Franchise

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DEFINITION of '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.

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