What is Franchising?
Franchising is a growth strategy that companies commonly use to enter new markets or expand in existing ones. It enables companies to broaden their reach across various cities and towns by building a legal and commercial partnership with entrepreneurs looking to launch one or more independent branches, usually in the area where they live.
Whether it is a large restaurant chain, an international delivery service, a nationwide tax agency, or a national insurance corporation, the brand becomes the franchisor in this partnership. They give the entrepreneur — or franchisee — the licensing rights to open and run an independent branch of the company and use their branding, their trademarked logos, and their business model under specific guidelines.
This independent branch location is what’s known as a franchise. Depending on the franchisor’s requirements, you will likely have one of two options for setting up a new branch: lease a commercial space or lease an independent building to run the business. An international delivery service may be so nimble that leasing commercial office space in a shopping center works fine with the franchisor.
By contrast, a popular restaurant chain that encourages families and large groups to drop in for lunch and dinner to socialize, particularly on weekends, might require leasing a detached, independent building with its own parking lot to accommodate patrons.
A franchise typically sells all of the products or services that the franchisor offers. A pizza franchise located in Chicago, for example, will usually have all of the same menu items as their fellow franchisees in Dallas, Los Angeles, Seattle, and Miami. Occasionally regional product variations may exist due to differing market needs.
Launching a franchise requires a financial investment on the part of the franchisee. The initial franchise fee you will be required to pay varies by company, and that amount can range anywhere between several thousands of dollars to upwards of a million. You will likely also have to pay an annual licensing fee to keep your franchise active along with other costs, like royalty, like marketing and advertising fees, for example.
While investing in a franchise brings risks, but it also brings many benefits. As a franchisee, you will learn the franchisor’s branded business knowledge and their processes. However, you must remember that you will be legally and contractually bound to the partnership you form with the franchisor for a specific time period as a franchisee. While exceptions do exist, once you become a franchisee, your business also becomes an extension of the company’s brand. It is always in your best interest to make your franchise be the best it can be.
Today, most countries are dotted with franchises of all kinds, from fast-food restaurants like McDonald’s, Burger King, and KFC to real estate agencies, like Century 21, and home improvement retailers like Ace Hardware.
Franchising has swept across the globe during the past several decades, achieving strategic growth to secure large companies.
The modern-day concept of franchising dates back to the 1850s, when the New York-based company I.M. Singer & Co. (known as the Singer Corporation today) started licensing their business rights to shop owners interested in selling their $120 sewing machines.
These shop owners not only received the rights to sell these pricey machines but were also taught how to use them by workers of I.M. Singer & Co. That way, the shop owners could teach their customers how to use them at home. The idea took off across the country and abroad, and thousands of American and European households set aside their sewing kits in favor of a brand new Singer sewing machine — if their families could afford one, that is.
Today, it is estimated that franchising employs more than eight million people in the United States and generates economic activity of more than $827 billion.
Basic Terms and Definitions
Anyone new to franchising or interested in becoming a franchisee should consider learning the basic terms and lingo used in the franchising purchase process. Becoming familiar with the terminology ahead of the purchase process will give you a basic understanding of this type of business and help you make an informed decision. Here are several terms you need to know:
Advertising Fund: A pool of money the franchisor collects from their franchisees to market the brand. Most franchisors require that franchisees contribute to this fund by paying a monthly fee.
Area Franchisee: An individual who has bought the exclusive rights to open and run a franchise in a specific location or territory. This typically follows a schedule or a timeline that begins once a franchise agreement is signed.
Area Representative: This is typically a franchisee who also acts as a salesperson for the franchisor, receiving a commission for scouting new franchisees in his or her area.
Business Format Franchise: A franchise that, in addition to selling a branded product or service, also has complete access to the company’s method of running the business through materials like a marketing plan or an operations manual.
Company-Owned Locations: Also called corporate locations or units, company-owned locations are owned and operated by the franchisor and their brand.
Conversion: Rebranding an existing independent business into a franchise unit.
Discovery Days: When a franchisor invites a prospective franchisee to the corporate office to meet the staff and learn more about the company.
Franchise Disclosure Document (FDD): A disclosure document that the U.S. Federal Trade Commission requires franchisors to provide to prospective franchisees.
Field Consultant: An employee or contract worker of the franchisor who supports and assists franchisees at their locations.
Franchise: A license agreement that details the legal and commercial partnership between the franchisor and franchisee, including the use of trademarks and required fees.
Franchise Agreement: A legal contract between the franchisor and franchisee details the terms each party agreed to uphold regarding the franchise.
Franchise Broker: A business professional who scouts and grooms prospective franchisees in exchange for a fee from the franchisor after a franchise agreement is executed.
Franchise Development: A company’s process of bringing in new franchisees.
Franchise Fee: A one-time payment that is part of the initial investment required in purchasing franchise rights.
Franchisee: An individual or entrepreneur who obtains the rights to do business under the franchisor’s trademark or trade name.
Franchising: A business growth strategy that enables a company to broaden its reach by building a legal and commercial partnership with entrepreneur, giving them the licensing rights to open and run an independent branch of the company and use the company's branding, trademarked logos, and business model under specific guidelines.
Franchisor: A company that licenses the right to do business under its trademark or trade name.
Initial Investment: The amount of money a franchisee will need to pay upfront to get the franchise up and running.
Liquid Capital: The minimum amount of assets a franchisee can quickly convert to cash. Franchisors typically require that prospective franchisees have a minimum threshold amount of Liquid Capital.
Low-Cost Franchise: A franchise with an initial investment that is less than $100,000.
Multi-Unit Franchisee: When a franchisor gives the franchisee the right to run more than one outlet within a specific territory.
Product distribution franchisee: An individual who sells the franchisor’s products but does not have access to their business methods.
Renewal: The extension of the original franchise agreement.
Royalty Fee: The amount of money, usually a percentage of gross sales, that a franchisee must pay the franchisor regularly.
Single Unit: When a franchisor gives a franchisee permission to open and operate a single location.
Startup Costs: The initial costs required to launch a franchise, including the franchisee fee, construction costs, equipment purchases, and legal fees.
Territory: A designated area where a franchise is located. The franchisee usually has protection within the territory from other franchises of the same brand.
Trademark: The branding that identifies a franchisor, which is licensed to franchisees.
Transfer: When ownership of a franchise passes from one individual to another.
Turnover: The number, usually a percentage, of franchise locations that close within any given year.
Validation: When a prospective franchisee contacts several existing franchisees from the list provided in the FDD provided by the franchisor.
Franchise Model and Business Plan
A franchising agreement is a legal and commercial agreement between the franchisor and the franchisee. Under this agreement, the franchisee pays an initial startup fee in addition to other costs to be licensed to use the franchisor’s trademarked name, their franchise model, and their business plan to sell the brand’s products and services.
The franchisee might also receive training, ongoing support, and operational instruction from the franchisor in many cases. It is in this manner that a franchisee learns the company’s franchise model and business plan.
Different Types of Franchising
Franchising offers various opportunities for entrepreneurs to start their own business under an established brand. There are five common types of franchising: job franchising, product franchising, business format franchising, investment franchising, and conversion franchising.
Job franchising involves running a low-investment, service-based franchise that can be home-based or run out of a leased space, with the franchisee operating alone or with a small team. Product franchising, also known as distribution franchising, focuses on selling and distributing products by the brand company, with the franchisor licensing their trademark but not their business methods.
Business format franchising is the most popular type, allowing franchisees to operate under the franchisor's brand name and business model, receiving comprehensive support and training. Investment franchising involves investing significant capital into a large-scale business, such as hotel chains or large restaurants, primarily to turn a profit with limited personal involvement.
Lastly, conversion franchising is a hybrid method where an existing franchise converts an independent business into a new franchise, adopting the franchisor's trademarks, advertising, marketing, and business model. This method helps franchisors grow rapidly by leveraging existing businesses and is popular among service industries like electricians, florists, HVAC servicers, plumbers, professional service providers, and real-estate brokers.
Support of the Franchisor
Franchising is a lucrative growth strategy that helps a company broaden its reach in new or existing markets and supports the franchisor by generating additional revenue streams.
These revenue streams are monies paid by the franchisee and revenue generated by the franchises themselves, with a larger number of customers having access to the franchisor’s products or services.
Franchise Contracts
A franchise contract is a temporary agreement that expires after a certain time period. It does not signify ownership. Instead, it is more like a lease or a rental agreement that lapses after a certain amount of time, typically between five and 30 years.
Franchisors typically include a clause in the contract that allows them to terminate the agreement if the franchisee breaches any terms. If something like this happens, the franchisor can terminate the contract ahead of the expiration date and keep all monies paid by the franchisee. They may even be entitled to collect additional costs for the termination.
In addition to the rights and clauses outlined in a franchise contract, three payment categories are usually included. These payment categories are all of the fees the franchisee must pay the franchisor. The categories are:
- An upfront fee to purchase the controlled rights or trademark of the franchisor
- Payment for training, equipment, or business consulting services
- Ongoing royalty payments or a percentage of the operation’s sales
Franchise Rules and Regulations
In the U.S., franchises are regulated by the states. In 1979, the Federal Trade Commission (FTC) established the Franchise Rule, which mandates that franchisors provide prospective franchisees with all of the material information they need to weigh the risk and benefits of franchise investment.
Under the Franchise Rule, franchisors must give all potential franchisees a Franchise Disclosure Document that contains 23 specific items about the offered franchise, the franchisor's officers, and other franchisees.
This document must also include other key details, like an outline of any risks, benefits, or limits the franchisee may face, fees and expenses, the franchisor’s litigation history, a list of approved business vendors or suppliers, and the franchisor’s estimated financial performance expectations.
Visit BizBuySell's Franchise Learning Center to learn more about franchising.