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Franchise

A contractual arrangement whereby the franchisor allows the franchisee to use its intellectual property, as well as its business processes and systems

What is a Franchise?

A franchise refers to a contractual arrangement whereby one party (the franchisor) allows another party (the franchisee) to use its trademarks (or tradenames) and other intellectual property, as well as certain business processes and systems.

 

Franchise

 

Franchising can include the manufacturing and marketing of a good or service according to the already established franchisor’s criteria. In other words, the franchisor grants the franchisee the right to use its business model, including its brand name, and sell its products and services to customers.

 

 

Quick Summary

  • A franchise is an agreement between two independent parties: the franchisor and the franchisee. One party (the franchisor) offers its business model, brand name, and intellectual property to another party (the franchisee) that will use the resources to start a business according to the existing system.
  • To use a franchise, the franchisee needs to pay a one-time fee (lump sum contribution) at the beginning to acquire the rights of using the franchisor’s business model.
  • Franchising is a popular tool to scale business operations worldwide and accounts for a large portion of the U.S. market.

 

How Does Franchising Work?

Franchising is a marketing strategy and currently a very popular tool used for business expansion purposes. When a company with a proven business model wants to scale its operations by increasing its share in certain markets, it can consider opening a franchise for its products or services.

A franchise is like a joint venture between the company wanting to expand the business (franchisor) and another party (franchisee) that wants to benefit from the franchisor’s brand name, stable operations, and working business model. Therefore, the franchisee does not need to launch a new venture from scratch or spend resources on branding and advertising.

In essence, a franchisee acts as a dealer. In return, it pays a commission or a one-time fee called a lump-sum contribution to the franchisor. During the dealership, the franchisee shares a certain percentage of revenue (gross income) with the franchisor as specified in the contract. The fee is called a royalty or licensing fee.

 

Real-World Examples

The franchise business model is popular in highly competitive industries such as the fast-food industry, video rentals, and automotive services. The model first appeared in the US after the Civil War, and it gained popularity in the 1950s and 1960s through to the 1990s.

Large companies such as McDonald’s, Dairy Queen, Taco Bell, Denny’s, Jimmy John’s Gourmet Sandwiches, Subway, 7-Eleven Inc., Anytime Fitness, etc., are considered top franchises worldwide.

Small businesses in the US use the franchising model to grow into national chains and gain a foothold in other locations such as Europe, Canada, and China. On the other hand, overseas franchisors turn to franchises to establish themselves in the US market, using funds provided by the franchisees in the US mainland.

 

Franchising Requirements and Regulations

Since franchising is a contractual arrangement, it involves a lot of bureaucracy and complex contracts. However, the complexity of the paperwork varies across franchisors.

The agreement typically includes three categories of payment and the amounts the franchisee needs to transfer to the franchisor. First, the franchisee purchases the controlled rights and intellectual property from the franchisor business, paying a lump sum contribution or a one-time fee.

Secondly, the franchisor is paid by the franchisee for training, equipment, and business advisory services. In the end, the franchisor receives royalties every month.

In the United States, franchises must adhere to state laws. The Federal Trade Commission (FTC) serves as a federal regulatory body that aims to protect consumers and ensure strong competition in the markets.

The Franchise Rule, which is published by the FTC, represents a legal disclosure conveyed to a potential buyer of the franchise from the franchisor. It is designed to fully inform a potential franchisee about future benefits, risks, and limits. It also includes direct information about the franchisor’s business, including litigation history, a list of existing suppliers, estimated financial performance expectations, etc.

 

Franchisor vs. Franchisee Relationship

The relationship between the franchisor and the franchisee is that of an advisor and advisee, where the franchisor provides guidance to the franchisee on how to structure the business. Each of the parties has a role to play and interests to protect in the arrangement. The following are the roles of each party in the contract:

 

Role of Franchisor

The franchisor is required to provide business support to the franchisee by providing training, equipment, and knowledge to the staff employed in the business. The training ensures that the unit staff understand their role in the franchised business, and possess the right skills to maintain the image of the franchisor. The franchisor also develops advertising and promotion merchandise that affirm the brand image and increase customer awareness.

However, the franchisor does not take part in the day-to-day running of the franchisee’s business, and the franchisee is free to hire, compensate, and set employment standards for its business without requiring input from the franchisor.

 

Role of Franchisee

The franchisee is required to uphold the business model set up by the franchisor and maintain consistency in the state of operations in all business locations under the brand name. The franchisee must also put in place the standardizations required by the franchisor, such as logos, signs, and trademarks in a prominent location within the business premises.

The franchisee can aim to grow their business through marketing, but the marketing campaigns must be approved by the franchisor before the material is released to the public. Most franchisees benefit from national marketing/advertising done by the franchisor.

 

Disadvantages of Franchising

Apart from the advantages, franchising comes with several drawbacks, such as relatively heavy start-up costs, followed by royalties. The costs are often dependent on the kind of business and franchise you are going to buy.

Taking McDonald’s as an example, the estimated total costs to launch a franchise range from $1 million to $2.2 million. When it comes to royalties, the franchisee needs to remit 4%-8% of its revenue to the franchisor per month.

Another disadvantage is the lack of creativity in the business since you work according to the existing rules and structure.

 

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:

  • Brick and Mortar
  • Market Positioning
  • Strategic Alliances
  • Total Addressable Market (TAM)

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