What Is a Franchise, and How Does It Work?

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What Is a Franchise?

A franchise is a type of license that grants a franchisee access to a franchisor's proprietary business knowledge, processes, and trademarks, thus allowing the franchisee to sell a product or service under the franchisor's business name. In exchange for acquiring a franchise, the franchisee usually pays the franchisor an initial start-up fee and annual licensing fees.

Key Takeaways

• A franchise is a business whereby the owner licenses its operations&#;along with its products, branding, and knowledge&#;in exchange for a franchise fee.
• The franchisor is the business that grants licenses to franchisees.
• The Franchise Rule requires franchisors to disclose key operating information to prospective franchisees.

• Ongoing royalties paid to franchisors vary by industry and can range between 4.6% and 12.5%.

Understanding Franchises

When a business wants to increase its market share or geographical reach at a low cost, it may franchise its product and brand name. A franchise is a joint venture between a franchisor and a franchisee. The franchisor is the original business. It sells the right to use its name and idea. The franchisee buys this right to sell the franchisor's goods or services under an existing business model and trademark.

Franchises are an effective way for entrepreneurs to start a business, especially when entering a highly competitive industry such as fast food, or an industry that is established and requires time to develop its operating processes from scratch. One big advantage to purchasing a franchise is you have access to an established company's brand name, management knowledge, processes and procedures, financial toolbox, and metrics. You won't need to spend time and resources building them and getting your name and product out to customers.

The franchise business model has a storied history in the United States. The concept dates to the mid-19th century when two companies&#;the McCormick Harvesting Machine Company and the I.M. Singer Company&#;developed organizational, marketing, and distribution systems recognized as the forerunners to franchising. These novel business structures were developed in response to high-volume production and allowed McCormick and Singer to sell their reapers and sewing machines to an expanding domestic market.

Before buying into a franchise, investors should carefully read the Franchise Disclosure Document, which franchisors are required to provide. This document contains information about franchise fees, expenses, performance expectations, and other key operating details.

The earliest food and hospitality franchises were developed in the s and s. A&W Root Beer launched franchise operations in . Howard Johnson Restaurants opened its first outlet in , expanding rapidly and paving the way for the restaurant chains and franchises that define the American fast-food industry until this day.

There were 790,492 franchise establishments in that supported the U.S. economy, with an expected 805,436 for . These franchises contributed over $500 billion to the economy. In the food sector, franchises included recognizable brands such as McDonald's, Taco Bell, Dairy Queen, Denny's, Jimmy John's, and Dunkin'. Other popular franchises include Hampton by Hilton and Days Inn, as well as 7-Eleven and Anytime Fitness.

Franchise Basics and Regulations

Franchise contracts are complex and vary for each franchisor. Typically, a franchise agreement includes three categories of payment to the franchisor. First, the franchisee must purchase the controlled rights, or trademark, from the franchisor in the form of an upfront fee. Second, the franchisor often receives payment for providing training, equipment, or business advisory services. Finally, the franchisor receives ongoing royalties or a percentage of the operation's sales.

A franchise contract is temporary, akin to a lease or rental of a business. It does not signify business ownership by the franchisee. Depending on the contract, franchise agreements typically last between five and 30 years, with serious penalties if a franchisee violates or prematurely terminates the contract.

In the U.S., franchises are regulated at the state level; however, the Federal Trade Commission (FTC) established one federal regulation in . The Franchise Rule is a legal disclosure a franchisor must give to prospective buyers. The franchisor must fully disclose any risks, benefits, or limits to a franchise investment.

This information covers fees and expenses, litigation history, approved business vendors or suppliers, estimated financial performance expectations, and other key details. This disclosure requirement was previously known as the Uniform Franchise Offering Circular before it was renamed the Franchise Disclosure Document in .

Advantages and Disadvantages of Franchises

Advantages

There are many advantages to investing in a franchise, and also drawbacks. Widely recognized benefits include a ready-made business formula to follow. A franchise comes with market-tested products and services, and in many cases established brand recognition.

If you're a McDonald's franchisee, decisions about what products to sell, how to layout your store, or even how to design your employee uniforms have already been made. Some franchisors offer training and financial planning, or lists of approved suppliers. But while franchises come with a formula and track record, success is never guaranteed.

Disadvantages

Disadvantages include heavy start-up costs as well as ongoing royalty costs. To take the McDonald&#;s example further, the estimated total amount of money it costs to start a McDonald&#;s franchise ranges from $1.3 million to $2.3 million, on top of needing liquid capital of $500,000.

By definition, franchises have ongoing fees that must be paid to the franchisor in the form of a percentage of sales or revenue. This percentage can range between 4.6% and 12.5%, depending on the industry.

For uprising brands, there are those who publicize inaccurate information and boast about ratings, rankings, and awards that are not required to be proven. So, franchisees might pay high dollar amounts for no or low franchise value.

Franchisees also lack control over territory or creativity with their business. Financing from the franchisor or elsewhere may be difficult to come by. Other factors that impact all businesses, such as poor location or management, are also possibilities.

Pros

• Ready-made business formula

• Market-tested products and services

• Established brand recognition

• Large decisions already made

• List of approved suppliers

  With competitive price and timely delivery, THE MIDI. sincerely hope to be your supplier and partner.

• Training and financial planning provided

Cons

• Success not guaranteed

• Large start-up costs

• Ongoing fees

• Lack of territory choice

• Lack of creative control

Franchise vs. Startup

If you don't want to run a business based on someone else's idea, you can start your own. But starting your own company is risky, though it offers rewards both monetary and personal. When you start your own business, you're on your own. Much is unknown. "Will my product sell?", "Will customers like what I have to offer?", "Will I make enough money to survive?"

The failure rate for new businesses is high. Two-thirds of businesses survive just two years, and 50% survive just five years. If your business is going to beat the odds, you alone can make that happen.

To turn your dream into reality, expect to work long and hard hours with no support or expert training. If you venture out solo with little or no experience, the deck is stacked against you. If this sounds like too big a burden, the franchise route may be a wiser choice.

People typically purchase a franchise because they see other franchisees' success stories. Franchises offer careful entrepreneurs a stable, tested model for running a successful business. On the other hand, for entrepreneurs with a big idea and a solid understanding of how to run a business, launching your own startup presents an opportunity for personal and financial freedom. Deciding which model is right for you is a choice only you can make.

What Are the Advantages of Franchises?

Some of the widely recognized advantages of franchises include a ready-made business formula to follow, market-tested products and services, and, in many cases, established brand recognition. For example, if you're a McDonald's franchisee, decisions about what products to sell, how to layout your store, or even how to design your employee uniforms have already been made. Some franchisors offer training and financial planning, or lists of approved suppliers; however, despite these benefits, success is never guaranteed.

What Are the Risks of Franchises?

Disadvantages include heavy start-up costs as well as ongoing royalty costs. By definition, franchises have ongoing fees that must be paid to the franchisor in the form of a percentage of sales or revenue. This percentage can range between 4.6% and 12.5%, depending on the industry.

There is also the risk of a franchisee being duped by inaccurate information and paying high dollar amounts for no or low franchise value. Franchisees also lack control over territory or creativity with their business. Financing from the franchisor or elsewhere may be difficult to come by and franchisees could be adversely affected by poor location or management.

How Does the Franchisor Make Money?

Typically, a franchise agreement includes three categories of payment to the franchisor. First, the franchisee must purchase the controlled rights, or trademark, from the franchisor in the form of an upfront fee. Second, the franchisor often receives payment for providing training, equipment, or business advisory services. Finally, the franchisor receives ongoing royalties or a percentage of the operation's sales.

The Bottom Line

A franchise can be a great way for an individual to enter the world of entrepreneurship, as the majority of the groundwork has already been laid and you are leveraging off an established, successful, and well-known business and brand name. There are also many businesses with franchises to choose from.

For a fee and start-up costs, you can be on your way to being your own boss and entering a possibly lucrative career. Though it must be noted that success is not guaranteed and franchises require a lot of work to be profitable.

Business franchising involves an established business (known as the franchisor) allowing a third party (known as the franchisee), to trade as their own businesses under the franchisor&#;s brand. This licence is usually granted on the condition that the franchisee pays the appropriate fee to the franchisor whilst following its standard business model. The franchisee will usually also receive training for key staff, ad hoc assistance with operational matters and centralised marketing.

Franchising is a continually growing market. The British Franchising Association (BFA) reported that at the date of its most recent survey ():

1. 93% of franchisees claim profitability and less than 1% of franchisors close each year due to commercial failure;
2. 60% of franchised units turn over more than £250k per annum;
3. Franchised businesses turnover £17.2bn (with average growth in the market of approximately £1bn per annum);
4. Franchised business employed 710k people; and
5. Lots of franchisees experience growth in their franchises, with 36% of franchisees now running multiple units.

The market research carried out by BFA proves that franchising is an effective and profitable method of establishing a business. The operational business support and the benefit of franchisor&#;s economies of scale significantly reduces the risk of business failure, mixed with the scope for rapid growth into multiple units contributes to the ever growing franchise market.

Franchising has numerous other advantages over starting a new business, including:

• Proven business model and ongoing support

A franchisor will provide operations manuals detailing the know-how and business techniques used to run a successful franchise. Additionally, a franchisor will usually provide ongoing guidance and training to the franchisee on general business or management skills, or the requisite industry specific knowledge in relation to the business. This will prove useful to a first-time business owner.

• Trading under an established brand name

A franchisee can take advantage of the franchisor&#;s pre-established name and reputation. This will significantly reduce the lead time in making a business successful and reduces the franchisee&#;s working capital requirements.

• Increased availability of finance

Franchisees may be able to benefit from more readily available finance and obtain that finance at a higher borrowing ratio than individuals setting up their own business. Most banks have dedicated franchise departments. The lower risk of business failure with franchises increases the likelihood a bank will lend to a franchisee and may also increase the sum the bank is willing to offer. Depending on the how established the franchise is, banks may be prepared to lend two or three times the amount to a franchisee than to an individual starting their own business.

• Economies of scale

The franchisee may benefit from the franchisor&#;s purchasing power and size in reducing the overall unit costs in supplying goods and services.

• Shared advertising and marketing budget

Franchisees will usually benefit from a shared advertising budget with other franchisees and the franchisor. Additionally, the franchisor will usually undertake its own advertising (sometimes on a national scale) to increase its brand.

Joel Gocool specialises in advising on and negotiating franchise agreements. Joel has a wealth of experience in identifying the key considerations a franchisee should make before starting a new franchise venture. If you require advice on franchising, please contact Joel Gocool on  686 222 or at .

This reflects the law at the date of publication and is written as a general guide. It does not contain definitive legal advice, which should be sought as appropriate in relation to your own particular matter before action is taken.

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