An introduction to franchising
A franchise is a major force within the business world, yet it’s often a business model that gets overlooked in an era of Silicon Valley startups and “unicorn” companies. Across the globe, one in seven businesses is a franchise, which is equivalent to around two million franchised companies within the world. Franchises are also responsible for employing approximately 19 million people, proving just how vital they are to the global economy.
If you’ve ever considered buying into a franchise or even franchising your own business but didn’t know where to start, you’re not alone. With benefits such as high profits, ongoing support, a tried-and-tested business model, and being your own boss, it isn’t hard to see why millions choose this road to success.
In this in-depth guide, we share everything you need to know about franchising, including what is a franchise, how a franchise works, its agreements and regulations, examples of franchises, and so much more.
- 1. What is a franchise?
- 2. How does a franchise work?
- 3. Types of franchises
- 4. The franchise agreement
- 5. Franchise rules and regulations
- 6. The advantages of franchising
- 7. The disadvantages of franchising
- 8. Examples of franchise businesses
- 9. Frequently asked franchise questions
1. What is a franchise?
A franchise (or franchising) is a business model that allows franchisee access to a franchisor’s exclusive business knowledge, processes, and trademarks. As a result, the franchisee is then able to sell a product or service using the franchisor’s business name, branding, and established business system. In return for acquiring a franchise, a franchisee must pay the franchisor fees, often including an initial start-up fee and ongoing licensing fees.
In the franchise business model, the franchisor grants the franchisee the right to operate their business in accordance with their own successful system for a set amount of time. This period of time may vary by franchise or industry but will be documented in the franchise agreement between both franchisor and franchisee. This franchise agreement is a contract, which also outlines what the franchisee can and can’t do while running the franchise.
While the franchisee runs the franchise as their business, the franchisor is ultimately in control of the brand, and therefore determines many aspects of that business. This includes financial, operational, and corporate matters. Decisions about store opening hours, sales targets, number of employees, and business expenses and costs may fall to the franchisor, for example.
When we break down what a franchise is, it is often described as a contractual relationship between a franchisor and franchisee. According to the IFA, franchising is defined as an agreement or license between two legally independent parties which gives:
- An individual or group of people (the franchisee) has the right to market a product or service using the trademark or trade name of another business (the franchisor)
- The franchisee has the right to market a product or service using the operating methods of the franchisor
- The franchisee has the obligation to pay the franchisor fees for these rights
- The franchisor has the obligation to provide rights and support to franchisees
Of course, the definition of a franchise may vary slightly across different states or countries, however, this provides a thorough understanding of what the term implies.
At its core, a franchise is a joint venture between a franchisor (the original business) and a franchisee (the business allowed to use the franchisor’s brand and system to sell products or services).
The concept of a franchise isn’t new. In fact, the business model dates back to the mid-19th century and can be attributed to two American companies: the McCormick Harvesting Machine Company and the I.M. Singer Company. When both companies were experiencing a high volume in production and demand, they decided to develop new business models, which would allow them to sell their reapers and sewing machines to an expanding domestic market.
These innovative, new business models involved the development of organizational, marketing, and distribution systems, and are recognized as the forerunners to franchising.
It was in the 1920s and 1930s that the idea of franchising emerged in the food and hospitality industries. A&W Root Beer launched its first franchise operations in 1925, while in 1935, Howard Johnson Restaurants opened its first branch in 1935. The restaurant went on to achieve great success, causing it to expand rapidly and inspire the American fast-food chain model that exists to this day.
2. How does a franchise work?
As we’ve touched upon, a franchise is a contractual agreement between a franchisor and a franchisee. This contract can be quite complex and varies for each franchise, however, it will commonly include three categories of payments that are required to be paid to the franchiser.
- The trademark: This is also known as the controlled rights from the franchisor, and will be paid as a one-time, upfront fee by the franchisee.
- Training, equipment, or business advisory services fee: This will vary depending on what the franchisor is providing the franchisee with; however, this cost is required to be paid by the franchisee.
- Ongoing royalties: A franchisor will also receive ongoing royalties or a percentage of the franchisee’s sales. This percentage can range between 4.6% and 12.5%, depending on the industry, and is collected on a monthly basis by the franchisor.
It’s important to mention that this franchise agreement is temporary and doesn’t signify complete ownership of the business by the franchisee. You could liken this contract to the lease or rental of business space, for example.
Depending on what’s outlined in the contract, a franchise agreement will usually last for as little as five years, and as much as thirty years, on average. If a franchisee violates or terminates the contract before the time period agreed upon, however, serious penalties (such as fines) can occur.
3. Types of franchises
There are three main types of franchises — including business format franchises, product franchises, and manufacturing franchises — each of which operates in different ways. Let’s take a closer look at each type below.
Business format franchises
The most common format of a franchise is the business franchise, which we spoke about earlier in this guide. To recap, a business format franchise is one where a company (the franchisor) allows an independent business owner (the franchisee) to carry out business under their established brand in exchange for fees and royalties.
When you think about a business format franchise, you might think of famous fast-food chains, including McDonald’s, KFC, and Pizza Hut.
With a product franchise agreement, a manufacturer allows a retailer to distribute or sell their products using their logo, trademarks, and trade name. Typically, this will take the form of a supplier-dealer setup, and retailers aren’t provided with an operating system to run the business with.
To gain the rights to these products, however, retailers may have to pay fees or purchase a minimum number of products.
The third type of franchise is a manufacturing franchise. This agreement sees a franchisor grant a manufacturer permission to produce and sell its products using its brand name and trademark. This is especially common among clothing, food, and beverage brands. Coca-Cola, for example, sells its syrup concentrate to a bottling company, who then mixes these ingredients with water, bottles the product, and sells it.
4. The franchise agreement
The franchise agreement is a legally binding document between the franchisor and franchisee, which outlines in-depth what the franchisor expects from the franchisee in terms of how they operate every part of their business.
Prior to signing this important document, a franchisee should have an attorney specializing in franchise law review it on their behalf. The franchisee and franchisor will then be required to each sign the document before it comes into effect.
In every franchise agreement, there will be a number of fundamental provisions outlined in some shape or form. Typically, these will be the following:
- Location or territory in which the franchisee will operate
- Operations, including how the franchisee is expected to operate their branch
- Training and ongoing support included from the franchisor
- Duration of the franchise agreement
- Franchise fees or investments required
- Royalty fee structure
- Trademark, patent, and signage information, including how a franchisee can use these elements
- Advertising and marketing commitments from the franchisor, including the fees associated with these
- Renewal rights, termination, and cancellation policies
- Exit strategies, including policies surrounding whether a franchisee can resell their franchise at their discretion, as well as buy back or right of first refusal clauses
The franchise agreement will also define the franchisee and franchisor relationship, including detailed information about proprietary statements and things such as site maintenance and upgrade requirements.
5. Franchise rules and regulations
A franchise is made up of a franchise agreement, as well as many other regulations to ensure each franchise meets the requirements set out by the Federal Trade Commission (FTC).
Although franchise regulations vary from location to location, they generally share many similarities with those operating in the United States. In the US, for example, franchises are regulated at the state level. In 1979, however, the Federal Trade Commission (FTC) established one federal regulation known as the Franchise Rule.
The Franchise Rule is a legal disclosure a franchisor must give to prospective franchisees. This disclosure used to be known as the Uniform Franchise Offering Circular before it was renamed the Franchise Disclosure Document in 2007.
Under the Franchise Rule, the franchisor must be fully transparent about any risks, benefits, or limits to a franchise investment. This information would cover fees and expenses, litigation history, approved business vendors or suppliers, estimated financial performance expectations, and other crucial details, for example.
6. The advantages of franchising
Franchising has proved to be a successful business model for numerous brands over the centuries and offers numerous advantages to franchisees and franchisors. Let’s look at them in more detail below.
- Business assistance. Running your own business can be daunting, which is why many franchisees enjoy the additional assistance provided by their franchisor. While each situation will depend on the individual franchise agreement, it’s quite common for a franchisee to receive a business that’s basically all set up and ready to go — including the established brand, equipment, supplies, and advertising plan. This takes a lot of uncertainty, not to mention months or years’ worth of effort, out of the equation. Alternatively, some franchises might not come with all of these elements, however, the franchisee will gain access to the knowledge and wisdom of the franchisor — both of which are vital to running a successful business. The franchisor might be able to access this information through a searchable digital knowledge base or through one-on-one mentorship from the franchisor themselves.
- Brand recognition. While it’s one advantage to gain an existing brand identity, it’s another huge benefit to automatically inherit brand recognition. When starting a business entirely from scratch, you must build your customer base, awareness, and recognition from the ground up. Franchisors, however, have already done this heavy lifting for franchisees, allowing them to inherit an in-built customer base, reputation, and brand recognition. This means consumers will already know what a franchise provides and why they’re a better choice than the competition.
- Lower failure rate. On average, franchisees have a lower failure rate than solo businesses. This is because when a franchisee buys into a franchise, they are essentially buying into an established business that has already proven that its concept is successful. Furthermore, franchisees have the confirmation that the products or services being offered are already in demand.
- Buying power. Thanks to the large size of a franchise network, franchisees are often able to buy their goods in bulk, therefore reaping the benefits of a discount. This is because the franchisor can use the size of their operation to negotiate better deals, which allows franchisees to dramatically benefit too. Unlike standalone businesses that are unable to negotiate cheaper prices, this allows franchises to lower the overall costs of their business.
- Profits. Another reason why franchises are generally more successful than standalone businesses is that their recognizable brand sees higher profits. This is even true for large or well-known franchises which require a higher initial investment.
- Lower risk. There’s no doubt that starting any business is risky, however, franchisees also experience less risk in their endeavors. This is mainly due to two reasons. Firstly, the majority of franchises are owned by established companies that have tested and proven the business model of the franchise in multiple markets. Secondly, this lower risk can make it easier for franchisees to access loans, including SBA franchise loans, to help their business thrive.
- Built-in customer base. We touched upon this previously, but a franchise’s built-in brand awareness and recognition, not to mention their established customer base, is a huge advantage for franchisees. Even if you were to expand a franchise by opening up a branch in a small town, chances are residents would still be familiar with the brand’s products or services due to previous advertisements or word-of-mouth.
- Be your own boss. Many people start their own business because they dream of being their own boss. With advantages such as creating your own schedule, having autonomy over your career, and potentially working from home, who could blame them? Starting an independent business is often extremely risky, however, causing some entrepreneurial spirits to give up on their dream altogether. Becoming a franchisee eliminates much of this risk, however, as it allows you to enjoy many of the perks of being your own boss, yet with the additional advantage of receiving ongoing support from the franchise’s knowledge base.
7. The disadvantages of franchising
We thoroughly covered the advantages of franchising, let’s delve into the disadvantages this business model may present.
- Restricting regulations. While a franchisee might consider themselves to be their own boss, they must follow the restrictions laid out in the franchise agreement. Depending on this contract, the franchisor can control aspects of the business, including:
- Branch location
- Hours of operation
- Holiday closures
- Store layout and furnishings
- Products sold
- Advertising and marketing
- Conditions regarding resale
These restrictions create uniformity among all brand franchisees.
- Initial cost. Although a franchise can be a profitable option to pursue, the high initial investment cost can cause stress for some. It’s therefore vital to weigh the opportunity against the initial investment and determine the right balance for your business.
- Ongoing investment. There are also additional and ongoing fees that are required of franchisees. These commonly include:
- Royalty fees
- Advertising costs
- Training services fees
- Potential conflict. Where there’s an imbalance of power, it’s only natural that the risk of conflict between stakeholders is higher. It’s therefore vital that each party screen one another before entering into a franchise agreement. This will allow them to ensure they’re on the same page about many aspects of business first, thus minimizing the risk for conflict down the line.
- Lack of financial privacy. The franchise agreement will likely specify that the franchisor can manage the entire financial system of the franchise. While some may see this lack of financial privacy as a disadvantage, others welcome the financial guidance it allows them to receive.
8. Examples of franchise businesses
In Chapter 4, we looked at the three main types of franchises: business format franchises, product franchises, and manufacturing franchises. Now, it’s time to delve deeper into the many different examples of franchise businesses, including what sectors they belong to.
There are currently more than 785,000 franchise establishments in the United States alone, which contribute around $500 billion to the economy.
most common sectors for franchises include:
- Restaurants and hotels
- Automotive repairs and services
- Environmental services
- Hair salons
- Health aids and services
- Computer and phone repair
- Clothing stores
- Children’s services
- Home repair and remodeling
- Carpet cleaning
- Household furnishings
- Maintenance and cleaning services
- Mail processing
- Advertising services
- Package shipping
- Personnel services
- Printing services
- Anytime Fitness
- Pizza Hut
- Marriott International
- Taco Bell
- Burger King
- Hilton Hotels & Resorts
- H&R Block
- F45 Training
- Century 21
9. Frequently asked franchise questions
After learning all about what is a franchise, you might still have some queries regarding this business model and what it entails. Below, we’ve answered the most frequently asked questions about franchises to help you out.
1. What are the risks of franchising?
When considering franchising a business, franchisors face three main risks.
- Reputational damage. When franchisees invest in a franchisor’s business model, they’re also investing in the reputation of the brand. Similarly, franchisors rely on the franchisee to maintain that good reputation. When one party does something that damages this reputation, both parties can suffer. Reputational damage occurs when one franchise location’s poor standards result in consumers associating the entire brand – including all franchise locations – with these poor standards, despite each location being separately managed. If the shortcomings are serious enough, such as food poisoning or injury, they can also result in a franchisee being sued. If this were to happen, the franchisor may be held accountable due to the standard of vicarious liability.
- Joint employer liability. Joint employer liability means that both franchisee and franchisor could be responsible for penalties if labor violations were to occur. Although the standards used to determine whether a franchisor is a joint employer keep changing, the most recent ruling determined that entities are considered to be joint employers “if there is proof that one entity has exercised control over essential employment terms of another entity’s employees.” In 2014, for example, the National Labor Relations Board (NLRB) concluded that McDonald’s was a joint employer in complaints against its franchisee’s treatment of staff. This meant that as the franchisor, McDonald’s was partially responsible for the employment practices of the franchisees.
- FDD Compliance Issues. According to the Federal Trade Commission’s Franchise Rule, franchisors must provide a Franchise Disclosure Document (FDD) to potential franchisees before a contract is signed. This document contains comprehensive information about the franchise, including its litigation history, financial performance, advertising requirements, and training requirements. The Franchise Disclosure Document is vital for both parties and requires the franchisor to provide all the required information while ensuring that information is accurate and complete. Additionally, the franchisee is expected to go through the document carefully, as their business decisions should be based on the information within the FDD.
2. What’s the difference between a franchisor and a franchisee?
The franchisor is the individual or corporation that owns the original business model and trademarks. The franchisor then licenses the use of this business model and trademark to the franchisee, often in exchange for an upfront sum and recurring royalty payments.
The franchisee is the individual or corporation that then owns and operates the business using the business model system and trademark, as licensed by the franchisor.
3. Who can become a franchisor?
If you own a business and have the resources available to expand into an operation with multiple franchised branches, then you can become a franchisor. A successful and effective franchisor will possess the following qualities:
- Good communication
- Proven success in the industry
- Industry-specific knowledge
- Willingness to train others and offer ongoing support
4. Who can become a franchisee?
The criteria to become a franchisee isn’t strict. In fact, almost anyone with the financial capacity can begin running a franchise. Not only are low-cost franchising options available, but some banks also offer franchise loans, which can cover up to 70% of required fees.
Additionally, because many franchises also offer in-depth training and other business resources, franchisees don’t have to have prior experience within the industry they’re buying into.
In saying that, franchisees will still need to meet vital criteria to satisfy a franchiser’s requirements. Overall, a franchisee should be:
- Driven to succeed
- Willing to learn
- Positive and enthusiastic about the franchise
- Good learners
- Experienced with managing others
- Good at training or teaching others
5. Franchise vs. starting: which one works best?
If the idea of running a business based on someone else’s concept and business model doesn’t sound quite as satisfying as starting your own business, then there are some things you may wish to consider.
Starting any company from the ground up is highly risky, though the personal and monetary rewards can be plentiful if success is achieved. Unlike buying into a franchise, however, starting your own business means you’re on your own. With this comes the unknown, with start-up business owners frequently having to ask:
- Will my product sell?
- Will customers like what I have to offer?
- Will I make enough money for my business to survive?
When starting a business, however, these fears are valid. This is because only 30% of startups are still in business after 10 years. Only 50% of startups last until the fifth year, and perhaps most disturbing of all, up to 20% of startups won’t even survive their first year in business.
Of course, if you’re willing to work long and hard hours with little support or expert training, then there’s no doubt that your startup could achieve the success you dream about. For entrepreneurs with a great business idea and a thorough understanding of how to run a business, launching their own startup offers the chance for personal and financial freedom.
However, if the idea of venturing into the world of startups by yourself and with little experience sounds daunting, then the franchise route may be a wise choice. This is because franchises provide entrepreneurs with a tried-and-tested model for running a successful venture.
Deciding between pursuing your own startup or buying into a franchise needs careful consideration, and is a choice only you can make for yourself.
It isn’t hard to see why around two million franchised companies exist in the world today. With benefits for both franchisees and franchisors — including lower failure rate, higher brand recognition, a built-in customer base, efficient growth, and being your own boss — franchises seem like a great idea for many entrepreneurs.
After reading this guide, you now have an in-depth understanding of franchising, as well as its advantages and disadvantages, how it works, the different types of franchises, agreements and regulations, and so much more.
Armed with this knowledge, you are now in a great position to determine if becoming a franchisee is the right decision for you, and how you can then move forward with achieving your dream.