What Is a Franchise, and How Does It Work?

Check now

What Is a Franchise?

A franchise is a type of license that grants a franchisee access to a franchisor's proprietary business knowledge, processes, and trademarks, thus allowing the franchisee to sell a product or service under the franchisor's business name. In exchange for acquiring a franchise, the franchisee usually pays the franchisor an initial start-up fee and annual licensing fees.

Key Takeaways

• A franchise is a business whereby the owner licenses its operations&#;along with its products, branding, and knowledge&#;in exchange for a franchise fee.
• The franchisor is the business that grants licenses to franchisees.
• The Franchise Rule requires franchisors to disclose key operating information to prospective franchisees.

• Ongoing royalties paid to franchisors vary by industry and can range between 4.6% and 12.5%.

Understanding Franchises

When a business wants to increase its market share or geographical reach at a low cost, it may franchise its product and brand name. A franchise is a joint venture between a franchisor and a franchisee. The franchisor is the original business. It sells the right to use its name and idea. The franchisee buys this right to sell the franchisor's goods or services under an existing business model and trademark.

Franchises are an effective way for entrepreneurs to start a business, especially when entering a highly competitive industry such as fast food, or an industry that is established and requires time to develop its operating processes from scratch. One big advantage to purchasing a franchise is you have access to an established company's brand name, management knowledge, processes and procedures, financial toolbox, and metrics. You won't need to spend time and resources building them and getting your name and product out to customers.

The franchise business model has a storied history in the United States. The concept dates to the mid-19th century when two companies&#;the McCormick Harvesting Machine Company and the I.M. Singer Company&#;developed organizational, marketing, and distribution systems recognized as the forerunners to franchising. These novel business structures were developed in response to high-volume production and allowed McCormick and Singer to sell their reapers and sewing machines to an expanding domestic market.

Before buying into a franchise, investors should carefully read the Franchise Disclosure Document, which franchisors are required to provide. This document contains information about franchise fees, expenses, performance expectations, and other key operating details.

The earliest food and hospitality franchises were developed in the s and s. A&W Root Beer launched franchise operations in . Howard Johnson Restaurants opened its first outlet in , expanding rapidly and paving the way for the restaurant chains and franchises that define the American fast-food industry until this day.

There were 790,492 franchise establishments in that supported the U.S. economy, with an expected 805,436 for . These franchises contributed over $500 billion to the economy. In the food sector, franchises included recognizable brands such as McDonald's, Taco Bell, Dairy Queen, Denny's, Jimmy John's, and Dunkin'. Other popular franchises include Hampton by Hilton and Days Inn, as well as 7-Eleven and Anytime Fitness.

Franchise Basics and Regulations

Franchise contracts are complex and vary for each franchisor. Typically, a franchise agreement includes three categories of payment to the franchisor. First, the franchisee must purchase the controlled rights, or trademark, from the franchisor in the form of an upfront fee. Second, the franchisor often receives payment for providing training, equipment, or business advisory services. Finally, the franchisor receives ongoing royalties or a percentage of the operation's sales.

A franchise contract is temporary, akin to a lease or rental of a business. It does not signify business ownership by the franchisee. Depending on the contract, franchise agreements typically last between five and 30 years, with serious penalties if a franchisee violates or prematurely terminates the contract.

In the U.S., franchises are regulated at the state level; however, the Federal Trade Commission (FTC) established one federal regulation in . The Franchise Rule is a legal disclosure a franchisor must give to prospective buyers. The franchisor must fully disclose any risks, benefits, or limits to a franchise investment.

This information covers fees and expenses, litigation history, approved business vendors or suppliers, estimated financial performance expectations, and other key details. This disclosure requirement was previously known as the Uniform Franchise Offering Circular before it was renamed the Franchise Disclosure Document in .

Advantages and Disadvantages of Franchises

Advantages

There are many advantages to investing in a franchise, and also drawbacks. Widely recognized benefits include a ready-made business formula to follow. A franchise comes with market-tested products and services, and in many cases established brand recognition.

If you're a McDonald's franchisee, decisions about what products to sell, how to layout your store, or even how to design your employee uniforms have already been made. Some franchisors offer training and financial planning, or lists of approved suppliers. But while franchises come with a formula and track record, success is never guaranteed.

Disadvantages

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 $1.3 million to $2.3 million, on top of needing liquid capital of $500,000.

By definition, franchises have ongoing fees that must be paid to the franchisor in the form of a percentage of sales or revenue. This percentage can range between 4.6% and 12.5%, depending on the industry.

For uprising brands, there are those who publicize inaccurate information and boast about ratings, rankings, and awards that are not required to be proven. So, franchisees might pay high dollar amounts for no or low franchise value.

With competitive price and timely delivery, THE MIDI. sincerely hope to be your supplier and partner.

Franchisees also lack control over territory or creativity with their business. Financing from the franchisor or elsewhere may be difficult to come by. Other factors that impact all businesses, such as poor location or management, are also possibilities.

Pros

• Ready-made business formula

• Market-tested products and services

• Established brand recognition

• Large decisions already made

• List of approved suppliers

• Training and financial planning provided

Cons

• Success not guaranteed

• Large start-up costs

• Ongoing fees

• Lack of territory choice

• Lack of creative control

Franchise vs. Startup

If you don't want to run a business based on someone else's idea, you can start your own. But starting your own company is risky, though it offers rewards both monetary and personal. When you start your own business, you're on your own. Much is unknown. "Will my product sell?", "Will customers like what I have to offer?", "Will I make enough money to survive?"

The failure rate for new businesses is high. Two-thirds of businesses survive just two years, and 50% survive just five years. If your business is going to beat the odds, you alone can make that happen.

To turn your dream into reality, expect to work long and hard hours with no support or expert training. If you venture out solo with little or no experience, the deck is stacked against you. If this sounds like too big a burden, the franchise route may be a wiser choice.

People typically purchase a franchise because they see other franchisees' success stories. Franchises offer careful entrepreneurs a stable, tested model for running a successful business. On the other hand, for entrepreneurs with a big idea and a solid understanding of how to run a business, launching your own startup presents an opportunity for personal and financial freedom. Deciding which model is right for you is a choice only you can make.

What Are the Advantages of Franchises?

Some of the widely recognized advantages of franchises include a ready-made business formula to follow, market-tested products and services, and, in many cases, established brand recognition. For example, if you're a McDonald's franchisee, decisions about what products to sell, how to layout your store, or even how to design your employee uniforms have already been made. Some franchisors offer training and financial planning, or lists of approved suppliers; however, despite these benefits, success is never guaranteed.

What Are the Risks of Franchises?

Disadvantages include heavy start-up costs as well as ongoing royalty costs. By definition, franchises have ongoing fees that must be paid to the franchisor in the form of a percentage of sales or revenue. This percentage can range between 4.6% and 12.5%, depending on the industry.

There is also the risk of a franchisee being duped by inaccurate information and paying high dollar amounts for no or low franchise value. Franchisees also lack control over territory or creativity with their business. Financing from the franchisor or elsewhere may be difficult to come by and franchisees could be adversely affected by poor location or management.

How Does the Franchisor Make Money?

Typically, a franchise agreement includes three categories of payment to the franchisor. First, the franchisee must purchase the controlled rights, or trademark, from the franchisor in the form of an upfront fee. Second, the franchisor often receives payment for providing training, equipment, or business advisory services. Finally, the franchisor receives ongoing royalties or a percentage of the operation's sales.

The Bottom Line

A franchise can be a great way for an individual to enter the world of entrepreneurship, as the majority of the groundwork has already been laid and you are leveraging off an established, successful, and well-known business and brand name. There are also many businesses with franchises to choose from.

For a fee and start-up costs, you can be on your way to being your own boss and entering a possibly lucrative career. Though it must be noted that success is not guaranteed and franchises require a lot of work to be profitable.

There have been three constants that fueled the growth of franchising: the desire to expand, the limitations on human and financial capital and the need to overcome great distances.  And, while franchising is often thought of as a modern-day invention, its origins can be traced to the expansion of the church and as an early method of central government control before the Middle Ages. Historically, the purpose of commercial franchising was to allow workers or journeymen to establish their own businesses supported by franchisors.   

Franchising in England and Europe

Franchising was used in England and Europe, where the Crown owned land and granted rights to powerful individuals, including the church, to manage its property.  In exchange for these land grants, the noblemen and church officials were required to protect the territory by establishing armies, and were free to set tolls and collect taxes, a portion of which was paid to the Crown.  The nobles divided the land among the local farmers who paid a royalty for the right to use the land either as a portion of the crops they grew or the animals they hunted.  This system of governmental control existed in England until being outlawed by the Council of Trent in .

Much early exploration and trading was conducted through franchising.  For example, the Dutch East India Company () was founded as a franchisee of the Dutch Republic to conduct exploration and trade between the Cape of Good Hope and the Straits of Magellan. Expanding its operations, in the company engaged the services of Captain Henry Hudson to explore the New World and to find a northeast passage in the New World.  Through this arrangement, the Dutch were able to claim the Hudson Valley in New York as far as Albany. 

Another example is the grant by the King of England to the London Company in , granting a charter for Virginia.  Captain Christopher Newport, who was succeeded by Captain John Smith, brought settlers to Virginia and established Jamestown, the first permanent British settlement in the New World.  Following the massacre of the 347 settlers by the Powhatan Indian Confederacy in , the king, charging mismanagement by the London Company, withdrew its charter. 

Commercial co-partnership/franchising relationships existed in England and Europe in the brewery industry. In exchange for financial assistance, tavern owners agreed to purchase all of their beer and ale from the sponsoring breweries.  The breweries did not exercise any controls over the day-to-day operation of the local tavern except for the sole purchase arrangement.  This method of down-stream distribution is known today as traditional, product or trademark franchising.

Modern Day Franchising

In the United States, many histories about modern franchising have often cited Albert Singer and the Singer Sewing Machine Company as being the first commercial franchisor, dating franchising to . However, in , John &#;Albert&#; Singer was only seven or eight years old and the Singer Manufacturing Company never actually offered any franchises.  The company grew through local offices independently managed by its employees.

Commercial franchising in the United States began in the Colonies, in Philadelphia, when on Sept. 13, , Benjamin Franklin and Thomas Whitmarsh entered into an agreement &#;for the carrying on of the Business of Printing in Charlestown in South Carolina.&#; 

While the agreement is not identical to the modern-day franchise system, many of the most important elements we recognize in franchising today were included.  The term of the agreement was for six years; Whitmarsh was required to manage the business himself. He was responsible for the expenses of the business &#; all of the equipment and paper needed for the business were to be purchased from Franklin and Whitmarsh was responsible for maintaining the equipment. In addition, Whitmarsh agreed to an in-term covenant not to engage in any other printing business during the term, while Franklin was free to enter into additional relationships with others. Whitmarsh printed many of Franklin&#;s works including &#;Poor Richard&#;s Almanac;&#; and Franklin had the right to appoint a successor should Whitmarsh die or leave the business.

When Whitmarsh died in , Franklin appointed Louis Timothé to operate the South Carolina printing business.  Upon his death in , Franklin appointed his wife Elizabeth, and then in , her son Peter.  It is interesting to note that Franklin&#;s third franchisee was a woman, giving Elizabeth Timothé the distinction of being the first female publisher in North America.  

Following the establishment of the South Carolina print shop, Franklin went on to establish a series of similar relationships with James Parker (New York); Thomas Smith and  Benjamin Mecom (Antigua); James Franklin Jr. and Ann Franklin (Newport, R.I.); William Dunlap, Samuel Holland and  John Henry Miller (Lancaster, Pa.) and Thomas Fleet (Boston) who published the &#;Boston Evening Post.&#;  In addition to those whose names have been identified, Franklin also entered into relationships for the operation of print shops in Dominica, Jamaica, North Carolina, Georgia, Canada and Great Britain.  Part of Franklin&#;s support while he lived in France negotiating the French entrance into the U.S. war for independence, came from the income he earned from his franchise system. 

While Franklin may have established the first commercial franchise network in North America, there are numerous references in early American history to similar arrangements.   Robert Fulton licensed his steamboats in the United States, England, Russia and India; the federal and local governments executed monopolistic licenses/franchises to build much of the nation&#;s electric and transportation infrastructure; and general stores at military outposts, the sale of livestock and other goods were built on a license/franchise arrangement that provided for exclusive territories and other rights.  

The first modern day franchisor was likely Martha Matilda Harper, a Canadian-American who began to franchise the Harper Method Shops in .  Headquartered in Rochester, N.Y., she included in her hair care franchise many of the elements we have come to expect in a modern commercial franchise system including initial and continuing training, branded products, field visits, advertising, group insurance and motivation.  Harper started her salon business in and grew the franchise system to more than 500 salons and training schools at its peak, with the last location closing in . 

Franchising Expands the United States 

Franchising was instrumental in the expansion and further development of the United States.  Around the turn of the 20th century, the United States entered into its Industrial Revolution and the growing mobility of Americans created opportunities for manufacturers, gasoline retailers, hospitality and restaurant franchises.  The early commercial franchises were in the manufacturing, automotive and beverage industries.  

Because of the Industrial Revolution, the mass production of consumer goods allowed companies to retail their products at a lower cost creating an explosion in consumer demand.  This movement from an agrarian economy to a merchant economy required manufacturers to sell and distribute products efficiently and cost effectively over greater distances. 

General Motors sold its first franchise in to William Metzger of Detroit.  That was a considerable improvement over Henry Ford&#;s use of pharmacies to sell his automobiles. 

As the automotive manufacturers solved their distribution challenges, the need to provide gasoline locally to fuel cars became critical.  Lacking the capital required for purchasing real estate and establishing an adequate distribution system to meet the needs of the growing number of automobiles across the United States, the oil industry began to establish franchised dealerships at the turn of the century.

Beverage companies such as Coca-Cola faced similar challenges as the high cost of transporting finished product in glass bottles kept the soft drink bottling a localized industry.  By shipping syrup concentrate to its franchisees, and requiring the local franchisees to bottle under strict formulas and processes, soft drink manufacturers were able to control the quality of their product in distant markets, and expand rapidly. Coca-Cola issued its first franchise in to the Georgia Coca-Cola Bottling Company.

In , Louis Liggett formed a manufacturing cooperative among 40 independent drug stores, each investing $4,000 to start the manufacturing cooperative of the Rexall Drug Store chain.  Following the end of World War I, the cooperative began to offer franchises to independently owned retail outlets supplying them with branded Rexall products. 

One of the greatest innovations in franchising came in with the establishment of the Western Auto franchise.  Up to that time, product franchisors sought franchisees with industry experience and, except for the supply of branded product, did not provide any significant business-related services.  While still relying on a product markup and not on a royalty, Western Auto provided its franchisees with many of the same services that modern franchisors provide today including site selection and development, retail training, merchandising, marketing assistance and other continuing services. 

In , Roy Allen purchased the formula for his root beer recipe from a pharmacist and, together with his partner, Frank Wright, began to make A&W Root Beer. After buying out Wright, Allen began to franchise the A&W concept in offering car-side service provided by &#;tray boys.&#;  It was only later that A&W added women servers or &#;car hops&#; on roller skates to serve the customers.  Early A&W franchisees were Sherman and J. Willard Marriot who later founded the Marriott hotel chain. The Ben Franklin general merchandise stores and White Castle restaurants also began to franchise in the s.  Hertz began franchising in and Avis followed in .

During the s, Howard Dearing Johnson began selling three flavors of ice cream together with a limited menu of cooked items in his Howard Johnson restaurants and in awarded the first franchise to Reginald Sprague. By then, the company had evolved to selling 28 flavors of ice cream.  Developing a distinctive roadside presence from orange-roofed locations, and featuring one of the first pylon signs with its name and logo, the company secured the first toll road contract on the Pennsylvania Turnpike.  

The innovation of the early franchise and restaurant pioneers influenced others.  Many of the legendary chains that began franchised operations over the next three decades included Kentucky Fried Chicken (); Carvel (); Arthur Murray Dance Studio (); Dairy Queen (); Duraclean (); Dunkin Donuts (); Burger King (); McDonald&#;s (); and The International House of Pancakes ().  The stories of these pioneering concepts have been the basis for many books over the years and the lessons learned are evident in the many food-service chains that followed.

While franchising continued to grow until the beginning of World War II, the truly explosive growth in franchising did not occur until the war was over.  Franchising&#;s emergence in the post-war s took advantage of pent-up consumer demand, an abundance of available franchisees with the returning veterans, and capital provided by separation pay and the GI Bill.  However, the most important post-war event to benefit franchising came in with the enactment of the federal Lanham (Trademark) Act.  Under the act, property owners were able to safely enter into licenses with third parties &#; an essential requirement for franchising to expand. 

Franchising boomed in the s and s with the expansion of branded goods and services chains.  In , McDonald&#;s began to sell stock publicly when it reached 1,000 locations.  The stock opened its trade at $22.50, then closed at $30. At the end of its first month of stock sales, the value had reached $50 a share.  During the same 10-year period, Nate Sherman&#;s Midas Muffler franchise had grown to 400 locations, Kemmons Wilson&#;s Holiday Inn grew to 1,000 locations and Jules Lederer&#;s Budget Rent A Car opened its 500th franchise.  Some of the other brands that emerged during that period were automotive aftermarket: Midas Muffler and Lee Myles; hotels: Holiday Inn and Sheraton; ice cream and treats: Dairy Queen, Tastee Freeze and Orange Julius; convenience stores: 7-Eleven; trades: Roto-Rooter; professional services: Dunhill Personnel, Pearle Vision and H&R Block; laundry and dry cleaning: Martinizing Dry Cleaning.  Subway, the largest franchisor in number of units did not start franchising until , with the opening of its first location in Wallingford, Conn.

Franchising boomed in the s and s with the expansion of branded goods and services chains. 

The rapid growth of franchising did not come without challenges and the International Franchise Association was founded in to begin to address some of the practices in franchising that were at the root cause of these issues.  Today, the IFA represents more than 1,300 franchisors, 10,000 franchisees and more than 600 professionals and suppliers to the franchise industry.   

The evolution of modern franchising, created by the innovative companies and the pioneers that led them, is an exciting story. The future of franchising, energized by still unimagined new concepts, new business techniques and international expansion, promises to add yet more dynamic chapters to the continuing and growing opportunities in franchising.

For more information, please visit retail store franchise.