What is Franchising?

Franchising is based on a marketing concept that can be adopted by an organization as a strategy for business expansion. However, franchising can also be used in businesses that are just starting.

Franchising can be described as a contractual relationship between two legally independent entities, a franchisor, and a franchisee, the brand owner - the franchisor licenses some or all of its know-how, procedures, intellectual property, use of its business model, brand, and rights to sell its branded products and services to a franchisee. In return, the franchisee pays certain fees and agrees to comply with certain obligations, typically set out in a franchise agreement.

For the franchisor, the use of a franchise system is an alternative business growth strategy, compared to expansion through corporate-owned outlets or chain stores. Adopting a franchise system business growth strategy for the sale and distribution of goods and services minimizes the franchisor's capital investment and liability risk.

Franchising is rarely an equal partnership, especially in the typical arrangement where the franchisee is an individual, unincorporated partnership, or small privately held corporation, as this will ensure the franchisor has substantial legal and/or economic advantages over the franchisee. The usual exception to this rule is when the prospective franchisee is also a powerful corporate entity controlling a highly lucrative location and/or captive market (for example, a large sports stadium) in which prospective franchisors must then compete to exclude one another. However, under specific circumstances like transparency, favorable legal conditions, financial means, and proper market research, franchising can be a vehicle of success for both a large franchisor and a small franchisee. Franchising is also used as a foreign market entry strategy.

Three important payments are made to a franchisor: (a) a royalty. A payment made by one party to another that owns a particular asset, for the right to ongoing use of that asset. Royalties are typically agreed upon as a percentage of gross or net revenues derived from the use of an asset or a fixed price per unit sold of an item of such, but there are also other modes and metrics of compensation. 

(a) royalty interest is the right to collect a stream of future royalty payments for the trademark, 

(b) reimbursement for the training and advisory services given to the franchisee, and, 

(c) a percentage of the individual business unit's sales. These three fees may be combined into a single 'management' fee. A fee for "disclosure" is separate and is always a "front-end fee".

A franchise usually lasts for a fixed period (broken down into shorter periods, which each require renewal), and serves a specific territory or geographical area surrounding its location. One franchisee may manage several such locations. Agreements typically last from five to thirty years, with premature cancellations or terminations of most contracts bearing serious consequences for franchisees. A franchise is merely a temporary business investment involving renting or leasing an opportunity, not the purchase of a business for ownership. It is classified as a wasting asset due to the finite term of the license.

Franchise fees are on average 6.7% with an additional average marketing fee of 2%. However, not all franchise opportunities are the same, and many franchise organizations are pioneering new models that challenge antiquated structures and redefine success for the organization as well as the franchisee.

A franchise can be exclusive, non-exclusive, or "sole and exclusive".

Although franchisor revenues and profit may be listed in a franchise disclosure document (FDD), no laws require an estimate of franchisee profitability, which depends on how intensively the franchisee "works" the franchise. Therefore, franchisor fees are typically based on "gross revenue from sales" and not on profits realized.

Various tangibles and intangibles such as national or international advertising, training, and other support services are commonly made available by the franchisor.

Franchise brokers help franchisors find appropriate franchisees. There are also main 'master franchisors' who obtain the rights to sub-franchise in a territory.

According to the International Franchise Association, approximately 44% of all businesses in the United States are franchisee-worked.

Rationale and Risk Shift

Franchising is one of the few means available to access Venture capital without the need to give up control of the operation of the chain and build a distribution system for servicing it.

After the brand and formula are carefully designed and properly executed, franchisors are able to sell franchises and expand rapidly across countries and continents using the capital and resources of their franchisees while reducing their own risk.

There is also risk for the people buying the franchises. However, failure rates are much lower for franchise businesses than for independent business startups.

Franchisor rules imposed by the franchising authority are becoming increasingly strict. Some franchisors are using minor rule violations to terminate contracts and seize the franchise without any reimbursement.

Janet Mbene, Senior Associate Consultant, Modesta Mahiga LLC.

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