Franchising is a legal agreement that allows one business to be operated using the name and business procedures of another (1). The value of a franchise is determined by two factors. The first is the rights granted to the franchisee, and the second is the cash flow potential. Each factor is different depending on the franchise you choose. According to the authors of Entrepreneurial Small Business, there are five types of franchising agreements:
1. Trade Name Franchising – only provides the rights to use the franchisor’s trade name and/or trademarks. E.g. TrueValu Hardware
2. Product Distribution Franchising – provides the franchisee with specific brand name products, which are resold by the franchisee in a specified territory. E.g. auto dealerships
3. Conversion Franchising – provides an organization though which independent businesses may combine resources. E.g. Century 21 Real Estate in which individual real estate businesses combined to make a national brand name.
4. Business Format Franchising – includes the rights to trade names, specifications of the product to be sold, operating methods, marketing plan, and national advertising. Franchisees pay an up-front fee to the franchisor to obtain the rights and percentage of gross sales. The prime example of this is McDonalds.
5. Master Franchising – require opening multiple stores within a specified area as well as in a specified time period in which they may do so by selling subfranchises within the development area. Subway is the best example of this type.
Business Format Franchising and Master Franchising are the two types of franchising that will be focusing on.
Why and How Franchising Works
Franchises are an incredible opportunity for those interested in owning and operating a small business without the great risk associated with independent business ownership. In its simplest form, a franchise is a legal agreement between the following two entities:
- Franchisor –sets the conditions and standards and who grants operating permissions.
- Franchisee – pays a fee for the rights, and who agrees to abide by the conditions and standards.
The legal agreement between the franchisee and the franchisor offers a great picture of how a franchise works. When you understand what’s involved, you can understand why the success rate is often higher than that of an independent business. According to the authors of Entrepreneurial Small Business, there are four elements essential for an agreement to constitute as a franchise:
1. The agreement provides the franchisee with a legal right to participate in all aspects of the business such as the offering, selling, or distributing of goods and services.
2. It provides that the franchisee may participate in the business using a marketing plan or system provided by the franchisor.
3. It also grants the franchisee use of a brand name, trademark, service mark, logo, or other commercial symbol which designates the franchisee as an affiliate of the franchisor.
4. It requires the franchisee to pay a fee for the right to enter into the business.
The franchisor is frequently a large company such as McDonald’s Corporation. They know exactly what makes a successful franchise work. It’s also in their best interest for the franchise to succeed because it promotes the franchisor’s company and can, in turn, increase the franchise fee. Therefore, the franchisor company is going to do everything in its power to reduce, if not eliminate, risk in order to structure a successful business.
The price of the franchise can often be an indicator of how successful the franchise will be in comparison to other franchise opportunities. Some franchises will be more expensive than others. Why? The Small Business Administration gives three reasons for this. First, the more expensive franchises are better known in the marketplace; therefore, you are oftentimes buying into the value of a well-known name. The less expensive franchises may not have any name recognition and are possibly looking to expand their presence in the market by offering their franchises at a much lower price. Second, the more expensive franchises probably have proven formulas for success, which means your investment risk factor will be lower than it would be for a less proven franchise system. And finally, the more established franchises have experienced a long history of advertising and promotion of their products that have, in turn, created a higher level of demand for their products, which results in a premium price for their franchise. (2)
Although the success rate of a typical franchisee, regardless of franchise price, is higher than that of an independent business owner, it is still extremely important that you decide if owning a franchise is right for you. If your primary concern is the risk in opening a small business, franchising may be the best option for you, but remember that hard work, dedication, and sacrifice are also required to make any business a success.
What Do You Need to Consider Before Buying a Franchise?
According to one of the leaders in providing small business information, SBA.gov, there are five areas to research when you’re considering buying a franchise (2).
1. Request an information packet from the franchiser.
2. Interview owners of current franchises.
3. Research the industry and other franchises in this industry.
4. Seek expert advice to better understand the franchise agreement.
5. Review costs related to getting into this franchise and compare them to the costs of starting a nonfranchised business in this industry.
Once you thoroughly explored these areas, you’re ready to move select the perfect franchise for you.
On the website SBA.gov, there is a Franchise Directory as well as a link to Franchise Registries and Evaluations (3).
What are the Advantages and Disadvantages?
Before you decide if owning a franchise or turning your successful business into a franchise is right for you, you must weigh the pros and cons.
Advantages (4, 5)
The franchisee benefits greatly from a franchisor’s trademark and business concept. Opening a franchise is in many ways like owning your own business. However, the risk of business failure is reduced when a particular franchise has already proved itself to be successful in the marketplace. The use of an established trademark saves the franchisee the cost of creating a name and marketing it to potential customers or clients. Franchisees do not have to worry about advertising costs because franchisors usually do most of the marketing for the franchise and conduct national advertising campaigns. The advantages of collective buying power make operations more profitable. In addition, franchisors offer franchisees significant training opportunities and mentor them through the initial stages of opening a franchise. This helps the franchisee gain valuable knowledge and expertise instead of having to learn it the hard way through trial and error. With the help of the expertise from franchisors, franchisees can be able to expand and grow their franchise to levels that wouldn’t be possible with a regular business.
Franchisors can expand their business and reduce their risks and costs from selling franchises. Franchisors sell franchises to investors and are able to expand and grow rapidly across countries and continents using the capital and resources of their franchisees. Furthermore, the franchisor may leverage the franchisee by building a distribution network. The need of franchisors to closely manage business operations is greatly reduced because franchisees do a majority of the day-to-day management of the franchise. In addition, franchisors are relieved of many of the tedious duties necessary to start a new business, such as obtaining the required licenses and permits. Franchisors can minimize their risk and thus maximize their profits because the franchisees bear the expense of operating the business in compliance with city, state, and federal laws.
Disadvantages (4, 5, 6)
Franchisees lose much of their control when operating a franchise as opposed to owning their own small business. Franchisees must submit to strict operational requirements and specifications from the franchisor. In addition, the franchisee is under a binding contract and is obligated to accept any alterations as demanded by the franchisor. Furthermore, conflicts may arise when the franchisor is incompetent and does not promote the brand wisely or will not adequately train or assist you when problems arise. Franchisees have little legal power when wronged by the franchisor, because most franchisors make the franchisee sign an agreement waiving their rights under federal and state law.
Franchisors lose much of their operating control to franchisees. It is much more difficult to remove an incompetent franchisee than it is to replace an incompetent manager of a directly owned business. A franchisors’ reputation could be damaged if an incompetent franchisee is cited for legal violations or provides the community with substandard goods and services. In addition to the loss of control over the management of the day-to-day operations of the business, there are a limited number of investors with the financial resources and the desire to purchase and open a franchised business.
What are the Legal Aspects of Owning/Buying a Franchise? (1)
In most cases, franchises are a great way to run your own business at relatively low risk. Unfortunately, this is not true for all franchises. Consider the following legal aspects of franchise ownership before signing the dotted line.
Before you commit to any franchise, you need to personally study two documents:
1. UFOC – Uniform Franchise Offering Circular; this is the standard document franchises use to explain their operations, requirements, and costs to potential franchisees. You can get a guide to help interpret the UFOC at the Federal Trade Commission site.
2. Franchise Agreement – this is the specific contract signed, often incorporating the information included in the UFOC.
Both documents are complex. You may want to consult a franchise lawyer. A lawyer will help you understand the following aspects of franchise ownership:
- If and how you can transfer the franchise license to someone else
- How you may terminate the contract – make sure you are able to terminate in case the franchisor goes bankrupt
- How the franchisor may terminate the contract
- What disclosures you are required to take
For example: If the contract prevents you from transferring the franchise to another if it requires that you achieve unrealistic results to be able to renew, an unscrupulous franchisor will now have the opportunity to take over at a low price. All your money and effort will be for nothing.
Franchising has a history of law suits and fraudulent behavior. Due to these unethical and illegal operations, the U.S. government and all fifty state governments have passed regulatory legislation for franchisors. The minimum disclosure requirement that franchisors must meet is given in Rule 436 of the FTC. Unfortunately, this doesn’t mean that all franchisors are safe. In other words, do your homework and hire a lawyer if at all possible!
Today, finding information on franchising can be very simple and quick. The following are different resources for finding the perfect franchise for you:
- The Internet (7, 8) – There are tons of web sites solely dedicated to franchise opportunities. If you Google search the phrase “franchising opportunity” the result is well over 1 million pages. It takes little time and effort to browse through each site’s database and it is likely you will come across franchises you have never heard of. By going online, you have the ability to see the starting requirements and hoops you will have to jump through to start out strong. Additionally, you will be able to see if a franchise you have in mind will want you as much as you want them. Some of the bigger companies want a good business resume while a home-based business franchise would require less. If you know which Franchises will probably see you as under-qualified, you can avoid wasting your time on them or you can take the necessary steps to get qualified.
Some of the better sites allow you to search by the industry or location. Furthermore, there are some that list each corporation’s contact information which is valuable in acquiring information. There are even some sites that will allow you to get email alerts when new franchise opportunities come up.
One of the most useful and well known sites is http://www.franchise.org. This is the International Franchise Association’s (IFA) website. The IFA’s mission is to protect, enhance, and promote franchising. They are a membership organization that has been around since 1960. Becoming a member grants access to their database of more than 1,200 franchising opportunities. Along with the database, you can find access to a step by step guide for beginners in the world of franchising.
- Franchise Conventions and Expositions (9) – Going to franchise conventions and expositions are great ways to gain knowledge about franchise opportunities. In addition to the knowledge you will receive from franchisors; going to these events will allow you to gain great networking connections which could be of great use to you in the future. The IFA will be hosting the International Franchise Expo during April of 2010 in Washington DC. It is the franchise industry’s premier annual event showcasing hundreds of franchise concepts. This event attracts investors from throughout the United States and over 80 countries. By going to events like this, you can get real answers to all of your questions.
- Daily Newspapers– Often times you can find franchise opportunities in daily newspapers. They can be found in the classified section under “Business Opportunities.” It is not uncommon for a buyer to run a blind ad. A blind ad does not give the name of the franchise; instead, it provides an address to write to for more information. This is a technique that franchisors will sometimes use in order to prevent wasting time with “franchise shoppers” and focus their attention on the “franchise buyers”.
- Franchise and Trade Publications (8) – Many companies find franchises by looking at advertisements placed in trade publications. There are many publications devoted entirely to franchising. Publications can be a great source of information. The so-called bible of franchising is the “National Franchise Report”. This monthly publication reports the details of new franchises offers, lists the current franchise shows, and typically contains an editorial comment. To gain access to these publications, you can check them out at any library as most have subscriptions to them.
- Go to the source– If you know what specific franchise you would like to own, you can go straight to the company to acquire information. For example, if you want to own a McDonald’s franchise, you can go to the company and find out which ones are available for purchase or how you can start your own McDonald’s franchise in your area.
Evaluating a Franchise (10, 11)
After using the different ways to find franchising opportunities, you will most likely have a list of potential franchises to invest in. Before you invest any money or sign any papers, you should do an extensive amount of research on each franchise, particularly if they are a new company. Figuring out which will be the best for you involves a lot of additional research.
Although industry facts and statistics are relatively useful for evaluating the strength of a franchise; the best way to evaluate the opportunity is by looking at how other franchises are doing in the particular market you are interested in. You could compare finding a franchise to finding a stock. If you were looking for a good stock to invest in, it wouldn’t necessarily matter if the market is doing great and going up if your stock is going down.
There are many disreputable franchise operations, so you should be sure you know what you are getting into. Lawyers and franchise consultants offer their services to assist people in choosing franchises; some consultants also conduct seminars. The Federal Trade Commission (FTC) publishes The FTC Consumer Guide to Buying a Franchise and other relevant publications. IFA also provides free buying advice. It would be beneficial to also read the Uniform Franchise Offering Circular (UFOC). The UFOC is a disclosure document in which franchisers must disclose certain information about finances and problems with franchises. The Federal Trade Commission requires all franchisers to supply prospective franchisees with a UFOC.
To further assess the business, you should analyze its potential for success. The following are questions the Small Business Association recommends considering:
- How long has the franchisee operated the franchise?
- Where is the franchise located?
- What was their total investment?
- Were there any hidden or unexpected costs?
- How long did it take them to cover operating costs and earn a reasonable income?
- Are they satisfied with the cost, delivery, and quality of the goods or services sold?
- What were their backgrounds prior to becoming a franchisee?
- Was the franchiser’s training adequate?
- What ongoing assistance does the franchiser provide?
- Are they satisfied with the franchiser’s advertising program?
- Does the franchiser fulfill its contractual obligations?
- Would the franchisee invest in another outlet?
- Would the franchisee recommend the investment to someone with your goals, income requirements, and background?
Along with the answers to these questions you should give a personal survey of the business. This can be done by going to the business itself and watching what takes place. You can take note of the amount of traffic, or see if customers are browsing as opposed to shopping, etc. By visiting the place of business you can further determine if the franchise is the one for you.
1. Entrepreneurial Small Business by Jerome Katz & Richard Green:
Katz, Jerome, and Richard Green. Entrepreneurial Small Business. New York: McGraw-Hill/Irwin, 2009.