What is a Franchise?

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Definition:

A franchise is a type of business model where one party pays a fee to do business under another party’s business name and processes.

🤔 Understanding a franchise

A franchise is a business relationship between a franchisor (who starts a business and establishes a trademark and operations) and a franchisee (who pays a fee to the franchisor). In exchange for the fee, the franchisee can use the franchisor’s trademarked name, as well as their business processes. Franchisors typically make more money as they bring more franchisees on board. The deal can also benefit franchisees because they can open a business and bring in profits without having to start from scratch. Franchisees may also gain advantages like marketing, which is typically paid for by a central corporation (aka the franchisor). Both the federal and state governments regulate franchises.

Example

The largest franchisor in the world (as of 2020) is McDonald’s. Founded in 1955, the company has more than 37,000 locations worldwide, more than 90% of which are franchises. McDonald’s has an onboarding process of 12 to 18 months for anyone wishing to become a franchisee. By one estimate, the total start-up costs for a franchisee can range from $1M to $2.5M. When someone signs up to become a McDonald’s franchisee, they get the perk of running a business that is already a household name, as well as its national marketing and existing supply chain.

Takeaway

Joining a franchise is like building a house in a planned community…

When you build a house from the ground up, you can usually do anything you want with it. When you build a house in a planned community with a homeowners’ association, there are typically certain rules governing things like the color you paint your house or the type of landscaping you may do. But you also get the upsides of living in a community that may come with amenities like a neighborhood pool or lawn-care services. Starting a business is similar. An entrepreneur could, in theory, start a business from scratch and make it what they want. A franchisee may be bound to rules, but they may also gain the perks of a framework that someone else has already created.

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What is a franchise?

A franchise is a specific kind of business relationship where one party pays royalty and start-up fees to operate a business under the trademarked name of an existing company. The term franchise refers to the contractual agreement between the two parties. There are several different types of franchises. A typical franchise business model often involves the aspiring business owner (aka franchisee) paying a fee to the company (aka franchisor) to operate under its trademark. The franchisee gets to adopt the franchisor’s name. Usually, the franchisee also gets to use the franchisor’s business process, training, branding, marketing, and supply chain.

What is a franchisee?

A franchisee is the party in the franchise relationship that pays a fee to an existing company to operate a business under the company’s trademarked name and business processes. The franchisor, on the other hand, is the existing business that allows other business owners to operate under its trademark.

Let’s say you wanted to open a coffee shop. You’re new to business ownership and the food and beverage industry, so you decide that signing onto a franchise might be a better decision. You decide to open a Dunkin’ (formerly Dunkin’ Donuts) franchise. In this business relationship, you are the franchisee, and Dunkin’ is the franchisor.

In exchange for the ability to operate under the franchise license, there are certain requirements that a franchisee typically has to meet. For example, a franchisee is usually required to maintain the standards of the franchisor. These standards might include guidelines for cleanliness and customer service. They also likely have to operate under the umbrella of the franchise company — In other words, they can’t operate their own marketing and innovations outside of the approval of the franchisor.

What are the basics of a franchise?

While each franchise relationship is unique, generally speaking, they involve the following basic elements:

  • A franchisor
  • A franchisee
  • A franchise disclosure document: The Federal Trade Commission requires that this document accompanies all franchise contracts. The document lays out the rules for the franchise relationship.
  • A particular type of franchise: There are a few different types of franchises, depending on the type and size of the business.
  • A particular number of units: A single-unit franchisee is one who owns just one unit. Franchisees can also own more than one unit as a multi-unit franchisee.
  • Territories: Each company will have maps that determine where new franchises can open. Some companies might allow a master franchisee — A single owner who has the rights to an entire region.

What are the types of franchises?

There are several different types of business models that a franchise might use. The models differ based on how much money the franchisee will have to invest and what type of industry they work in. Here are a few examples.

Job franchise

Job franchises tend to operate on a smaller scale than other kinds of franchise operations. They usually involve relatively low start-up costs compared to other franchises. Job franchises are often service-based businesses that the owner can run from their home or vehicle — Including travel agencies, event planning, lawn care, and cleaning services. Product franchise

A product franchise (aka a distribution franchise) is a business relationship where the franchisee acts as a distributor for the franchisor’s product. Unlike other types of franchises where the franchisee has access to the company’s entire process, a product franchisee generally only has access to use the trademark. Some car manufacturers, like Ford and Chrysler, operate with this type of franchise model with car dealerships and auto parts stores.

Business format franchise

In a business format franchise, the franchisee has access to the trademark and entire business processes of the franchisor. Because the franchisee uses the same operations, training, and support as the franchisor, each franchised location is nearly indistinguishable from the next. Many restaurants, fast food, retail, and fitness companies use this model.

Investment franchise

Investment franchises generally require a bit more start-up capital than a business format franchise operation. Typically, a franchisee invests substantial money to get the business built and up and running, then they may have the franchisor operate the business for them or bring in their own team to manage operations. A hotel chain is an example of this arrangement. Conversion franchise

In a conversion franchise, existing businesses convert into franchise locations. An independent business owner might open a shop and start operating their firm, then later sign on with a franchisor to convert their company to the franchise’s brand. They’d likely take on the franchise’s name, marketing, and training standards. Real estate brokers are an example of a type of company that may use this model.

How do franchises work?

When a business wants to expand, it might do so by opening up the firm to franchisees. When someone signs on as a franchisee, they receive a document with necessary information about the business. They pay a series of fees in return for the company’s trademarked name, businesses plan, and marketing efforts.

Typically, franchisors have a lot of say over the business operations of each individual franchise, like the site of each location, design standards, operation requirements, and what products the franchisee can or cannot sell. Throughout the business relationship, the franchisee usually continues to pay the franchisor royalty payments and possible advertising fees. In return, the franchisor continues to set the business operations, handle marketing, and take care of the big-picture business planning.

How do franchisors make money?

Franchisors make money in several different ways. First, the franchisee pays an initial franchise fee to the company. This fee typically covers their trademark license and access to the company’s business operations. It might also include assistance in getting the business set up. The franchisee also usually pays a royalty to the franchisor, often based on a percentage of the business’s income. Royalties are usually based on the gross income, meaning income before expenses. The royalty fee allows a franchisee to continue using the company name. Some franchisors may require franchisees to pay advertising fees, which help pay for things like a national advertising campaign.

What is the history of the franchise?

Franchising, as it exists in the United States today, took off during the Industrial Revolution. Restaurants, gas stations, and automotive companies began using the franchise business model to expand nationwide. Back in 1898, General Motors signed on its first franchisee, and other auto manufacturers followed suit. Soon afterward, beverage companies like Coca-Cola began franchising their operations, as did drug stores. Restaurants started franchising in the early 1900s, with A&W, White Castle, and Howard Johnson. Before long, fast-food restaurants like KFC, Burger King, and McDonald adopted the model. Franchises continued to grow over the next several decades, reaching their peak after the 1950s. Part of this growth was made possible by the Lanham Trademark Act in 1946, which allowed property owners to enter into licensing agreements and made franchising easier. Today, businesses in many different industries use the franchise model, including restaurants, automotive parts, convenience stores, dry cleaning, and other professional services.

What are the regulations for U.S. franchises?

The Federal Trade Commission (FTC) regulates franchises through the FTC Franchise Rule. For a franchise to exist under federal law, the agreement has to meet the following standards:

  1. The franchisee can operate under the franchisor’s trademark and sell the goods and services that the franchisor sells.
  2. The franchisor has significant control over the operations of the franchisee’s business and provides assistance.
  3. The franchisee makes payments to the franchisor.

The FTC Franchise rule also says that franchisors have to supply franchisees with a franchise disclosure document, which contains information including the history of the business, fees, and franchise rules. In addition to the federal Franchise Rule, many states implement additional regulations for franchise businesses.

What are the advantages and disadvantages of owning a franchise?

One of the advantages of opening a franchise location is that it allows you to own a business without putting the legwork that generally comes with opening a brand new business — Things like developing a business name, business model, and product line. Another benefit is that the brand is often already a household name. For example, if you’re opening a McDonald’s franchise, you don’t have to worry about educating anyone about what McDonald’s is. Additionally, the company will usually pay for costs like marketing, to help attract new customers.

There are also a few downsides to becoming a franchisee. Opening a business under an existing, widely known company’s name might also mean that you have to live with its reputation — Your customers may have already formed an opinion about your business. Another possible disadvantage is that a franchisee may have little creative control over their business. They probably can’t develop new products or branding, for example, because the franchisor is responsible for that. Implementing your own new ideas might be a breach of contract. Operating a franchise can also be expensive. There are upfront and continuing costs that a franchisee typically has to pay the franchisor, which can sometimes add up to millions of dollars. Costs like royalty payments may be required even if your business is struggling.

Should you buy a franchise?

There are several factors you may want to consider when looking into a franchise. For example, what’s the reason and goal for the business? Does the franchise model fit with those goals? For example, if you set out to start a business because you’re passionate about entrepreneurship and innovation, you may want to take into account that a franchise model may not offer much room for innovation — A franchisee is typically bound by contract to operate within the company’s existing brand and processes. It may also be worth considering the potential upfront investment required to open a franchise. These costs can vary significantly, and may be high enough to require financing. It’s always a good idea to do your research and consider the pros and cons when considering a franchise.

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