Franchises and Franchise Opportunities

Four types of franchising

According to Webster's Encyclopedic Unabridged Dictionary, a franchise is permission granted by a manufacturer to a distributor or retailer to sell his/her products and the territory to which such permission extends. The legal definition expands this meaning -- a franchise may also extend the right to use a predetermined method for marketing products or services through outlets that use a known name or trademark. The International Franchise Association, the major trade association in franchising, defines franchise as a "continuing relationship in which the franchisor provides a licensed privilege to do business, plus assistance in organizing, training, merchandising and management in return for a consideration from the franchise." There are four basic types of franchises used by business in the United States.

Product Franchise.

Manufacturers use the product franchise to govern how a retailer distributes their product. The manufacturer grants a store owner the authority to distribute goods by the manufacturer and allows the owner to use the name and trademark owned by the manufacturer. The store owner must pay a fee or purchase a minimum inventory of stock in return for these rights. Some tire stores are good examples of this type of franchise.

Manufacturing franchises.

These types of franchises provide an organization with the right to manufacture a product and sell it to the public, using the franchisor's name and trademark. This type of franchise is found most often in the food and beverage industry. Most bottlers of soft drinks receive a franchise from a company and must use its ingredients to produce, bottle, and distribute the soft drinks.

Business opportunity ventures.

These ventures typically require that a business owner purchase and distribute the products for one specific company. The company must provide customers or accounts to the business owner, and, in return, the business owner pays a fee or other consideration as compensation. Examples include vending machine routes and distributorships.

Business format franchising.

This is the most popular form of franchising. In this approach, a company provides a business owner with a proven method for operating a business using the name and trademark of the company. The company will usually provide a significant amount of assistance to the business owner in starting and managing the company. The business owner pays a fee or royalty in return. Typically, a company also requires the owner to purchase supplies from the company.

Terms and definitions

Several terms are commonly used in association with the concept of franchising. A person interested in purchasing a franchise needs to be familiar with these terms. Here you will find explanations for the most important franchising terms.

Franchise

A legal agreement that allows one organization with a product, idea, name or trademark to grant certain rights and information about operating a business to an independent business owner. In return, the business owner (franchisee) pays a fee and royalties to the owner.

Franchisor

A company that owns a product, service, trademark or business format and provides this to a business owner in return for a fee and possibly other considerations. A franchisor often establishes the conditions under which a business owner operates but does not control the business or have financial ownership. McDonald's is an example of a franchisor.

Franchisee

A business owner who purchases a franchise from a franchisor and operates a business using the name, product, business format and other items provided by the franchisor. For example, McDonald's sells a franchise to a franchisee. This allows the franchisee to open and operate a McDonald's fast-food restaurant.

Franchise fee

A one-time fee paid by the franchisee to the franchisor. The fee pays for the business concept, rights to use trademarks, management assistance and other services from the franchisor. This fee gives the franchisee the right to open and operate a business using the franchisor's business ideas and products.

Royalty fee

A continuous fee paid by the franchisee to the franchisor. The royalty fee is usually a percent of the gross revenue earned by the franchisee.

Franchise trade rule

A law regulated by the Federal Trade Commission that places several legal requirements on franchisors. It requires that franchisors disclose all pertinent information to potential buyers of a franchise. These disclosures provide potential buyers with most information needed to make a wise purchasing decision.

Federal Trade Commission (FTC)

A commission authorized by the United States Congress to regulate the franchise business. The Federal Trade Commission oversees the implementation of the Franchise Trade Rule and monitors the activities of franchisors. You can register complaints about a franchisor with this agency. Contact the office of your local U.S. Representative or Senator for information about how to register a complaint with the FTC.

Disclosure statement

Sometimes called an offering circular, a document that provides information on twenty items required by the FTC. The law requires that a franchisor provide a disclosure statement to a potential franchise buyer.

Trademark

A distinctive name or symbol used to distinguish a particular product or service from others. A trademark must be registered with the U.S. Patent and Trademark Office. It can be used exclusively by the owner, and no one else can use it without the owner's permission. Part of a franchise's value is the right to use a recognized trademark.

The franchisor's perspective

What motivates a business to offer a franchise? The answer to this question will help a potential franchisee become a more knowledgeable consumer. Understanding the franchisor's perspective can help the franchisee select a franchise and negotiate its purchase.

More rapid expansion. A primary reason for a business to become a franchisor is the capability to expand more rapidly. A lack of capital and a dearth of skilled employees can slow business expansion. The franchisee provides both when a new outlet is opened. A franchisor may assist a franchisee in obtaining financing for a new business, but the franchisee bears the liability for repayment of the funds. In addition, the franchise owner usually is selected because of his/her business experience and management skills. Thus, a franchise operation is a mutually beneficial proposition for both the franchisor and the franchisee.

Higher motivation. When a business franchises its operations, it acquires a motivated group of managers. Each manager is an owner and has a high level of motivation for success. A manager is also more accountable for actions because the manager as an owner is totally responsible for business outcomes. This means that a potential franchisee should ask why a franchisor wants the franchisee to purchase a franchise. If the only benefit a franchise brings is money, the franchisee should be cautious about why the franchisor wants to do business.

Capital. There is another advantage to franchising a business. It allows a company to raise money without selling an interest in the business. The franchisor uses franchise fees for business expansion. Issuing stock often results in reduced control and less profits per shareholder. Loans are often given with certain provisions attached and cost a significant amount of money in the form of interest paid. Franchising is an alternative that overcomes these disadvantages. However, it is useful to explore some drawbacks faced by a franchisor.

Image. The name and image of a company are at risk when it is sold to other individuals. Thus, a franchisor is often quite particular about quality and the standards that franchisees are expected to meet. Franchisors therefore usually designate very specific business practices that franchisees must follow. The concern over image also helps explain why many franchisors reserve the right to buy back a franchise operation. Potential franchisees can take comfort in the fact that most franchisors want to see them succeed. This also motivates franchisors to provide the support necessary to help achieve success.

Less profitability for franchisor. Another disadvantage to a franchisor is the sacrifice of profits. A company-owned outlet is often more profitable than a franchise. In addition, the company owns the outlet's assets. A potential franchisee should consider future motivations of a franchisor when purchasing a franchise. Will the franchisor try to buy back a business after a franchisee invests the time and energy to make the operation profitable? A franchisor should view the success of a profitable operation as beneficial to both parties.

Potential competition. Franchising a business also has the liability of training competitors. Franchisees may learn how a business operates and then decide to replicate the operation under another name. This has happened to some franchisors, so it makes others cautious. A good franchisor will try to establish a positive relationship with franchisees to avoid this problem. The restrictions placed on franchisees are usually balanced by rewards in an attempt to retain their loyalty.

As you review a franchise agreement, keep in mind the franchisor's perspective. Look for an agreement that takes a balanced approach. A good franchisor is one that desires to create a relationship where both parties are winners.

The franchisee's perspective

It is important to consider the benefits and costs from the franchisee's perspective before deciding to buy a franchise.

Benefits

The following benefits provide a good rationale for starting a business by purchasing a franchise. These must be balanced by the costs or disadvantages.

Lower Risks. Most business experts agree that a franchise operation has a lower risk of failure than an independent business. The statistics on this vary depending on the definition of failure. Whatever statistics are used, they consistently suggest that a franchise is more likely to succeed than are independent businesses.

Established product or service. A franchisor offers a product or service that has sold successfully. An independent business is based on both an untried idea and operation. Three factors will help you predict the potential success of a franchise. The first is the number of franchises that are in operation. The second predictor is how long the franchisor and its franchisees have been in operation. A third factor is the number of franchises that have failed, including those bought back by the franchisor.

Experience of franchisor. The experience of the franchisor's management team increases the potential for success. This experience is often conveyed through formal instruction and on-the-job training.

Group purchasing power. It is often possible to obtain lower-cost goods and supplies through the franchisor. Lower costs result from the group purchasing power of all franchises. To protect this benefit, most franchise agreements restrict the franchisee from purchasing goods and supplies through other sources.

Name recognition. Established franchisors can offer national or regional name recognition. This may not be true with a new franchisor. However, a benefit of starting with a new franchisor is the potential to grow as its business and name recognition grow.

Efficiency in operation. Franchisors discover operating and management efficiencies that benefit new franchisees. Operational standards set in place by the franchisor also control quality and uniformity among franchisees.

Management assistance. A franchisor provides management assistance to a franchisee. This includes accounting procedures, personnel management, facility management, etc. An individual with experience in these areas may not be familiar with how to apply them in a new business. The franchisor helps a franchisee overcome this lack of experience.

Business plan. Most franchisors help franchisees develop a business plan. Many elements of the plan are standard operating procedures established by the franchisor. Other parts of the plan are customized to the needs of the franchisee.

Start-up assistance. The most difficult aspect of a new business is its start-up. Few experienced managers know about how to set up a new business because they only do it a few times. However, a franchisor has a great deal of experience accumulated from helping its franchisees with start-up. This experience will help reduce mistakes that are costly in both money and time.

Marketing assistance. A franchisor typically offers several marketing advantages. The franchisor can prepare and pay for the development of professional advertising campaigns. Regional or national marketing done by the franchisor benefits all franchisees. In addition, the franchisor can provide advice about how to develop effective marketing programs for a local area. This benefit usually has a cost because many franchisors require franchisees to contribute a percentage of their gross income to a co-operative marketing fund.

Assistance in financing. It is possible to receive assistance in financing a new franchise through the franchisor. A franchisor will often make arrangements with a lending institution to lend money to a franchisee. Lending institutions find that such arrangements can be quite profitable and relatively safe because of the high success rate of franchise operations. The franchisee must still accept personal responsibility for the loan, but the franchisor's involvement usually increases the likelihood that a loan will be approved.

Proven system of operation. An attractive feature of most franchises is that they have a proven system of operation. This system has been developed and refined by the franchisor. A franchisor with many franchisees will typically have a highly refined system based on the entire experience of all these operations.

Costs

The benefits to purchasing a franchise explain why more than 500,000 franchise opportunities exist in the United States. However, this compares to almost 14 million independent businesses. There are obviously reasons why not everyone chooses the franchise option.

Payment of franchise fee. A major drawback to starting a franchise is the initial franchise fee. This can range from a few thousand to several hundred thousand dollars. There are two critical matters that affect your decision about buying a franchise. These are whether you can afford the franchise fee and if you can expect a reasonable return on investment.

On-going royalty fees. Franchisors also will typically require a franchise to pay continuous royalty fees. The fees are a percentage of the gross income form the business. Usually the royalty fee is less than ten percent. Some franchisees begin to resent the royalty fees after several years because they have developed experience and built a strong customer base. This success often results in a feeling that the business could continue without the assistance of the franchisor. Besides the royalty fee, franchisors often require a cooperative marketing payment that amounts to a small percentage of gross income.

Conformity to standard operating procedures. It is important to understand that for most franchisors, there is just one way to do things, and that is their way. Success results from proven methods of operation, so the franchisor does not want any variations. A franchisee can become frustrated when he or she believes that there is a better way to do things.

Inability to make changes readily. A franchisor may prohibit you from selling products or services other than those approved by the franchisor. These restrictions are difficult to follow when you believe that there is strong customer demand for a new or different product. There is often a method for making suggestions, but this can be cumbersome and time-consuming. The franchisee is subject to decisions made in the central office of the franchisor. As a franchisee, you must be willing to limit your independence as an entrepreneur.

Underfinanced, inexperienced, weak franchisor. It is important to realize that all franchisors are not equal. You may have more to offer the franchisor than the franchisor has to offer you. It is critical that you carefully check the credentials of the franchisor's management team and board of directors. However, do not ignore a franchisor just because the franchisor is new. Doing this may result in the loss of a great bargain. How many people wish they could have bought a McDonald's franchise when Ray Kroc first began selling them?

Duration of relationship. There is typically no way to extricate yourself from a relationship with a franchisor other than to sell the business. Find out what restrictions exist on selling the franchise to another person. Also, determine what conditions must exist to force the franchisor to buy back the operation. Given the permanency of most franchise relationships, you need to ask yourself whether you want to be involved with the franchisor for the rest of your business career.

Dependent on franchisor's success. The success of a franchise is usually dependent on the franchisor's success. Some well-known franchisors have failed such as Lums and Arthur Treacher's Fish & Chips. When this occurs, the franchisee usually fails. Carefully examine a franchisor's business plans and financial reports. This will help identify potential weaknesses. However, many problems occur when a franchisor is purchased by a larger corporation or when a new management team is brought in to run the business. When this occurs, the franchisees are unable to control the situation.

People who decide to purchase a franchise are typically happy with their decision. According to a 1992 Gallup poll, 73 percent of franchisees met or exceeded their expectations. The growth rate for franchise operations often outpaces the economy. Thus, franchising can be an excellent choice. But is it the right choice for you?