What is a Franchise?


Proprietors in front of new franchise

Entrepreneurs who are leery about buying an existing business, but who are also too risk averse to start a new one from scratch, have another option: Franchising.

Franchising is not only a less risky means for aspiring entrepreneurs to have their own businesses but is also a less risky means for existing, branded companies to grow.

What is a franchise?

One can think of franchising as a way of reconciling the conundrum in the opening paragraph of starting a new business without the risk that comes from engaging in an untested venture. A franchise is essentially a licensing business structure in which a private investor/entrepreneur purchases the rights to operate and run a location of an established company using its well-known brand equity and its proven training resources. The trade-off from this arrangement is quite obvious: An entrepreneur gains the peace of mind that comes from an established, reputable business at the expense of 100 percent personal profit retention.

Definition of franchisor and franchisee

Franchising involves one company selling the rights to a name/brand, territory, logo and business model to other individuals or groups. The company selling these rights is referred to as the “franchisor” and the person or group purchasing these rights is referred to as the “franchisee.”

A franchise is often a particular retail location, such as a specific Subway, Motel 6 or Maaco. A franchise can also have no retail location but cover a specific service area, as with Merry Maids, Coveralls and ServPro. When an aspiring entrepreneur (the franchisee) purchases a franchise, he or she purchases the right to operate a business system under the franchisor’s specific requirements and guidelines.

In exchange for an upfront cost and ongoing fees, the franchisor assists the franchisee in many or all activities required to start up and open for business. The franchise agreement, which governs the franchisor-franchisee relationship during the entire time the franchisee operates the franchise, clearly outlines the scope of the supported activities.

For retail locations, activities include locating a suitable business location, negotiating permits and construction, negotiating a lease and building out the premises. For all franchises, the scope includes all or a portion of setting up the business, hiring personnel and initial marketing.

In additional to offering the initial training, franchisors also provide ongoing support and assistance to ensure the success of the franchisee. This includes marketing, business operations, sales, financing and other support.

One primary role for franchisors is to continually market and brand the business to help drive customers to its franchises. In addition, franchisors typically provide marketing materials such as signage, brochures, websites and telemarketing scripts. Another primary role for franchisors is new product or service development. Franchisees do not conduct research and development, the franchisor does. This continually fills the pipeline to ensure the organization keeps pace with market changes.

Franchisors also monitor direct competition. They protect the franchises in their system from encroachment on a designated territory or market service area by another franchise. The purpose is to ensure that each franchise generates sufficient sales to maintain profitability.

Franchisors also typically assist those franchisees that want to expand. Franchisors will help existing franchisees purchase franchises in expansion areas and connect franchisees who want to retire with those who want to buy more units.

One of the biggest draws for entrepreneurs to franchising is the support received by these new business owners—instead of starting completely from scratch, franchisees use a proven business system and receive ongoing, strong guidance to help them succeed.

Why do companies franchise

Typically, a company with a proven concept and a proven business system wants to expand the business or business concept at a more rapid pace, over a larger geographic area, using less internal funds. So, instead of building the company from within and hiring hundreds or thousands of employees to expand, the company chooses to expand through franchising.

History of franchising

This type of business ownership was created shortly before the American Civil War, by Isaac Singer. Mr. Singer created the franchise form of business ownership to promote and sell the sewing machine, which he invented, and to distribute it more effectively to larger markets. It was also used by Thomas Edison to market many of his inventions.

This idea spread to the restaurant industry in the mid-1950s and was incorporated by Ray Kroc, the founder of McDonald’s, to spread the fast food chain all over the U.S. and across the globe. In the western hemisphere, current franchise opportunities have spread beyond the fast food chain to include convenience stores, oil change garages, hair salons and hotels.

Franchising regulations

While franchises are typically governed by state laws, the Federal Trade Commission acts as the regulatory body, ensuring compliance and protecting the interests of both parties. Because franchise laws are deferred to the states, each state has a different set of constraints for registering a franchises.

However, there's one federal regulation that governs all 50 states. Called the Franchise Rule, this regulation mandates that franchisors furnish the franchise agreement at least 14 days prior to signing any binding agreement or making any payment.

Two parties form this type of arrangement—a franchisor and a franchisee—by signing a franchise contract with the franchisee, detailing the terms and the company’s conditions for operating the franchise. The franchisee must agree to the terms of operating that franchise, and they are required to operate the business according to the franchisor’s requirements. These are typically non-negotiable. These terms usually include specific components, such as building location, local advertising, manager and employee training, legal trademark and copyright compliance, renewal opportunities and the conditions of termination.

These types of business arrangements present several advantages and disadvantages that should be taken into account by the franchisee before consummating a franchising agreement.

Advantages of a franchise

Established customer base - Franchisors offer strong advantages in return for additional capital and commitment. One advantage of owning a franchise is the inherent awareness of the company name and brand. Because corporate brand awareness is already well-established, consumers are generally more comfortable purchasing items from a firm with which they are familiar. This provides an established customer base.

Training - Franchisors provide comprehensive training for employees and managers to support their franchisees in their entrepreneurial effort, and the training usually includes continued support from the franchisor.

Safety - Franchising opportunities offer safety and low risk for both parties, and the failure rates among new franchisees is significantly lower than for other new businesses due to the brand awareness, as the product, service and reputation have already been established.

Credit - Bankers look favorably upon franchisees—successful franchise chains are perceived as being lower risk due to the historical higher repayment history.

Advertisement - Established franchise companies advertise locally and nationally, providing exposure to help boost sales for all franchisees without having to absorb the additional cost of advertising.

Disadvantages of a franchise

High initial investment - The largest and most prohibitive disadvantage of operating a franchise is the high initial cost of buying the rights to operate the franchise. Some of the major franchises can cost between $500K and $2.5 million.

Royalties - The typical royalty rate can range from less than 1 percent to over 45 percent or more of gross revenue, depending on the company. Moreover, the franchisee is liable for continued operating expenses, which reduce profits significantly.

Restrictive agreements - Franchise agreements are usually stringent and very restricting to some franchise owners, as they must adhere to the franchise bylaws and guidelines explicitly or risk termination for non-compliance.

Lack of autonomy - Autonomy is sacrificed and business decisions in most cases must be in perfect alignment with the franchisor's operations guide.

Market restrictions - There is restricted territory that limits where and when a franchisee may operate.

Cash outlay to exit - If a franchisee sells there is the standard fee that must be paid to the franchisor per the franchise bylaws.

Uncertain continuity - At the conclusion of a franchise term, the franchisor may choose not to renew. As in all matters with legal implications, entrepreneurs should always consult a lawyer and a CPA, and not sign a franchise agreement if they do not feel the fees and costs are reasonable, focusing more on what the franchisee gets relative to what the franchisor is requiring in terms of cash outlay.

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