What is a ‘Franchise’
A franchise is a type of license that a party (franchisee) acquires to allow them to have access to a business’s (the franchiser) proprietary knowledge, processes and trademarks in order to allow the party to sell a product or provide a service under the business’s name. In exchange for gaining the franchise, the franchisee usually pays the franchisor initial start-up and annual licensing fees.
BREAKING DOWN ‘Franchise’
Franchises are a very popular method for people to start a business, especially for those who wish to operate in a highly competitive industry like the fast-food industry. One of the biggest advantages of purchasing a franchise is that you have access to an established company’s brand name; meaning that you do not need to spend further resources to get your name and product out to customers.
History of the ‘Franchise’
The United States is the world leader in franchise businesses and has a storied history with the franchise business model. The concept of the franchise dates back to the mid-19th century, the most famous example of which is Isaac Singer. Singer, who invented the sewing machine, created franchises to successfully distribute his trademarked sewing machines to larger areas. In the 1930s, Howard Johnson Restaurants skyrocketed in popularity, paving the way for restaurant chains and the subsequent franchises that would define the unprecedented rise of the American fast-food industry.
To this day, franchises account for a large percentage of U.S. businesses. The 2015 top 15 business franchises include McDonald’s (MCD), Subway, Pizza Hut (YUM), Denny’s (DENN), Jimmy John’s Gourmet Sandwiches and Jack in the Box (JACK). Other popular franchises include the chain hotel industry such as Hampton by Hilton (HLT) and Day’s Inn (WYN), as well as 7-Eleven Inc. and Dunkin’ Donuts (DNKY).
Franchise Basics & Regulations
Franchise contracts are complex and vary for each franchiser. Typically, a franchise contract agreement includes three categories of payment that the franchisee must pay the franchiser. First, the franchisee must purchase the controlled rights, or trademark, to the franchiser business in the form of an upfront fee; second, the franchiser often receives payment for training, equipment, or business advisory services from the franchisee; and lastly, the franchiser receives ongoing royalties or a percentage of the business’ sales.
It is important to note that a franchise contract is temporary, akin to a lease or rental of a business, and does not signify business ownership by the franchisee. Depending on the franchise contract, franchise agreements typically last from five to 30 years, with serious penalties or consequences if a franchisee violates or prematurely terminates the contract.
In the U.S., franchises are regulated by law at the state level. However, there is one federal regulation established in 1979 by the Federal Trade Commission (FTC). The Franchise Rule is a legal disclosure given to a prospective purchaser of a franchise from the franchiser that outlines all the relevant information in order to fully inform the prospective purchaser of any risks, benefits, or limits of such an investment. Such information specifically stipulates full disclosure of fees and expenses, any litigation history, a list of suppliers or approved business vendors, even estimated financial performance expectations, and more. This law has gone through various iterations, and has previously been known as the Uniform Franchise Offering Circular (UFOC), before it was renamed in 2007 as the current Franchise Disclosure Document.
Pros & Cons
There are many advantages to investing in a franchise, and there are also drawbacks. Widely recognized benefits to buying a franchise include a ready-made business operation. A franchise comes with a built-in business formula including products, services, even employee uniforms and well-established brand recognition such as that of McDonald’s. Depending on the franchise, the franchisor company may offer support in training and financial planning, or even with approved suppliers. Whether this is a formula for success is no guarantee.
Disadvantages include heavy start-up costs as well as ongoing royalty costs. To take the McDonald’s example further, the estimated total amount of money it costs to start a McDonald’s franchise ranges from $500,000 to $1.6 million. Franchises, by definition, have ongoing costs to the franchiser company in the form of a percentage of sales or revenue. This percentage can range from 4 – 8%. Other disadvantages include lack of territory control or creativity with your own business, as well as a notable dearth of financing options from the franchiser. Other factors that affect all businesses, such as poor location or management, are also possibilities.
16 Common Franchise Terms: Explained
Franchisee: An individual who purchases the right to operate a business under the franchisor’s name and system.
Franchisor: The parent company that allows individuals to start and run a business using its trademarks, products and processes, usually for a fee.
Franchise fee: The initial fee paid to a franchisor to become a franchisee, outlined in Item 5 of the Franchise Disclosure Document (FDD). For some franchises, this is a flat, one-size-fits-all fee; for others, it varies based on territory size, experience or other factors. Many franchisors offer franchise fee discounts for veterans, minorities or existing franchisees.
Franchise Disclosure Document: All franchisors are required by the U.S. Federal Trade Commission to provide this legal document to prospective franchisees. FDDs are updated annually and consist of 23 sections, called items, which explain the company history, the fees and costs, contractual obligations, unit data and more. Don’t make a move without reviewing it.
Startup cost/initial investment: The total amount required to open the franchise, outlined in Item 7 of the FDD. This includes the franchise fee, along with other startup expenses such as real estate, equipment, supplies, business licenses and working capital.
Royalty fee: Most franchisors require franchisees to pay a fee on a regular basis (weekly, monthly or yearly). Usually, it’s a percentage of sales; sometimes it’s a flat fee. Some franchisors also require a separate royalty fee to cover advertising costs.
Franchise agreement: The written contract, included in the FDD, which outlines the responsibilities of both the franchisor and the franchisee.
Term of agreement: This spells out the length of time that your franchise agreement is valid–usually anywhere from five to 20 years. At the end of your term, if you are a franchisee in good standing, most franchisors will allow you to renew your agreement for a percentage of the then-current franchise fee.
Company-owned units: These are locations that are owned and run by the parent company (the franchisor), rather than by franchisees.
Registration states: Fifteen states require franchisors to register their FDDs with a state agency before they are legally allowed to sell franchises within that state. Find a list at FTC.gov.
Conversion: Some franchisors offer entrepreneurs the opportunity to convert their existing independent business into a franchise.
In-house financing: Financing offered by the franchisor to franchisees to help with expenses, which can include the initial franchise fee, startup costs, equipment and inventory as well as day-to-day expenses such as payroll.
Third-party financing: Financing provided by a source other than the franchisor. Many franchisors have relationships with banks or are registered with the SBA in order to expedite the loan process for their franchisees.
Absentee ownership: An option offered by some franchisors that allows a person to own a franchise without being actively involved in its day-to-day operations.
Master franchise: A master franchisee serves as a subfranchisor for a certain territory. Master franchisees can issue FDDs, sign up new franchisees, provide logistical support and receive a cut of the territory’s royalties.
Area developer: An area developer agrees to open a certain number of franchise units in a large territory within a specified time period. They may open and operate the units themselves or recruit other franchisees to open them.