What Is a Franchise?

A franchise is a type of license that a party (franchisee) acquires to allow them to have access to a business's (franchisor) 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 an initial start-up and annual licensing fees.



How Franchises Work

When a business wants to increase its market share or increase its geographical reach at a low cost, it may create a franchise for its product and brand name. A franchise is a joint venture between a franchisor and a franchisee. The franchisor is the original or existing business that sells the right to use its name and idea. The franchisee is the individual who buys into the original company by purchasing the right to sell the franchisor's goods or services under the existing business model and trademark.

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.

A Brief 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 2017 top 15 business franchises include McDonald’s, Taco Bell, Dairy Queen, Denny’s, Jimmy John’s Gourmet Sandwiches, and Dunkin’ Donuts. Other popular franchises include the chain hotel industry such as Hampton by Hilton and Day’s Inn, as well as 7-Eleven Inc. and Anytime Fitness.

While startup costs and earning potential are obviously crucial factors to consider, you also have to do your homework and take a hard look at the failure rate; plenty of first-time franchise owners have defaulted on SBA loans for franchises that have failed to thrive—and you might be surprised to find out which ones are the guilty culprits.

Franchise Basics and Regulations

Franchise contracts are complex and vary for each franchisor. Typically, a franchise contract agreement includes three categories of payment that must be made to the franchisor by the franchisee. First, the franchisee must purchase the controlled rights, or trademark, from the franchisor business in the form of an upfront fee.

Second, the franchisor often receives payment for training, equipment, or business advisory services from the franchisee. Lastly, the franchisor receives ongoing royalties or a percentage of the business’s 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 franchisor that outlines all of 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.

Key Takeaways

  • A franchise is a type of business whereby a business owner licenses the rights to operate a particular company, along with its products, branding, and knowledge, for a fee.
  • The franchisor is the business that grants licenses to various franchisees,
  • Franchise contracts are complex, and the costs and responsibilities to potential franchisees will vary from offer to offer.
  • While some franchises are established brands with lower risk and a reliable customer base, others are risky and may require a substantial financial outlay to the franchisor.

Pros and Cons of Franchises

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 $1 million to $2.2 million.

Franchises, by definition, have ongoing costs to the franchisor company in the form of a percentage of sales or revenue. This percentage can range from 4% to 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 franchisor. Other factors that affect all businesses, such as poor location or management, are also possibilities.

Franchise vs. Startup

If you don't want to carry on somebody else's idea for a business, you can start your own. While founding your own company has plenty of potential rewards, both monetary and personal, it is also risky. When you start your own business, you are on your own, and much is unknown. Will the product sell? Will customers like it? Will I make enough money to survive?

Also, the failure rate is high. Statistics show that 25% of startup businesses don’t survive the first year. About half make it to year five, while approximately 30% last ten years. If your business is going to survive, you alone will have to make that happen. To turn your dream into a reality, you can expect to work long, hard hours with no support or expert training. If you try this on your own without any experience, the deck is stacked against you. If this sounds like too big a burden to bear, the franchise route may be a wiser choice.

People purchase a franchise because the model often works. It offers careful entrepreneurs a stable, tested model for running a successful business. It also requires them to operate on someone else’s business model. For those 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.