You’ve heard the term before, but what exactly does it mean? How does a franchise work?
It may all seem complex at first, but franchising comes down to how a few key components work with each other. Here’s a closer look at how franchising works, including the important foundations of franchising basics!
How Franchising Works
Franchising essentially revolves around the relationship between two parties: the franchisee and the franchisor.
The franchisor is the person or business that owns the trademarks and rights to a business model. They license the right to these trademarks and business model to franchisees, the people or businesses who own and operate the business location using the trademarks and business model licensed by the franchisor in exchange for fees and royalties.
Franchising offers a middle-ground between completely independent small business ownership and total corporate control of a company, as the franchisor ensures that their franchisees are operating under their trademark and approved business practices, while the franchisee still gets to maintain a lot of independence while operating their business as part of a recognized brand with its own training and support system in place.
The franchisor-franchisee relationship forms the crux of franchising and, when done successfully, can help both parties succeed in their respective goals!
What are the Advantages of Franchising?
Franchising, being distinct from both pure corporate control of a business and fully independent business ownership, offers a number of notable benefits due to its unique business model. For both the franchisor and the franchisee, the benefits of franchising can be immense.
Now that we have a better grasp of how franchising works, let’s examine the advantages of franchising for both the franchisor and the franchisee!
Benefits of Franchising for the Franchisor
Franchising offers many advantages for franchisors. Just a few of these include:
- Easy capital for expansion. For businesses, franchising is an excellent way to obtain expansion capital. Since franchisees pay for the right to own and operate franchise units, businesses can expand quickly without having to tap into their own capital or obtain financing from banks and other financial institutions.
- Fast expansion. Franchising also offers the potential for rapid business expansion compared to a top-down plan micromanaged by a corporate boardroom. By giving franchisees a degree of independence, many businesses are able to expand faster and beat out their competitors in key markets.
- Access to talent. Franchising can also make it easy to attract and retain talented managers by offering them a degree of independence and share of the company’s profits.
- Ongoing revenue stream. When franchisees request to license franchise units from a business, they pay an upfront franchise fee and ongoing royalty fees, creating a continuous revenue stream for the franchisor.
- Reduced risk. In franchising, franchisees bear the responsibilities of things like the initial investment in the franchise unit, paying for build-outs, purchasing inventory, hiring employees, and the like. This, in turn, reduces the financial risks for the franchisor and also minimizes the time and energy they need to spend to get each business location up to par quickly and effectively.
Benefits of Franchising for the Franchisee
Franchisees also have much to gain from franchising. A few notable examples include:
- Built-in brand recognition and customer base. Launching an independent business can be intimidating enough, especially since the entrepreneur needs to build up their brand image and attract customers from scratch. However, franchising allows entrepreneurs to tap into an established brand and pre-built customer base, giving them more time to focus on running their business as opposed to creating awareness for it and attracting a steady stream of customers.
- Training and support. One of the great things about franchising is that even people with no business experience can run their own business unit. This is because franchisors provide extensive training and ongoing support in the form of advertising campaigns, employee training instructions, and the like, making it simple for aspiring entrepreneurs with no experience to jump right in and run a business of their own.
- Being your own boss. While franchisees need to adhere to the rules and regulations laid out by the franchisor, they also laid a large degree of independence compared to in-house corporate managers and can truly be their own boss, as franchising offers the independence of running your own small business with the benefits provided by a corporation for support.
- Proven business model. With franchising, entrepreneurs don’t need to spend months or even years trying to figure out the best practices for running their business, as this heavy-lifting has already been done for them.
- Collective buying power. When franchisees purchase a franchise unit, they become part of the franchisor’s larger system and can benefit from the company’s collective buying power and established relationships with various suppliers and vendors.
Franchising vs. Business Opportunities: What’s the Difference?
Now, all of this being said, franchising can still differ quite a bit from a traditional business opportunity. What’s the difference between them? That can be tricky to define, but in general, the key difference between how franchising works and other business opportunities includes:
- Business opportunities don’t often involve the sale of licensing rights as franchising does.
- While franchising involves paying royalty fees to the franchisor, general business opportunities usually don’t do this.
- A business opportunity, generally speaking, isn’t restricted to a specific geographic market or territory as franchise units typically are.
- Most business opportunities don’t offer the ongoing support and initial training for entrepreneurs that franchising does.
So, generally speaking, a business opportunity is usually a one-time deal for an independent business, while franchising involves both franchisees and franchisors working together over the long-term to mutually succeed.
Understanding how franchising works also means understanding the unique costs that franchising entails, especially for franchisees. Here’s a closer look at some of them and what they mean!
Initial Franchise Fee
This is a one-time, upfront fee that franchisees are required to pay in exchange for obtaining the rights to own and operate a franchise unit with the company, as well as receive training and ongoing corporate support. The costs of an initial franchise fee vary greatly by franchise, but typically range anywhere from $2,000 to $100,000.
These are ongoing fees paid by the franchisee to the franchisor, typically on a monthly or quarterly basis. They’re usually calculated as a percentage of gross sales, but may be a fixed dollar amount too.
In some instances, the franchisee is responsible for buying or renting a building for their franchise unit, or buying the land use to construct it. If a franchisee is renting their franchise unit location, they’re typically responsible for any leasehold improvements as well as for paying the monthly lease and a one-time security deposit. In some cases, the franchisor will provide a leasehold improvements allowance and almost always disclose what these costs will be estimated to be in their franchise disclosure document (FDD).
Outdoor signage for storefronts can be pricey. Most franchisors have signage packages already created that the franchisee is required to purchase when building out their location.
Equipment types and costs can vary greatly depending on the franchise itself, though the good news for franchisees is that many banks offer loans for them, as they can serve as collateral.
Opening inventory is typically a two-week supply of product stock, though this is again something that varies by franchise.
Most franchisors require their franchisees to pay into a regional or national advertising fund. While this is an additional expense, it can help boost their franchise’s brand recognition and attract new customers in a cost-effective and efficient way.
Franchisees also need to have a certain amount of working capital on-hand at their franchise location for expenses such as payroll, utilities, and the like.
Franchise Laws and Regulations
Finally, understanding how franchising works means having a solid grasp of franchise law and regulations.
The FTC Rule and Franchise Disclosure Documents (FDDs)
One of the most important Federal franchise laws in the United States was the enactment of the FTC’s Franchise Rule in 1979, which requires franchisors to fully disclose critical information to prospective franchisees to give them as much information as possible before deciding whether to officially join the franchise.
This rule led to the creation of franchise disclosure documents (FDDs), which are 23-point breakdowns of all the key information that entrepreneurs need to know before formally becoming franchisees. This information disclosure must take place at least 10 days before the potential franchisee signs any agreements to allow them to review it carefully and understand its terms in detail.
State Franchise Laws and Regulations
Although the FTC doesn’t require that franchisors register with the Federal government, several states do have registration rules and typically stricter franchise regulations. These registration states are listed below, along with their agency that handles franchise registration and regulations and contact information:
|California||Department of Corporations||(916) 445-7205|
|Hawaii||Department of Commerce, Franchise & Securities Division||(808) 586-2722|
|Illinois||Attorney General’s Office, Franchise Division||(217) 782-4465|
|Indiana||Secretary of State Office, Franchise Division||(317) 232-6681|
|Maryland||Attorney General’s Office, Securities Division||(410) 576-6360|
|Michigan (notice required)||Attorney General’s Office, Consumer Protection Division, Franchise Section||(517) 373-7117|
|Minnesota||Minnesota Department of Commerce, Franchise Division||(651) 296-6328|
|New York||Department of Law, Franchise & Securities Division||(212) 416-8211|
|North Dakota||Office of the Securities Commissioner, Franchise Division||(701) 328-2910|
|Oregon (filing not required)
|Division of Securities, Dept. of Insurance and Finance
Division of Securities, Franchise Office
|South Dakota||Division of Securities, Franchise Office||(605) 773-4013|
|Virginia||State Corporation Commission, Franchise Office||(804) 371-9276|
|Washington||Department of Financial Institutions, Securities Division||(360) 902-8760|
|Wisconsin||Wisconsin Securities Commission, Franchise Office||(608) 266-3364|
Is Franchising Right for You?
After having a strong grasp of how franchising works, it’s important to ask yourself if franchising is right for you. Typically, franchising is a good idea for entrepreneurs who value their independence and want the benefits of small business ownership, but also like the idea of having training and ongoing corporate support to help hone their entrepreneurship skills and business experience.
In general, a successful franchise owner is someone who can communicate effectively, wants to lead others towards a common goal, can understand how to follow the rules, and has a “team player” mindset that values collaboration with others. If that sounds, like you, franchising may be the way to go as an entrepreneur!
Franchising Basics: Putting It All Together to Understand How Franchising Works
So, that’s how franchising works in a nutshell! Understanding the franchising basics is the first step towards deciding if franchising is right for you and something worth pursuing as an entrepreneur.