Franchise Agreement Compliance Review for Pre-IPO Companies

The first half of 2025 has already seen the SFC issue two separate reprimands against sponsor firms for inadequate due diligence on franchise-heavy business models, a trend that signals heightened regulatory scrutiny for pre-IPO companies whose revenue depends on third-party operator networks. The SFC’s Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the Code), specifically paragraph 17.6 and its associated sponsor due diligence guidelines, mandates that sponsors must verify the legal validity and enforceability of all material contracts — including franchise agreements — or face potential enforcement action. For a company filing an A1 application on the Main Board or GEM, a single franchise agreement with ambiguous termination clauses or unregistered intellectual property rights can trigger an extended comment period from the HKEX Listing Department, delaying the entire timetable by three to six months. This article dissects the specific compliance review framework that pre-IPO companies must implement for their franchise agreements, covering the PRC Regulations on the Administration of Commercial Franchises (State Council Order No. 485, as amended), the Hong Kong Trade Descriptions Ordinance (Cap. 362) implications for cross-border franchisors, and the disclosure requirements under HKEX Listing Rules Chapter 11 and Chapter 17 for connected transactions and continuing connected transactions. The analysis draws on actual HKEX listing decisions from 2023-2024 where franchise-related revenue recognition and control issues were the primary reasons for additional vetting.

The Regulatory Architecture Governing Franchise Agreements in a Listing Context

Pre-IPO companies operating under a franchise model face a dual compliance burden: they must satisfy both the substantive requirements of the jurisdiction where the franchise operates — typically the PRC for Hong Kong-listed companies — and the disclosure and due diligence standards imposed by the HKEX and SFC. The starting point for any review is the PRC Regulations on the Administration of Commercial Franchises (the Franchise Regulations), which came into effect in 2007 and were most recently amended in 2020. Article 7 of the Franchise Regulations requires a franchisor to own at least two directly-operated stores for a period of more than one year before granting a franchise — the so-called “two stores, one year” rule. For a pre-IPO company that has acquired a franchise network through M&A, verifying that the original franchisor complied with this requirement at the time of granting each franchise is a non-negotiable step. Failure to do so exposes the company to the risk that a franchise agreement may be voided by a PRC court under Article 9 of the Interpretation of the Supreme People’s Court on Several Issues Concerning the Application of the Franchise Regulations (Fa Shi [2011] No. 4), which holds that franchise agreements granted in violation of mandatory provisions of the Franchise Regulations are invalid.

The “Two Stores, One Year” Verification Process

The due diligence process for verifying compliance with the “two stores, one year” rule requires the sponsor and its PRC legal counsel to obtain, for each franchise agreement in the top 10 or top 20 revenue-generating stores (as defined by HKEX Guidance Letter GL57-13 on materiality thresholds), a certified copy of the franchisor’s business license, the lease agreements for the two directly-operated stores, and the tax filings proving one year of continuous operation prior to the franchise grant date. In practice, many franchisors in the PRC — particularly those in the food and beverage and education sectors — have maintained loose records. A 2023 survey by the China Chain Store & Franchise Association found that approximately 34% of franchise systems surveyed could not produce complete documentation for the “two stores, one year” requirement for all their franchisees. For a pre-IPO company that is itself the franchisor, the sponsor must also confirm that the company’s own directly-operated stores satisfy this requirement before any franchise agreements were signed. If gaps exist, the company must either retroactively obtain confirmatory documents from the relevant government authorities — such as the local commerce bureau (商务部) — or restructure the franchise network to eliminate the non-compliant agreements before the A1 submission.

Registration and Filing Obligations Under PRC Law

Article 8 of the Franchise Regulations mandates that a franchisor must file its franchise agreement with the local commerce bureau within 15 days of signing the first franchise agreement in that locality. The filing must include the franchise agreement template, the franchisor’s business license, and proof of the “two stores, one year” compliance. For a pre-IPO company with a national franchise network spanning multiple provinces, non-filing in even a single jurisdiction can create a material compliance risk. The sponsor must request a legal opinion from PRC counsel confirming that all franchise agreements have been properly filed, or that the failure to file does not materially affect the validity of the agreements. The SFC’s Sponsor Due Diligence Guidelines (March 2022 update) explicitly require sponsors to assess the legal validity of material contracts under applicable PRC law, and the HKEX has the authority under Listing Rule 9.11(4) to require the company to disclose any material non-compliance in the prospectus. A 2024 HKEX Listing Decision (LD134-2024) involved a retail company whose A1 application was returned because the sponsor had not adequately verified the franchise registration status in three provinces, leading to a four-month resubmission cycle.

Intellectual Property Licensing and Franchise Agreement Interplay

Franchise agreements in the PRC are fundamentally IP licensing arrangements. The Franchise Regulations define a franchise as a business model where the franchisor licenses its trademarks, trade names, business methods, and other IP to the franchisee in exchange for fees. For a pre-IPO company, the sponsor must verify that the franchisor — which may be the listing applicant itself or a connected person — holds valid and enforceable IP rights for all trademarks and trade names licensed under the franchise agreements. This requires a search of the PRC Trademark Office database (中国商标网) and the China National Intellectual Property Administration (CNIPA) records to confirm that each trademark used in the franchise network is registered in the correct class and has not expired or been challenged. Under Article 11 of the Franchise Regulations, the franchisor must also disclose in the franchise agreement whether the IP rights are subject to any third-party claims or litigation. If the pre-IPO company has licensed its IP from a third-party franchisor — for example, an international brand operating through a master franchise in Hong Kong — the sponsor must review the master franchise agreement to confirm that sub-licensing to franchisees is permitted and that the third-party franchisor has no right to terminate the master agreement if the company lists on the HKEX. The SFC’s Code of Conduct paragraph 17.6(b) requires sponsors to identify any material IP risks that could affect the company’s ability to continue its business, and failure to do so can result in enforcement action, as seen in the SFC’s 2024 reprimand of a sponsor for not detecting a lapsed trademark registration that affected 40% of the franchise network’s revenue.

Revenue Recognition and Financial Disclosure for Franchise Operations

The HKEX’s approach to revenue recognition for franchise-based businesses is governed by HKFRS 15 Revenue from Contracts with Customers, which requires companies to identify distinct performance obligations and recognize revenue when control of goods or services is transferred to the customer — in this case, the franchisee. For pre-IPO companies, the most contentious issue is the treatment of initial franchise fees, ongoing royalty fees, and marketing fund contributions. The HKEX’s Guidance on Revenue Recognition for Franchise Operations (issued in 2023 as part of the Listing Department’s FAQ series) clarifies that initial franchise fees should generally be recognized over the franchise term if the franchisor provides ongoing services, such as training, marketing support, or supply chain management. Immediate recognition of the entire initial fee upon signing is only appropriate if the franchisor has no further performance obligations after the store opening.

Deferred Revenue and Performance Obligations

A pre-IPO company must prepare a detailed schedule of its franchise agreements, broken down by the date of signing, the amount of initial fee received, and the company’s remaining performance obligations. The sponsor’s financial due diligence team must test a sample of franchise agreements — typically 25% by value or 20 agreements, whichever is higher — to confirm that the company’s revenue recognition policy is consistent with HKFRS 15. For example, if the franchise agreement requires the company to provide ongoing training for the duration of the 5-year term, the initial fee of HKD 500,000 must be deferred and recognized over 60 months. The deferred revenue balance must be disclosed in the prospectus as a current or non-current liability, depending on when the performance obligations are expected to be satisfied. The HKEX’s Listing Decision LD128-2023 involved a food and beverage company that had recognized 100% of its initial franchise fees in the year of signing, but the sponsor’s review revealed that the company had not provided any training or support after the first year. The HKEX required the company to restate its financial statements for the three track record years, reducing reported revenue by approximately 18% and delaying the listing by five months.

Royalty Fee Collection and Bad Debt Provisions

Royalty fees, typically calculated as a percentage of the franchisee’s gross revenue (usually 3% to 8%), represent the ongoing revenue stream for a franchisor. The sponsor must assess the collectability of these fees by reviewing the franchisees’ financial statements — if available — or by conducting site visits to verify that the reported gross revenue is accurate. For pre-IPO companies that do not have direct access to franchisees’ point-of-sale systems, the risk of under-reporting by franchisees is significant. The HKEX’s Guidance on Internal Controls for Franchise Operations (2023) recommends that companies implement a system of random audits and require franchisees to submit quarterly certified revenue reports. The sponsor must also evaluate the adequacy of the company’s bad debt provision for overdue royalty fees. Under HKAS 36 Impairment of Assets, if a significant number of franchisees are in arrears, the company may need to impair the carrying value of its franchise network as a whole. A 2024 study by the Hong Kong Institute of Certified Public Accountants (HKICPA) found that 22% of Hong Kong-listed companies with franchise models had to restate their bad debt provisions during the listing process, with an average adjustment of 12.5% of net profit.

Marketing Fund and Cooperative Advertising Disclosures

Many franchise agreements require franchisees to contribute to a cooperative marketing fund, typically 1% to 2% of gross revenue. The sponsor must verify that these funds are held in a separate bank account and used exclusively for marketing purposes, as required by the Franchise Regulations Article 17. If the company commingles marketing fund contributions with its general operating funds, the HKEX may require the company to disclose this as a material weakness in internal controls under Listing Rule 3.08 and the Corporate Governance Code (CG Code) provision D.2.1. The prospectus must also disclose the total amount of marketing fund contributions received and expended during each of the three track record years, along with a description of how the funds are allocated. Failure to provide this disclosure was cited in the HKEX’s 2024 Listing Decision LD138-2024 as one of the reasons for requiring a supplemental prospectus, which cost the applicant an additional HKD 2.8 million in professional fees and a two-month delay.

Connected Transaction and Continuing Connected Transaction Implications

Franchise agreements between the listing applicant and its directors, substantial shareholders, or their associates are classified as connected transactions under HKEX Listing Rules Chapter 14A. For a pre-IPO company, the most common scenario is a franchise granted by the company to a director’s family member, or a master franchise agreement between the company and a connected person who holds the master rights for a particular region. Under Listing Rule 14A.24, any franchise agreement with a connected person must be disclosed in the prospectus, and if the annual consideration exceeds 5% of the company’s revenue or HKD 10 million (whichever is higher), the transaction must be approved by independent shareholders. The sponsor must prepare a fairness opinion from an independent financial adviser, confirming that the terms of the franchise agreement are on normal commercial terms and not prejudicial to the interests of the company and its minority shareholders.

Master Franchise Agreements as Continuing Connected Transactions

A master franchise agreement — where the company grants a connected person the right to sub-franchise the brand in a specific territory — is typically classified as a continuing connected transaction (CCT) because it involves recurring royalty payments over the term of the agreement. Under Listing Rule 14A.52, CCTs must have a fixed term not exceeding three years, unless the company can demonstrate that the transaction requires a longer period due to the nature of the business. For a master franchise agreement with a 10-year term, the company must apply for a waiver from the HKEX under Listing Rule 14A.53, providing detailed justification for the longer term. The sponsor must also establish annual caps for the CCT, based on the expected royalty payments and franchise fees for each year of the three-year track record period. If the actual payments exceed the caps by more than 10%, the company must disclose the overrun in its annual report and obtain shareholder approval for the excess. The HKEX’s 2023 Listing Decision LD125-2023 involved a company that failed to set adequate caps for its master franchise CCT, resulting in a 40% overrun in the first year post-listing. The HKEX required the company to publish a corrective announcement and pay a fine of HKD 1.2 million under the Listing Rules Enforcement Policy.

Franchise Termination and Non-Compete Clauses

Franchise agreements often contain non-compete clauses that restrict the franchisee from operating a competing business within a defined radius for a period after termination. For a pre-IPO company, these clauses can create connected transaction issues if the franchisee is a connected person. Under Listing Rule 14A.39, any non-compete obligation that benefits a connected person must be disclosed in the prospectus, and if the obligation imposes a material restriction on the company’s business, it may require independent shareholder approval. The sponsor must also assess whether the termination provisions in the franchise agreement give the company adequate control over the franchisee’s use of the brand after termination. Under the Trade Descriptions Ordinance (Cap. 362), a franchisor in Hong Kong that fails to take reasonable steps to prevent a former franchisee from using its trademarks may be liable for false trade descriptions, which carries a maximum penalty of HKD 500,000 and imprisonment for 5 years. The sponsor should confirm that each franchise agreement includes a clear obligation on the franchisee to cease using all branding materials within 30 days of termination, and that the company has a process for enforcing this obligation.

Practical Implementation: The Pre-IPO Franchise Compliance Checklist

The compliance review process for franchise agreements should be integrated into the broader due diligence workstream from the outset of the pre-IPO preparation, typically 12 to 18 months before the planned A1 submission. The following checklist, derived from the SFC’s Sponsor Due Diligence Guidelines and the HKEX’s Listing Rules, provides a framework for the company’s internal legal team and external advisors.

Document Collection and Verification

The company must compile a complete register of all franchise agreements, including the date of signing, the franchisee’s name and location, the initial fee and royalty rate, the term of the agreement, and the status of registration with the local commerce bureau. For each agreement in the materiality sample, the sponsor should obtain: (i) a certified copy of the franchise agreement; (ii) proof of the franchisor’s compliance with the “two stores, one year” rule; (iii) evidence of IP registration for all licensed trademarks; (iv) the franchisee’s business license; and (v) the franchisee’s signed acknowledgment of the disclosure documents required under Article 21 of the Franchise Regulations. The sponsor’s PRC legal counsel must issue a legal opinion confirming that each agreement is valid, enforceable, and compliant with all applicable PRC laws.

Financial and Internal Controls Assessment

The company’s finance team must prepare a detailed revenue recognition schedule, showing the allocation of initial fees, royalty fees, and marketing fund contributions across the three track record years. The sponsor’s auditors should test the accuracy of the royalty fee calculations by comparing the reported franchisee revenue to the company’s own records of supply sales — if the company supplies products to franchisees, the supply volume should correlate with the franchisee’s reported revenue. The internal controls assessment should cover: (i) the process for approving new franchisees; (ii) the system for monitoring franchisee compliance with brand standards; (iii) the procedures for collecting and reconciling royalty fees; and (iv) the controls over marketing fund expenditures. Any material weaknesses must be remediated before the A1 submission, or the company must disclose them in the prospectus and explain the remediation plan under Listing Rule 3.08.

Prospectus Disclosure Strategy

The prospectus must include a dedicated section on the franchise business model, covering: (i) a description of the franchise system, including the number of franchisees and the revenue contribution from each category of fees; (ii) a summary of the material terms of the franchise agreements, including the term, termination rights, and non-compete clauses; (iii) a discussion of the regulatory environment, including compliance with the Franchise Regulations and any non-compliance events; (iv) a risk factor section addressing the risks of franchisee non-compliance, IP infringement, and regulatory changes; and (v) the connected transaction disclosures, including the annual caps for any CCTs. The sponsor should also prepare a management representation letter, signed by the CEO and CFO, confirming that all franchise agreements have been disclosed and that the company is in compliance with all applicable laws.

Actionable Takeaways

1. Verify the “two stores, one year” rule for every franchise agreement in the top 10 revenue-generating stores before the A1 submission, and obtain a PRC legal opinion confirming compliance, as failure to do so is the single most common reason for HKEX comment letters on franchise-based applications.
2. Implement a revenue recognition policy that defers initial franchise fees over the term of the agreement if the company has ongoing performance obligations, and have the sponsor’s auditors test a sample of at least 20 agreements against HKFRS 15.
3. Conduct a full IP audit of all trademarks licensed under the franchise agreements, including a search of the CNIPA database, and confirm that the master franchise agreement permits sub-licensing to the listed entity.
4. Classify any franchise agreement with a director or substantial shareholder as a connected transaction and prepare a fairness opinion from an independent financial adviser, with annual caps that have been stress-tested for a 20% variance.
5. Prepare a franchise compliance register that records the registration status with each local commerce bureau, and remediate any filing gaps at least six months before the A1 submission to avoid a Listing Department query.
6. Ensure the prospectus includes a dedicated risk factor for franchisee non-compliance with brand standards and revenue under-reporting, as the HKEX has specifically flagged this as a disclosure requirement in its 2023 Guidance Letter.
7. Engage PRC legal counsel to review the termination and non-compete clauses in all franchise agreements for compliance with the Trade Descriptions Ordinance (Cap. 362) if any franchisees operate in Hong Kong, and confirm that the company has a process for enforcing post-termination brand usage restrictions.