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.

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Franchise

How Franchises Work

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 franchisor and 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 a popular way for entrepreneurs to start a business, especially when entering a highly competitive industry such as fast food. One big advantage to purchasing a franchise is you have access to an established company's brand name. You won't need to spend resources getting your name and product out to customers.

A Brief History of the Franchise

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.

The earliest food and hospitality franchises were developed in the 1920s and 1930s. A&W Root Beer launched franchise operations in 1925. Howard Johnson Restaurants opened its first outlet in 1935, expanding rapidly and paving way for the restaurant chains and franchises that define the American fast-food industry until this day.

There are more than 785,000 franchise establishments in the U.S., which contribute almost $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 Gourmet Sandwiches and Dunkin' Donuts. Other popular franchises include Hampton by Hilton and Day's Inn, as well as 7-Eleven and Anytime Fitness.

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.

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 1979. The Franchise Rule is a legal disclosure a franchisor must give to prospective buyers. The franchisor must fully disclosure 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 2007.

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 disclosure key operating information to prospective franchisees.
  • Ongoing royalties paid to franchisors vary by industry and can range between 4.6% and 12.5%.

Pros and Cons of Franchises

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 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 million to $2.2 million. 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 rating, rankings and awards that are not required to be proven. So, franchisees might pay high dollar amounts for no or low franchise value.

Franchisees also lack control of 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.

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. Roughly 20% of startups don't survive the first year. About 50% last until year five, while just 30% are still in business after 10 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.