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Franchising: Opportunities and Challenges
Business Essentials · Chapter 4: Business Ownership, Growth, and EntrepreneurshipSection 4.3 · lesson 21 of 10514 min · free with a free account
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In this lesson
Owning a business built on a brand you do not own.
- Describe the franchise relationship and its forms
- Explain what each side provides and pays
- Weigh the advantages and constraints on both sides
- Assess a described franchise opportunity
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Business Ownership, Growth, and Entrepreneurship
Franchising: Opportunities and Challenges
Franchising is one of the most common ways people come to own a business. It promises a tested format, a known brand, and support, in place of starting from nothing. Earlier we met franchising as a way into foreign markets, and as a form of ownership. Here we treat it in full, as a route to owning and to growing a business. We'll look at what each side provides, what the franchisee really pays, and what each side gains and gives up. Then we'll read the agreement, especially the clauses that people examine least. And we'll test an illustrative franchise against its own numbers. Keep one question in mind throughout. What exactly does the franchisee own?
The Relationship
Owner and Licensee at Once
Franchising is a contractual arrangement. One party, the franchisor, licenses a business format, a brand, and a system to another party, the franchisee. The franchisee operates a business under them, and pays for the privilege. The essential point, and the one most often blurred in casual talk, is what each party owns. The franchisee owns a business. That includes its lease, its equipment, its staff, and its customers. And the franchisee bears the risk of running it. But the franchisee does not own the brand, or the system. Those remain the franchisor's property. The franchisee only has the right to use them, under the agreement's terms, and for its period. So a franchisee is an owner and, in an important sense, a licensee at the same time. The value of the business depends on the continuing right to use something it doesn't own.
Two Forms
Selling Products, or Running a Format
Two forms of franchising are distinguished. In product distribution franchising, the franchisee sells the franchisor's products under the franchisor's trade name. It typically acts as a distributor or dealer, and the franchisor supplies the goods. Motor vehicle dealerships are an example, and so are some beverage distribution arrangements. Business format franchising goes much further. The franchisor licenses a complete way of doing business. The brand, the operating methods, the training, the marketing, and the supply arrangements. The franchisee then operates a unit in that format. Think of restaurants, fitness studios, and service businesses. This is what the word franchising usually means in everyday use, and it's our focus for the rest of the section.
Division Of Labor
What Each Side Provides
The arrangement works because each side brings something different. The franchisor provides a brand that customers recognize, and a proven system that documents how the business is run. It provides training for the franchisee and staff, and supply arrangements for goods and materials. It provides marketing that promotes the brand as a whole. And it provides ongoing support, through advice, field visits, and updates to the system. The franchisee provides the capital to open the unit, and to keep it going. It provides the local operation, meaning the daily work of managing, hiring, and serving customers. And it provides adherence to the system. The business runs the way the agreement and the operating manual require. Here's the logic. The franchisor contributes what it can spread across many units, the brand and the system. The franchisee contributes what a local owner does best. Capital, and motivated attention to one business.
The Payments
Four Payments, and the Cost People Miss
Four kinds of payment flow from franchisee to franchisor. An initial franchise fee is paid at the outset, for the right to open, and for training and start-up help. A royalty is an ongoing payment, usually a percentage of the unit's sales. Notice what that means. It's due whether or not the unit is profitable. A marketing contribution is an ongoing payment into a fund that promotes the brand. And required purchases are the equipment, supplies, and services the franchisee must buy, often from the franchisor or approved suppliers. Their prices may be above what independent suppliers would charge. The franchisor may also charge technology fees, training fees, and fees on renewal or transfer. So the total cost is frequently understated in a prospective franchisee's own calculation. The most common omissions are a working-capital reserve to cover the losses of the early months, and the premium on required purchases. The smaller recurring fees get missed too. Count only the fee and the build-out, and the money may run out before the business becomes viable. Later chapters show why under-capitalization is the most common route to failure.
For The Franchisee
Reduced Risk Is Not No Risk
For the franchisee, the advantages are three. Risk is reduced compared with an independent start, because the format has been operated before and its methods tested. The established brand brings customers who already know what to expect. And the operating support spares the franchisee from inventing every process. But here's the honest caveat. Reduced risk is not the absence of risk. Failure rates vary widely by system, and reliable comparative data are limited. A franchisee can lose everything invested in a unit, even under a well-known brand. It still carries the lease, the debt, and the operating risk, and it depends on the franchisor's continuing success. The constraints are the price of the advantages. The menu or service list is prescribed. Pricing may be set or capped by the franchisor, within the limits of competition law. Suppliers are restricted, and location may be approved or even dictated. The agreement governs almost everything. So someone seeking an owner's independence may find a different reality. It's closer to being a manager, who also bears the risk.
For The Franchisor
Growth Through Other People's Capital
Now the franchisor's side. Franchising lets a brand expand using the franchisees' capital, so the franchisor doesn't have to raise the money to open each unit. It gets motivated local operators, because an owner has a stronger incentive than a salaried manager. And it gets faster reach, since many units can open at once. Against that, it accepts a loss of direct control. Franchisees are independent businesses. They can't be directed the way employees can. It also accepts reputational risk. A poorly run unit harms the brand, because customers can't tell franchised units from company-owned ones. That's why managing quality across the network, through standards, inspection, and training, is central to a franchisor's work.
Table 4.3.1
Obligations, Benefits, and the Governing Clause
The whole relationship can be mapped as obligations and benefits, each tied to a specific provision. The franchisor grants the right to use the brand and system in a defined area. In return, it gets fees, royalties, and growth on someone else's capital. That's governed by the license grant and the territory provisions. It provides training, an operating manual, and ongoing support, which gives it a consistent network. And it uses the marketing contributions to promote the brand and maintain standards, which strengthens every unit. The franchisee pays the initial fee, royalties, marketing contribution, and other fees, in return for the right to use the brand and system. It operates according to the system and buys from approved suppliers. In return, it gets a tested method and supply arrangements. And it provides capital, staff, and local management, and keeps records and reports sales. In return, it owns the unit's profits and value. Each obligation on one side matches a benefit on the other. So if you want to know what you can expect, or what you must do, read the provision. Don't rely on the brochure.
Disclosure And Assessment
Before You Sign Anything
Franchises are regulated. In the United States, the Federal Trade Commission administers a disclosure rule. A franchisor must give a prospective franchisee a Franchise Disclosure Document before any binding agreement is signed, or any money paid. There's also a minimum waiting period. The document sets out standardized information. That includes the franchisor's background and litigation history, the fees, and the initial investment. It covers the restrictions on the franchisee, the agreement's terms, and a list of current and former franchisees. Information on existing units' financial performance is included only at the franchisor's option. A number of states have their own franchise laws. Some require registration, and some regulate when a franchisor may terminate or refuse to renew. So assess the opportunity through questions, documents, and people. Ask how the unit makes money after every payment, and how many units closed or changed hands. Ask how healthy the franchisor is, and what happens at the end of the term. Read the disclosure document, the draft agreement, and financial statements, with an accountant's help. And talk to current and former franchisees, plus a franchise lawyer and an accountant who are not paid by the franchisor. The assessment is the buyer's to carry out.
The Clauses Read Last
Four Provisions That Decide Later Value
Four provisions largely decide what the business is worth later. They're examined least, because at signing they seem remote. Territory defines where the franchisee operates, and whether that area is exclusive, or merely protected in some respects. Encroachment, where a nearby unit or online sales take your customers, is a frequent source of dispute. Renewal decides what happens when the term ends. There may be no right to renew. Or the franchisee may have to sign the franchisor's current form, with new fees, or an obligation to remodel. Transfer governs selling the business. It usually needs the franchisor's approval, and may give the franchisor a right of first refusal. Since a franchisee normally exits by selling, transfer limits bear directly on the value of the business. Termination sets the grounds for ending the agreement, whether there's a period to cure a default, and what follows. That can include losing the brand, and a restriction on competing nearby. Disputes recur around the same issues. Encroachment, purchase prices and rebates, the marketing fund, and remodeling demands. Add the enforcement of standards, termination, claims about unit performance, and refusals to approve a transfer.
Worked Application
Testing a Franchise Against Its Own Numbers
Here's how to test a franchise against its own numbers. All the figures are illustrative. Suppose the literature says a typical unit reaches annual sales of six hundred thousand dollars by year three. The unit's own costs, for goods, labor, rent, and utilities, come to four hundred seventy thousand dollars. That leaves an operating profit of one hundred thirty thousand dollars, before the franchisor is paid. Royalty and marketing contribution take about sixty-four thousand dollars. The purchase premium adds twelve thousand, and the smaller fees six thousand more. That's eighty-two thousand dollars to the franchisor's side, before a single wage or rent payment. Many people stop calculating right there. What's left for the franchisee is forty-eight thousand dollars. That's the return to the franchisee's labor, and to three hundred seventy-five thousand dollars of capital, including the reserve for the early months. Is it enough? Compare it with what the franchisee could earn in wages, the idea of opportunity cost, and what the capital could earn elsewhere. Someone counting only the fee and build-out would think the capital was two hundred ninety thousand dollars, and the return far higher. And ask about the six hundred thousand figure itself. How many units fall below it, how long did they take, and how many closed first? A figure that describes the best units can be true, and still mislead you about the unit you'll actually run.
Case Vignette
The Clauses Read Last
Let's close with a composite case. Devon signs on to open a franchised fitness studio, after comparing fees, brand reputation, and start-up costs against two other systems. The agreement is long. Devon and a friendly adviser focus on the price and the training, and give little attention to territory and renewal. The studio grows well over the first term. Near the end of the term, two things happen. The franchisor starts selling online classes to customers in the same area, and opens a company-owned studio in a neighboring town. The agreement offers only limited protection. Then the franchisor offers renewal, but only on its current form, with a higher royalty and a remodel at Devon's expense. Devon can accept, or decline and lose the brand. Without it, the business would be worth far less. At signing, the trade-off was the time and cost of a proper legal review, against the apparent safety of a well-known brand. After eight years of building a customer base, there was no bargaining position left. Devon's conclusion is the lesson. The provisions that seem remote at the start decide who receives the value of the years in between.
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