A franchise is when a business (franchisor) allows a party (franchisee) to acquire its know-how, procedures, processes, trademarks, intellectual property, use of its business model, brand and rights to sell its products and services. The franchisee signs a contract (franchise agreement) with the franchisor to acquire the franchise and generally has a territory granted to operate.
Here at Vetted Biz, we want to help you find the best franchise or business for your investment. But what exactly is a franchise? And how is it different from a traditional business?
The dictionary definition of a franchise is “an authorization granted by a government or company to an individual or group enabling them to carry out specified commercial activities.” In simple terms, it is a business granting another person or group the opportunity to use their ideas, processes, expertise, profit model and more to further expand their own brand.
How exactly does business franchising work? Typically, a successful business with only a single unit will look for ways to expand and grow. There are two ways they can do this — they can do it internally, using their own resources and capital to build more units, or they can franchise their business model. This means allowing outside investors to take their business model and build a new unit elsewhere. While this means that the parent company, or franchisor, might lose out on maximizing revenue, it is a less costly version of expansion since most of the start-up capital will be coming entirely from the outside investor, or franchisee. Furthermore, by charging a royalty and various other fees, franchisors can still make money from expanding their units.
There are both pros and cons to a franchised business, both for the franchisor and the franchisee. As mentioned before, franchisors lose out on maximizing their revenue by allowing external rather than internal expansion. However, at the same time, they spend less resources growing their company. What other pros and cons exist out there?
Grow more, grow fast: By allowing outside investors to share the brunt of the work and costs in business expansion, franchising allows businesses to open more locations quickly and with fewer costs. After all, it’s allowed McDonalds to open more than 36,000 locations and Subway more than 44,000 units, making them titans in their respective industry.
Minimized growth risk: At the same time, even if expansion is occurring at a fast rate, risk is minimized in comparison to growing internally since the liability and costs are being shared with the franchisee
Recruit better talent: Entrepreneurs who have a stake in the business that they are running tend to work harder and stay motivated compared to employees who are managing a unit for a salary.
Loss of control: While franchisors definitely retain significant control over their franchisees, allowing outsiders into their system means an inevitable loss of control over how every single unit under the brand is run. This becomes truer as the franchise system expands, and a major reason why some businesses still refuse to franchise.
Differing goals: Franchisors make money from royalties, which are typically a gross percentage of sales, while franchisees make money from profits. So why is this a problem? Sales and profits are NOT the same thing. In fact, having high gross sales can be detrimental to profits, such as in the circumstance of selling goods that have a high cost. This is not always the case, but with certain business models this can create conflict between the franchisor and franchisee over what to prioritize.
Limited Innovation: It is harder to implement changes into the core business model since these changes will have to be implemented into all of the franchise units. This is far more difficult to coordinate with a franchise system as opposed to internally, where there is more control.
Minimize risk: Unlike coming up with an entirely new business model on one’s own, franchisees have the benefit of operating a (theoretically proven) successful business model. They don’t have to agonize over important decisions on how to operate their business — these have already been instructed to them by the franchisor. Of course, this is not always true and it is important to be wary of franchises that have a high failure rate.
Brand Recognition: Since a franchise system is essentially expanding upon a pre-existing business model, there is bound to be an already existing customer base and less effort needs to be put into making the business known in the market. In fact, many franchisors handle much of the marketing for the business on their own, which franchisees contribute to with a Marketing/Advertising fee.
Support in starting the business: Unlike entrepreneurs looking to start a business entirely on their own, franchisees have the benefit of access to a support system from the very beginning of opening their unit. The franchisor will usually provide important training, resources, and information so the franchisee is prepared to launch and subsequently operate the business successfully.
Limited Innovation: This is a con for the franchisee as well as the franchisor. Franchisees must stick to the business model that they have been given, and there is usually little room for major changes or innovation since they are bound by the franchise agreement. In fact, not sticking to the agreement can lead to severe penalties from the franchisor.
Predatory practices: Not all franchises are worth the investment. Some franchises, like Subway and 7-Eleven have a history of abusing their franchisees with unrealistic and unprofitable regulations, seizing back franchises for minor infractions, or building franchise units close to each other, creating unnecessary competition.
Additional Costs and Fees: All franchisees must pay a royalty fee to the franchisor, which may be of different amounts. They also have to pay other costs and fees that deal with both the initial set-up and ongoing operation of the business, such as an advertising fee, training fee, and opening inventory costs. However, much of these fees and costs have to do with the operation of the business, so ultimately are not much different than the costs associated with launching your own business.
You may have heard about another type of business expansion called licensing, and you may be wondering how this is different from franchising. After all, they both encompass the expansion of a brand by an outsider for a fee. The most important difference between franchising and licensing, however, is that licensing involves more independence — it is essentially a legal contract that allows for the use of a trademark in exchange for a fee. Licensed stores are often found in already existing businesses, like a Starbucks in a Macy’s department store.
While this independence might seem like an advantage over franchising, it is important to remember that one advantage of franchising is the support that the investor gets from the parent company. Franchisors provide a detailed business plan for the franchisee to follow, including everything from workplace training to health and safety measures along with service etiquette. This is something that licensees simply do not have — while they may have the trademark, the success of the business depends entirely on them.
Licensing is typically used for companies that are product heavy, while franchising is usually used for businesses that are service oriented. One real life example of licensing is Disney. Disney allows manufacturers to use their trademarks (aka the characters and images they create) to sell their products, but nothing more. While manufacturers enjoy the advantage of having a household name like Disney featured on their products, it is entirely up to them to actually sell them.
On the other hand, franchising is much more of a hands-on endeavor. For example, if one wants to invest in a McDonald’s franchise, not only will they be allowed to sell products under the McDonald’s trademark, but they will also receive all the necessary information and support on how to jumpstart their business.
There are several examples of major companies that allow for their units to be licensed rather than franchised.
An important element of investing in a franchise is the franchise disclosure document, or FDD. This document has all the crucial information one must know about a franchise, and also includes the franchise agreement, or legal contract that one enters into when investing in a franchise.
Under the Franchise Rule, a policy enforced under the Federal Trade Commission, all prospective franchisees must receive this disclosure document upon request. So what kind of essential information does the FDD contain?
Background and history of the franchise company in Item 1
Any litigation or bankruptcy involving the franchisor in Items 3 and 4, respectively. This is important since a franchisor with a history of litigation with franchisees could mean an unstable business model and a history of bankruptcy could mean financial insecurity within the business
Costs of owning/operating the franchise in Item 5 (initial franchise fee), Item 6 (other fees and expenses), and Item 7 (total estimated initial investment)
Financial performance representations in Item 19*
Number of units opened/closed in Item 20
*Note: Not all franchises disclose financial performance representations
If you are researching different franchises to invest in, it is important to know what to look for. Below are some examples of traits that successful franchises have in common.
High net profit: This information can be found in the Item 19 of an FDD. Although high net revenue or net sales may seem promising, it is important to remember that there are multiple elements of running a business that must be financially accounted for. For example, a business may have a high gross profit, but their net profit could be very low if costs to operate the business are too high.
Low failure rate: The number of franchises that have closed down can be found in Item 20 of the FDD. This is an important metric to calculate because franchises with a high failure rate, or many closures, are usually a sign of an unsuccessful or unprofitable business model.
High growth rate: The number of franchise projected openings can also be found in the Item 20 of the FDD. If a franchise company is projected to expand quickly and significantly, this is likely a sign that the business model is popular and has a lot of potential. However, it is important to also look at the failure rate and compare the two metrics — a franchise could have a high growth rate but counteracted by a high failure rate.
Lack of history with litigation and bankruptcy: This can be found in Items 3 and 4 of the FDD. If a franchise company has a long history of lawsuits, especially with their franchisees, or a history of bankruptcy, this could be a sign of an unsuccessful franchise model.
Industry outlook: Is the industry of the franchise expected to grow or shrink over the coming years? How has the industry been impacted by the COVID-19 pandemic? What are the average costs, fees, and success rates of franchises in a particular industry? These are all important factors to consider and find answers to before investing in any franchise in a particular industry.
Costs and fees: Does a prospective franchise have abnormally high start-up and operational costs as well as high initial and ongoing fees? These will all eat into the profitability of the business, so even if the franchise makes high net sales, it will ultimately be unprofitable. Some franchises also have a progressive royalty fee, meaning that the more a franchise makes, the more they will have to pay to the franchisor a percentage of their profits.
Investing in any business comes with a certain level of risk. Even if all the proper research is done, there is always a chance that the business will fail due to factors outside of your control. This is what we are here for — we want to make the franchise process as smooth as possible for you, providing transparent and accessible information so you can always put your best foot forward.
Thinking of investing in a franchise? Unsure where to start? Make sure to check out the listings page on the Vetted Biz website, where you can explore thousands of franchise options organized by industry and category.