refers to economic and political uncertainty in the country where the business should be situated. This means the level of environmental uncertainty in the country that is politically stable (Contractor and Kundu, 1998, p.33). Of course political elections, membership in political or economic blocks such as NATO, EU, NAFTA, development of new regulatory systems, rise or fall of foreign investments in the country, and other significant issues relate to the company entry mode choice as well.

Cultural Distance. Successful operations abroad require understanding of foreign work ethics, mental sets and cultural traditions. Agency theory suggests that there exists an “adverse selection” problem when recruiting employees in culturally different settings and then high costs of controlling them (agency relationships) occur. It is more likely that if the cultural difference between the home and host nation is large, the contractual mode of entry will be chosen.

Host Country’s Openness to Global Business. The countries that have open doors policy to the international operations and foreign investors entering country are expected to have greater number of ownership mode entry cases (Dunning and McQueen, 1981, p.204).

Firm Strategic Intent and Preferences

Company and country specifics only, however, cannot be a sufficient ground for the choice of entry mode. Decision can be made only after full evaluation of aforementioned factors and strategy and strategic importance of different aspects of the venture.

Perceived Strategic Importance of Control over Quality. In previous researches two dominating contradicting views about the strategic importance of control over quality relation to the choice of entry modes can be found. Firstly, Contractor and Kundu consider that franchising business is a problem because franchisee might not maintain the original quality of services or decide to shrink its operations. As in modern market the quality of service is crucial, franchising mode would be preferred, if regular and direct quality control over the franchisee could be maintained. Otherwise, ownership mode would be more appropriate.

The second view states that there is a trade-off between providing the agent with sufficient incentives to work hard and appropriate risk sharing and/or preventing free-riding on the brand reputation of the principal (Lafontaine and Oxeley, 2001, p.11). A “moral hazard” problem here involves possible shirking by employees and, consequently, high cost of monitoring abroad, as opposed to self-interested dedication on part of the franchisee. Which means those franchisors, which perceive control as important tool would choose entering foreign country via contractual mode.

Perceived Strategic Importance of the Brand. The brand for a company means the accumulation of its tangible and intangible assets. However, for a franchisee the importance and strategic perception of brand is dual. On the one hand, the brand is already acquired value, on the other hand, the franchisee is legally independent from the franchisor; thus if some problems occur, the franchisee bears losses, which in case of franchisee being risk averse can result in additional risk to franchisor and shrinking of brand value. Nevertheless, franchise unit and the principal company are indivisible parts and failures from any side would dramatically affect the brand name and thus both parties. Therefore it is expected that companies with higher levels of reputation specific assets would not prefer franchising as the means for going international.

Wish to Quickly Penetrate Foreign Market. It is expected that companies willing to quickly penetrate the foreign market would choose franchising entry mode, as it requires small capital investments and is usually faster than equity unit opening.

Level of Motivation to Learn Abroad. By going international the company also acquires know-how and knowledge by benefiting from international comparative advantages (Pak, 2002, p.30). The foreign market is a priceless source for new ideas and strategic knowledge. Organisational learning, both inside and outside the company, is central to understanding the underlying strategic intention of a company (Ingram and Braum, 1997, as cited by Pak, 2002, p.30). Most valuable is the personal work experience, which can be gained only in the operation of the company in foreign market and personnel participation in this operation. This is a portrait of the equity mode entry into the foreign market.

Level of Alertness to Rival Firm’s Activities. Thorough examination of market conditions in advance and showing high alertness to competitive power of rivalry results in ability to exercising more authority in foreign market, characterised by equity entry mode. This allows maintaining hands-on management and reacting fast to any challenges of competition. In addition, being aware of rivalry reduces the risk of investment; therefore, the company would be able to invest into the foreign country without fear of losing a major portion of investment. Franchising is less appropriate to the turbulent competitive situation.

Methodology

Choice of Research Strategy

Taking into consideration the exploratory objectives and the scope of the Thesis, the authors have chosen qualitative research approach. Firstly, the pilot study, where top management representatives of the companies have been interviewed on the semi-structured interview basis, was conducted. Then two case studies of Lithuanian capital based franchising companies Kemi and Pizza Jazz were tackled. In addition, the authors have also aimed at in-depth contemplation of Lithuanian SME involved in franchising, whereas simultaneous investigation and analysis of the information allows shaping the hypotheses for the reasons these companies preferred either contractual or ownership entry mode.

Selection of Case Companies

With the initial interest of local SME development only Lithuanian capital companies-franchisors have been chosen for the scope of research. Initial list of 5 franchising companies was drawn, consisting of Kemi, Pizza Jazz, Sarma Ltd., Senuku Prekybos Centras Ltd. and Presto Prekyba Ltd.

Out this sample only those companies, which have expanded their operations have been taken into account. In such way, the number of sample companies has decreased to three (Pizza Jazz, Kemi and Senukai). Consequently, Senukai as a case study company was rejected, since they have operated only a few months in Latvian market. Thus, the final case study sample companies are Kemi and Pizza Jazz.

Data Generation

Whereas the case study allows examining a phenomenon within its real life context (Yin, 1994, p.6-13), there are certain limitations for data generation. The basis for the research is the primary data obtained during the interviews with the top management of the companies and legal and industry experts as well as the secondary data acquired from databases and media. Subsequently, the chain of evidence has been set up and analysed according to the suggestion proposed by numerous researchers in this field.

Constraints and Delimitations

Firstly, the authors delimit themselves from looking at the franchisor-franchisee relationship within Lithuania as those have only indirect impact on the franchisor’s intentions to expand over the borders. Secondly, unsuccessful entry cases or the motives of Lithuanian franchisor for not entering Latvia are not assessed, as the data is either unavailable or not accessible for the authors. Besides, the questions are of highly sensitive nature, what prevents collection of reliable data. Thirdly, when looking at Kemi, the authors delimit themselves from analysis of wholesale business that is the second part of its entrepreneurial activity. This is done because Kemi is involved in franchising relationships within Lithuania only with its automobile service division and in its strategic plans only these service divisions will be franchised in Latvia.

Moreover, franchising entry mode was chosen to represent contractual entry modes into foreign market and equity mode was chosen to represent ownership entry modes into foreign market. The reasoning for such delimitation was dictated by the sample of the case study companies, who entered Latvian market exactly through these two modes. For this reason the authors decided not to elaborate on other ways of ownership and contractual entry modes.

Empirical part

Case study – Kemi entering Latvia

Background of the Company

Kemi is an establisher of automobile service centres as well as a wholesaler of car components. Founded in 1988, it currently has 22 outlets both of own equity and franchise type in Lithuania and two equity-based outlets in Riga, Latvia (Kemi Homepage). They entered franchising business in 1995 and are cooperating with 10 franchisee companies in Lithuania.

Since 1999 the Latvian outlet of Kemi has grown 250% in turnover (Lursoft Database), and is planning to grow even more with opening the third outlet in the nearest future.

Firm and Industry Specific Factors

Size of the Company. Kemi could be considered a large company. At the moment it decided to enter Latvian market, it already had six franchisees in Lithuania. Franchising fees are providing Kemi with valuable income that result in availability of capital resources if the company decides to make some investments needed for expansion.

Product Differentiation Specifics. The products and services provided by Kemi could not be considered unique; as car repair services they provide are rather similar to those provided in other car repair centres.

Industry Specifics. As already mentioned, since Kemi is involved in franchising business only with car repair services, the following analysis will not touch upon wholesale business.

Threat of new entrants. Possible barriers of entry in car repair business were not substantial in 1998: no minimum size requirements existed, and customers were not loyal to any particular brand, and many small garages were operating in Riga in 1998. Bargaining power of buyers. There are two distinct groups of buyers to whom Kemi provides services – private car owners and corporate clients. The competition in both client group car repair service industries in Riga is rather tense thus giving the customer freedom of choice between numerous alternative services.

Bargaining power of suppliers. The bargaining power of suppliers in both countries Latvia and Lithuania can be considered weak, because Kemi purchases goods from a very wide range of suppliers, cooperating with both small and large suppliers.

Threat of substitutes. The possible substitutes for car repair services are the decisions of the car owners to repair their cars on their own or not to repair them at all. However, the target group of Kemi mostly owns rather new cars which are not likely to be left not repaired or repairs of which would be done without specialist help.

Degree of rivalry power. Two different groups of competitors for Kemi in 1998 in Latvia could be identified: large car dealer service companies who service specific brands of automobiles, and small and cheap service firms with no brand name. In 1998 there were no middle level repair companies in Latvian market; however, it could have easily been predicted that such companies would soon appear.

The service companies of big car dealers exert fierce competition on Kemi for the market share of servicing the corporate clients who buy cars in the exact dealer company. Also the small service companies are rivals to Kemi, as in the location where Kemi is not present, it is reasonable to expect that car owners would choose the small company for the proximity convenience and loyalty to proven service quality in the competitive service centre. Therefore the direct rivalry power from all kinds of competitors was and still is high.

The risks exerted on Kemi by interested parties were rather high, as competitive firms could easily challenge the market share of Kemi, if they took one strategic move to attract the clients of Kemi. There obviously was a need for a hands-on approach in Latvia to protect against competition, which moreover could be increased because of low barriers to entry in this market.

International Experience. The Latvian market was Kemi’s first attempt to expand its operations to a foreign market and unfamiliar customers. In contrast to the theory presented that the novice company in foreign country would enter though contractual mode, Kemi has initially entered Latvian market with its own capital investment.

Country Characteristics

Country Risk. In order to proficiently examine the country-related risk the authors will examine macroeconomic variables with the assistance of PEST analysis.

Political. In 1998 the political stance in Latvia was stable and the positive future expectations appealed to the progressive development of the economy, attracting foreign investors. At the same time, the entry to Latvia for Kemi was rather complicated due to special procedures, lack of transparency among the public authorities and high fees for the employment of the foreign specialists.

Economic. Lithuanian and Latvian economic status was rather similar in the car repair sector. Still the concentration of business activities in Latvia is completely different than in Lithuania as 60% of business activities of Latvia took place in the capital city, thus strengthening positions there meant strong positions in the whole industry in Latvia.

Social. According to industry specialists a typical Latvian driver chooses price of service as priority to service quality. It implies that Kemi needs to address the price very carefully, bringing up the safety issue in a very delicate manner, not highly increasing prices. The quality of the repair should be satisfactory for the price asked and the safety ensured.

Technological. The business of Kemi is relatively flexible because of this ability to service all models of car. Therefore entry to the Latvian market, where services of some foreign brand cars were not yet widely available, guaranteed a comparative advantage. Moreover, the up to date equipment that was used would be preferred by potential customers.

In total Latvia, as a country of choice of entry for the Lithuanian franchisor, does not signal huge potential risks in the nearest future. Moreover, the chosen entry mode reflects rather stable and positive development of the company activities within the capital, Riga.

Cultural Distance. Lithuania and Latvia are neighbouring countries and have rather similar cultural background, perception, language, history, and mentality. At the same time, there exists cultural proximity between the consumers of both countries, e.g. the number of privately owned passenger cars in 1998 was 198 per 1000 inhabitants in Latvia and correspondingly 265 in Lithuania (Central Statistical Bureau of Latvia, 1999, p.310). Moreover, the age analysis of passenger cars in 1998 shows that more than three fourths of the passenger cars in both countries were older than 10 years. Such tendency implies a higher demand for repairs that is a similar trend in Lithuania and Latvia.

Latvia and Lithuania were in the same development phase and thus personal income per head and propensity to spend on car repairs were alike. The average monthly wage in Latvia was EUR 222 (Economic Development of Latvia Report, p. 65) and EUR 269 in Lithuania in 1998 (Department of Statistics of Lithuania Homepage).

Host Country Openness to Global Business. In 1998, when Kemi was considering an entry to Latvian market, the companies providing repair services for Audi, BMW, Volkswagen, Volvo were already operating there. Their existence in Latvian market indicated not only the country’s openness to foreign brands, but also customer readiness to pay for quality, and their trust in foreign businesses.

Firm Strategic Intent and Preferences

Perceived Strategic Importance of Control over Quality. According to company CEO, if Kemi entered Latvian market via franchising mode it would not be able to enforce the necessary control over its franchisees in this market. The only possible approach for Kemi was to open in Latvia its own branch from which the franchising network would start to develop in the future. In this way the future franchisees would be better controlled and Kemi would be more informed about new trends, developments and change of existing players strategies in the local market.

With regard to the agency theory, Kemi should have chosen the contractual mode of entry, as the monitoring quality would cost less. This means that the franchisee that has the residual claims to the profits of its company would be willing to maximise the residual value. But Kemi has had another motive for ignoring the importance of the problem of moral hazard, i.e. for the position of Kemi Baltija director was chosen a Lithuanian.

Perceived Strategic Importance of Brand. Kemi started to work in car repair industry in 1988; by the time it entered Latvia in 1998 it had already a strong brand name and customer loyalty developed in the local market. Kemi registered its trademark in May 1998 with the date of expiration on July 2008, thus protecting its intellectual property. Hence, it was obvious to Kemi that the brand was that main value.

Wish to Quickly Penetrate Foreign Market. Kemi entered Latvian market via equity mode with the future goal to have there a strong franchising network. Building long lasting relationship with the consumers rather than quick penetration is a primary aim of this company. The view expressed by Kemi management is that it is important to maintain quality and to do so a year for market examination is not that much of sacrifice for the 10 years of successful business.

Level of Motivation to Learn Abroad. Kemi management stresses that when going to enter other foreign markets it would definitely choose equity mode. Moreover, Kemi realised that knowledge of foreign market can not only positively affect its Latvian operations. The know-how and local expertise gained in Latvia would improve the whole business concept, recognising that before they became able to successfully sell franchises in local market, they must firstly learn the needs it possesses and adapt the company image to the local culture.

Level of Alertness to Rival Firm’s Activities. Before the entry to Latvia the company has thoroughly scrutinised the entire market for the car repair services, since there were many strong competitors in the small repair service sector and in dealer repair sector. This resulted in awareness of local market conditions and has built credibility in the actions to be pursued in future. Therefore the company was prepared to face the competition and continue operation in Latvian market.

Case Study – Pizza Jazz Entering Latvia

Background of the Company

The history of the company dates back to 1993, when two Lithuanian entrepreneurs established the Pizza Jazz trademark (hereinafter referred to as Pizza Jazz).

Pizza Jazz developed a franchise concept already in 1997, and is currently in control of 5 own investment based restaurants in Lithuania (4 in Kaunas and 1 in Vilnius) and 5 franchisees (4 in Riga and 1 in Marijampole, Lithuania). Since the spring of 2000 Latvian franchisee of Pizza Jazz has grown more than twice in sales. Also, international franchising to Belarus, Ukraine, and Kaliningrad region is considered as an option for future development.

Firm and Industry Specific Factors

Size of the Company. At the moment of entering the Latvian market (spring, 2000) Pizza Jazz did not possess extensive financial resources, though the business per se had been satisfactorily profitable. According to company management Pizza Jazz possessed enough capital potential to pursue no more than expansion of one or two own outlets in a year, and also in case they remained inside the country. Thus, opening two outlets simultaneously in a foreign country was a serious challenge to overcome.

Product Differentiation Specifics. Industry experts reveal that in 2000 the pizza and other fast food restaurant market in Riga, Latvia was rather developed (Dienas Bizness Homepage). Even if technological procedures and ingredients of food could create distinct characteristics the product per se could not be too much differentiated. As said by company management the value added for Pizza Jazz comes “from the special interior design […]and menus prepared in a certain manner: separate coffee and dessert menu, cocktail menu”. However, these peculiarities could not be treated as differentiation specifics at least in Pizza Jazz case, as they can easily be replicated by the competitors.

Industry Specifics.

Barriers to entry. Every pizza restaurant needs to possess special patents for performing certain activities in food preparation and serving customers. Thus, the existence of regulations, which might differ significantly from the domestic ones, makes it difficult for foreign companies to enter Latvian restaurant business.

On the other hand, also brand identity power makes the consumer come back to the same restaurant. The existing companies possess patents on their brand names and in such way are protecting their know-how and operating knowledge, thus restricting entry into the business.

Bargaining power of buyers. For the pizza and similar products restaurants the customers are fragmented and have different tastes for the products/services supplied in the market. Moreover, Pizza Jazz appeals to the medium income consumers, in the age of 16 - 40, who are willing to eat tasty and not too expensive food, thus choosing places to eat in a very haphazard manner. As a result, no buyer may possess any particular influence on the product or the price.

Bargaining power of suppliers. In Lithuania Pizza Jazz used only local market products for preparing food, only spices were purchased abroad. Similar strategy was also pursued on the Latvian market: Pizza Jazz started to work with several Latvian producers, only cheese and spices were imported. In that way sensitivity to local supplier quality and price changes was low, these could influence Pizza Jazz and pizzeria business as a whole only in the short run. Thus a general conclusion is that the supplier power was rather low.

Threat of substitutes. The potential substitutes for Pizza Jazz could be other restaurants, which do not serve pizza. Riga centre abounds with small restaurants, majority being cheaper or in the same price range as Pizza Jazz planned to be. Other group of substitutes is the home preparation of pizzas, which in a frozen way can be purchased in most of Riga food stores. These pizzas are cheaper and can be eaten at home. This substitute however is not direct, but the first alternative exerts a rather strong influence on the operations of Pizza Jazz and thus the threat of substitutes to the particular industry is strong.

Degree of rivalry power. Before Pizza Jazz entered Latvia, there already were two competitive pizzerias operating, both of them having more than one outlet and supplying rather similar products. The specifics of pizza restaurant business also are that the nutrition products are highly perishable. Whether they will be processed in required time and quantities is highly dependent on the demand for dishes in the pizzeria. Thus the companies must compete for the customers to have enough sales to avoid losses due to perishing of products. Furthermore, as the switching costs for consumers between the competitors were very low, the rivalry power in the market was moderately high.

International Experience. The company had not had any international franchising practice until year 2000 (year of entrance to Latvian market), but as the first experience with Marijampole franchisee was successful enough to endeavour similar strategy in Latvia. Moreover, CEO of Pizza Jazz claims that Pizza Jazz would not have committed EUR 0.5 million (Verslo Zinios Homepage) for the first opening of the restaurant, because the foreign market is unfamiliar to the top management. Therefore franchisee readiness to invest this amount was crucial.

Although, plausible franchisees are not looked for and in general the latter are the initiators of debates and negotiations. Pizza Jazz considers international franchising as an attractive strategy for further expansion.

Country Characteristics

Country Risk.

Political. Different governmental decisions on food hygiene requirements and local producers’ protection have made food transfer between the Baltic States rather complicated, e.g. even the Free Goods Movement Agreement, signed by Latvian, Lithuanian and Estonian Governments, which came into force in 1997 has not simplified Lithuanian milk and meat products export to Latvia (Verlso Zinios Homepage). Moreover, only the strongest restaurant chains would survive the new higher standard requirements due to the tendency of making the Latvian legal basis in compliance with the EU relevant legislation.

Economic. The purchasing power of Latvians is increasing. According to the data provided by the Central Bureau of Statistics of Latvia (CBS Latvia) the average gross monthly salary has risen from 150 LVL in 2000 to 159 LVL per month in 2001 (see Table 1). As Pizza Jazz business activities are mainly based in the public sector, the salary increase in real terms has a direct influence for the products and services consumed. Moreover the inflation rate (measured by CPI) has slightly increased by 1% for the food commodity group during 2001 – 2002 (Central Statistical Bureau of Latvia Homepage). That also implies moderate price increase for raw materials in the pizza business.

Social. Eating out is an important part of a personal life style in developed countries. In Latvia this tendency is becoming more and more popular. Moreover, health conscious type of living brings controversial risks of decrease of clients for restaurant businesses, but the industry expert admits this was not a treat in 2000.

There is a clear trend of population decrease in Riga, as compared to the preceding years. At the same time, there is rise in tourism to Riga, as Latvia is becoming more attractive as a tourism destination (Dienas Bizness Homepage). The official Statistical Yearbook of Latvia 2002 indicates an increase in the number of visitors coming to Latvia from 2,59 million in 2000 to 2,65 million (2002, p. 183-189). Therefore, Pizza Jazz as an international brand is subject to more attention from tourists as well as from Latvians themselves.

Technological. Though restaurant business is moderate in terms of innovativeness of technologies or recipes, Pizza Jazz is competitive, as the services are available via phone.

However, they have not yet developed a customer service via the Internet, having only informative site. Meanwhile, there exists a positive trend in the number of enterprises with access to Internet. In 2000 almost 20 % of all companies in Latvia had Internet access and 4.6% administrated home pages online, whereas year 2001 was progressively better with 26.4% and 7.4% respectively (Statistical Yearbook of Latvia 2002, 2002, p.180-181). Hence, Pizza Jazz (Latvia) could be regarded as a technologically progressive company.

With regard to the influences discussed above, Latvia does not signal high level of risks for the Lithuanian franchiser. The major attention should be paid to the accession to the European Union and adoption of legislation. The changes in macroeconomic variables would alter the stance of competitiveness of the company as well as industry growth/slowdown.

Cultural Distance. The food consumption pattern of Lithuanians and Latvians is very similar; this is mainly because of similar cultural background of the two nations. Both Latvians and Lithuanians are very much meat lovers and both have gone through the same development phases in the recent years to be familiar enough with such fast food products as pizzas. Also, the perception of dining out rather than having a meal at home is common for both nations. Usually Friday and weekend evenings are chosen for restaurants if income is sufficient and weekdays are mostly for home eating. Work at the restaurants is very much valued as an option in both countries. Finding an appropriate agent also was not a problem for Pizza Jazz, as the current Latvian franchisee manager is a Lithuanian who is living in Latvia, which means knowledge of cultures, mentalities and preferences of both nations.

Host Country Openness to Global Business. In 2000 when Pizza Jazz entered Latvian market, many foreign brands were already known in the restaurant business. Some coming with influence from the USA (American Fried Chicken), others from Asian countries (Sumo, Sue’s Indian Raja), also British restaurants and Irish pubs (Dickens, Tim McShanes), Jewish restaurants (Shalom), and many others were present in Riga before Pizza Jazz ever thought of coming to Latvia. Thus even without a thorough examination of Latvian market a conclusion about the existence of very many foreign cultures restaurants in this market could be made and the risk of entering foreign market would be considered low.

Firm Strategic Intent and Preferences

Perceived Strategic Importance of Control over Quality. Pizza Jazz management just like prescribed in franchising theory on a monthly basis assesses the quality of dishes and the technological preparation of them, as well as service provided and the environment in all the franchised outlets in Riga. Subsequently, reports and improvement suggestions for the franchisees are prepared and implementation of changes is monitored. Still, the major emphasis is put on trust. Both, franchisor and franchisee, agree that franchising business would be non-existent if the parties could not trust each other. Thus, the individual character traits make difference for trust building and control monitoring later on.

With regard to “moral hazard” problem, Pizza Jazz has chosen the advisable strategy for entering the foreign market with franchise format. Therefore, the residual claims for franchisee should be the motivational factor to act in compliance with the franchisor’s practices and advice.

Perceived Strategic Importance of Brand. Pizza Jazz trademark was registered in the end of year 1999 and the date of expiration is January 23, 2008 (Register of Trademarks of the Republic of Lithuania. The State Patent Bureau of the Republic of Lithuania Database) and the franchisee has a right to use it for marketing the products and services as well as developing business. For the moment being, brand awareness and customer loyalty to it are the major strategies for future growth in pan-Baltic environment. Hence, in order to make the brand known on Lithuanian-Latvian basis without definite investment of its own capital, Pizza Jazz has pursued franchise format strategy.

Wish to Quickly Penetrate Foreign Market. Pizza Jazz has a clear vision of franchising being a possibility to quickly penetrate the new market. Company management reveals that they would not commit so much resource for proper screening of the employees, dealing with numerous administrative issues, before starting up a company in a foreign environment. Legal experts indicate that “Lithuania and Latvia differ in legislative stance, thus it is significant to know about procedures, requirements and institutions to deal with in advance. Thus, locals could be much more insightful for certain reasons”. Certainly, this is one of the major motives to utilise franchising as all the proceedings take much less time than otherwise they would for foreigners due to unawareness of ways to tackle local bureaucracy.

Level of Motivation to Learn Abroad. According to Pizza Jazz management the decision to enter Latvia was unexpected, it was merely a coincidence that current franchisee manager approached him with a proposal to buy a franchise in Latvia. The company itself had had no intentions to go to foreign market beforehand. Still, positive answer to that proposal was not given immediately; the company took a long time to decide on its future strategy. Obviously, the possibility of easy and cost efficient move to foreign market appeared an attractive option to the management of Pizza Jazz, in whose plans promotion of own brand and increasing profitability was the major issue anyway. The franchising network enlargement to Latvia promised to foster the success and popularisation of Pizza Jazz brand. As the company had not planned foreign development in the first place, it was not concerned with gaining new knowledge from foreign sources, but simply with internal development. They knew that the Latvian representative would do the work in Latvia and that they would only have to take care of monitoring her without serious involvement in actual business process.

Level of Alertness to Rival Firm’s Activities. Entering Latvian market via franchising, Pizza Jazz has seized a niche as a pizza restaurant with a concept not only for eating but also for enjoying and relaxing after the study/workday. According to CEO of company, Pizza Jazz did not explore the market conditions in Riga at that time, thus it was completely unaware of the practices in Latvian pizza restaurant business as well as the rivalry forces. Even more, Pizza Jazz was not prepared to the risk of investing money in foreign country, as it has spotted much potential in the local market to be utilised.

Interpretations of Research Findings

The analysis of empirical data about the two case study companies has revealed several cases of contradiction between the theoretically proposed reasoning in favour of either of entry mode choices into foreign market and the practically encountered flow of reasoning by Pizza Jazz and Kemi. Table 2 summarises the findings of empirical part as to actual conformity or non-conformity with the criteria presented in theory. Pluses in the table indicate the conformity with the statements expressed in the left column and minuses indicate that the case study companies’ criteria do not match these statements. From the attained evidence on real cases several hypotheses on factors influencing the choice of entry mode into foreign market by the existing franchisors will be derived.

Hypothesis 1. The franchisor, which has enough resources, high level of motivation to learn abroad, is alert to the rival firm’s activities but is not striving for fast penetration of market chooses the ownership mode of entry into foreign country.

The resources the company possesses are one of the major determinants on which entry mode to choose; this was also confirmed by the case study companies. However, a clear link also existed between the way the company perceives the value of its brand and how much attention and resources it is ready to devote to exercising the control over the foreign unit, be it a franchisee or equity owned outlet. Kemi, the company choosing equity entry mode, undertook serious researches and analysis of the rivalry in Latvian car repair service industry before entering the country. This company did not rush to open as many outlets as possible, instead it wanted to retain the hands-on management and control over the operations of the outlets at least in the first years after the entry to be able to react fast to all turbulences, thus reducing the risks of loosing initial investments.

Pizza Jazz, on the contrary, was approached with an established business idea and had only to decide whether they were willing to turn their future strategy in the proposed direction. The researches and main supply chain contacting was and arrangements were left to be done by the prospective franchisee. It was only the screening process and initial arrangements that Pizza Jazz took part in, from the moment the outlet was opened the majority of business problems were handled by the agent and only regular controls to ensure proper compliance with quality requirements was required from Pizza Jazz management. As a result Pizza Jazz has entered Latvian market, and done it fast and resource efficiently.

Hypothesis 2. For a franchisor entering a culturally similar market with a low degree of country risk, previous international experience does not influence the choice of entry mode.

The two companies, Pizza Jazz and Kemi chose Latvia as their first foreign market. Neither of these companies ever tried going to a foreign unknown market, where the preferences of consumers, the market forces, governmental regulations, and conditions for opening outlets are different from the ones the companies have experienced up to that moment. Both companies in their first challenge of foreign market chose exactly the one, which is the closest in all respects: geographically, culturally, historically, economically and politically. In such way the risks of losing initial investments were reduced and entry in foreign market via equity was less risky. This is contradicting to the view expressed by Root (as cited by Fladmoe-Lindquist and Jacque 1995, p.1240), and proves that novice international firms may decide to commit significant resources to their first international venture, if the market they enter is culturally close and has low degree of risk.

Hypothesis 3. For a franchisor when choosing an entry mode into foreign market existence of highly powerful players in market to be entered does not necessarily result in equity mode being chosen.

The two case studies have revealed that foreign market can be entered via equity mode and via franchising mode irrespective of the fact that the pressure from key players in the market is very strong. Pizza Jazz was very much affected by substitute and buyer power, they had to monitor their competitors and be prepared for sudden strategic moves by them. Although the management of the company knew such situation, franchising mode was chosen, and Pizza Jazz managed to plan its strategy so that it was able to monitor the franchisees and create stable relationship with local market players. This example of Pizza Jazz contradicts with the theoretical understanding of how the existence of powerful players in the market would affect the choice of entry mode for franchisors into foreign market. The authors thus conclude that the existence of powerful players and high competitive forces in the potential market is not an obstacle for a company to choose franchising mode.

Hypothesis 4. For a franchisor that plans entering foreign market the absence of differentiation specifics of products or services is not an obstacle to choose the equity mode of entry.

The observations revealed that the company planning to enter foreign country with low differentiation specifics of its products/services does not perceive the latter factor as a determinant for the choice of franchising mode. Even though the services and products of Kemi are not unique, the company has seized the market with the “quality” image and certain additional services for the customer. These features have endowed Kemi with strong position in the market and thus left product differentiation specifics aside from the decisive role for the choice of the entry mode to the new market. In contrast to the theory constituting that in general the choice of equity mode is made with regard to high product differentiation specifics, Kemi has captured a niche in Latvian market. Considering these arguments, the franchisor could utilise the equity-based expansion to the foreign market without significant specifics of products or services.

Hypothesis 5. For a franchisor the perceived importance of brand and control over quality are not crucial factors for choice between contractual and equity mode of entry into foreign country.

The case studies have disclosed that there exist two aspects that are unalienable from the franchising per se, but are not perceived as the factors of key significance for the decision making of entry strategy. Evidently, Kemi and Pizza Jazz have indicated the perceived importance of brand and control over quality as the factors of crucial importance for the franchisors. The reasoning lies in the very roots of franchising concept as such – it is brand awareness that makes this format attractive for expansion and in order to sustain the branding value, there is a need to perform adequate control measures. Yet, Kemi and Pizza Jazz point out that from firm strategic intent and preference determinants these particular two factors are exceptionally vital for both companies. Subsequently, by ensuring a proper place in strategic values of company to the brand and control, the company has already taken care of the necessary measures to sustain franchise scheme development and growth. But neither of the companies identifies these motives to give a significant contribution to decision of entry mode be taken. Therefore, the authors conclude that the perceived importance of brand and control over quality are important, but not the decisive factors for the choice of entry mode.

Conclusion

The goal of the research was first of all to recognise and evaluate the factors that could influence the choice of entry mode to the foreign market by Lithuanian franchisor companies. The conclusion drawn was that there is no single most important factor and only several factor combinations can affect the choice of entry mode for franchisors.

The most important factors influencing the decision on selection of entry mode coincide with those correlations described in theory. For equity owned unit expansion the company size, its willingness to learn abroad and awareness of the competition in the corresponding industry in foreign market were the main reasons for deciding on exactly this mode of entry. For the company preferring contractual mode, indeed, the desire of fast penetration of the new market and inability to devote big resources to make significant investments in foreign outlet were the main driving forces for deciding in favour of franchisee agreement.

Also, the authors have revealed that Lithuanian franchisors, who wish to expand over the border, tend to prefer Latvia as their best option. Both case companies have chosen their first international expansion location to be Latvia, mostly because of its positive country specific factors, i.e. low risk, cultural proximity and country’s openness to foreign businesses. At the same time the two companies have picked different entry mode, which is a clear indication that the choice is not affected by existence of international business experience.

Another issue is that for a company it is important to be aware of the rivalry power in the foreign market independent of what mode it wishes to pursue. Still existence of highly powerful players in the market does not restrain the company to enter it via franchising.

Furthermore, the authors put forward that the findings of this research are reciprocal and can be used by Latvian franchisors who decide to enter Lithuania in order to establish there a franchising network. However, there are certain aspects that the authors have left out from the scope and the scale of the research and which could be subject to further studies. As the paper covers only the relationships between Lithuanian and Latvian businesses, the analysis of other culturally close countries would be valuable for confirmation of expressed hypotheses. For instance, Estonian and Finnish markets, which are culturally rather close, but differ in their economic development are interesting target markets for further research in this topic.

Moreover, a quantitative research might be suggested in order to test the presented hypotheses and to compare the results of Lithuanian cases to other countries. Yet the scarcity of such cases in developing economies would not present clear-cut judgement of how Lithuanian franchisors’ motives to enter foreign market differ from other emerging markets’.

To conclude, the authors (based on expert opinion) believe that in the future the Baltic franchisors will expand internationally and that franchising networks will be a significant part of the economic growth.

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Appendix

International Conference: Franchising 2002

Organised by Info-Consulting Franchise Centre (Latvia) and Legal Agency AAA (Lithuania) on 27th September 2002 at New Vilnius Hotel, Vilnius, Lithuania

1. Semi-Structured Interviews:

Edmundas Damauskis, Director of Economic Department, Achema Group

Ramunas Azukas, Financial analyst, Sarmanis

Ligita Saltiene, Director, Kavinukas Ltd.

Vilmantas Simoniutis, Director, Pizza Jazz

Renaldas Gineika, General Manager, Kemi

Juozas Tunaitis, Director of Innovation Department, Achema Group

2. Semi-Structured Interviews With Legal and Franchise Format Experts:

Vilija Viesiunaite, Assistant Attorney, Legal Agency AAA

Vytautas Kalmatavicius, Assistant Attorney, Legal Agency AAA

Lina Gustaite, Lawyer, Patent agency “Metida”

Robert Juodka, Attorney assistant, Vilnius 7th Lawyer Bureau

Ott Moorlat, Ph.D. Patent Attorney, Moorlat&Co Ltd.

3. Participation in Round Table Discussion (Legal and Economic Perspectives of Franchising; Franchising Development in the Baltic States):

Vytautas Kalmatavicius, Legal Agency AAA Assistant Attorney, Franchise agreement – conclusion and termination. Rights and Obligations of Franchiser and Franchisee

Dainius Butautas, Lithuanian Traders Association Chairman, Economic Development of Franchising and Trade in Lithuania

Eugeny Fortuna, Patent Law Office Foral Consultant, The Place of Intellectual Property Licencing in Franchise

Vilija Viesiunaite, Legal Agency AAA Assistant Attorney, Legal regulation of Franchising in Lithuania

Ott Moorlat, Moorlat & Co Patent Bureau Ltd Director, Franchising and Intellectual property Rights. Registration of Trademarks and Patenting of Technologies in Franchising

Ruta Bilkstyte, Deloitte & Touche Lithuania Manager, Taxation in Franchising

Elena Suskevica, Auditing Company BDO INVEST – RIGA Business and Intangible Assets Valuation Manager, Franchising and Business Risk Management

Mark Zarkhin, fast food restaurant chains Pizza Chelentano and Potato House Chairman, The Practice of Franchising

Andrey Teryavyainen, Elmi Enterprise Director, Pros and Cons of Franchising

4. List of Case Study Interviews

1. Zilvinas Danys, Head of Legal, State Patent Bureau, Vilnius, 12.11.2002

2. Lina Gustaite, Lawyer, patent agency Metida, Vilnius, 12.11.2002

3. Renaldas Gineika, General Manager, Kemi, Vilnius, 14.11.2002

4. Vilmantas Simoniutis, Director, Pizza Jazz, Kaunas, 15.11.2002

5. Vitalis Marscionka, Automobile spare part sales industry expert, Riga, 18.12.2002

6. Normunds Malinovskis, Public catering industry expert, Riga, 21.1.2003

7. Robert Juodka, Attorney assistant, Vilnius 7th Lawyer Bureau

-----------------------

|Criterion |Kemi |Pizza Jazz |

|Firm and Industry specific factors | | |

|Big size of the company |+ |- |

|High product differentiation specifics |- |- |

|Industry specifics – highly powerful key parties |+ |+ |

|Has international experience |- |- |

|Country specific factors | | |

|High country risk |- |- |

|High cultural distance |- |- |

|Host country open to global business |+ |+ |

|Firm strategic intent and preferences | | |

|High perceived strategic importance of control over quality |+ |+/- |

|Strategic perception of high importance of brand to franchisor |+ |+ |

|Wish to quickly penetrate foreign market |- |+ |

|High level of motivation to learn abroad |+ |- |

|High level of alertness to rival firm’s activities |+ |- |

Table 2 Criteria for choice of entry mode into Latvian market by case study companies.

Table 1 Average gross monthly wages and salaries, and changes in consumer price index. (Source: Central Statistical Bureau of Latvia)

| Year |1995 |1996 |1997 |1998 |1999 |2000 |2001 |

|Months | | | | | | | |

|Salary/wage level (LVL) |90 |99 |120 |133  |141 |150 |159 |

|Consumer Price Index as % of last period |25.0 |17.6 |8.4 |4.7 |2.4 |2.6 |2.5 |

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