What Is a Franchise?
Let me tell you directly: a franchise is a business model where you, as the franchisee, pay a franchisor for the right to use its brand, business processes, and proprietary knowledge to operate under the franchisor's name.
It's essentially a license that gives you access to the franchisor's proprietary knowledge, processes, and trademarks, allowing you to sell products or services under their business name. In return, you typically pay an initial startup fee and annual licensing fees.
Key Takeaways
Understand this: a franchise involves the owner licensing its operations, products, branding, and knowledge in exchange for a fee. The franchisor grants these licenses to franchisees.
The Franchise Rule mandates that franchisors disclose key operating information to you if you're a prospective franchisee. Ongoing royalties to franchisors vary by industry, ranging from 4.6% to 12.5%.
Understanding Franchises
When a business aims to expand its market share or geographical reach without high costs, it often franchises its product and brand name. This creates a joint venture between the franchisor—the original business—and you, the franchisee.
The franchisor sells the right to use its name and idea, and you buy this right to sell their goods or services under an existing model and trademark. Franchises are an effective way for entrepreneurs like you to start a business, especially in competitive industries like fast food or those requiring time to develop processes from scratch.
One major advantage is access to an established brand, management knowledge, processes, procedures, financial tools, and metrics. You won't have to build these yourself or spend resources getting your name and product known to customers.
The franchise model has a long history in the U.S., dating back to the mid-19th century with companies like McCormick Harvesting Machine and I.M. Singer, which developed systems seen as forerunners to modern franchising. These structures responded to high-volume production needs.
Before you buy into a franchise, carefully read the Franchise Disclosure Document that franchisors must provide. It includes details on fees, expenses, performance expectations, and other operating information.
Early food and hospitality franchises emerged in the 1920s and 1930s, with A&W Root Beer starting in 1925 and Howard Johnson in 1935, influencing today's fast-food industry. In 2022, there were 790,492 franchise establishments supporting the U.S. economy, expected to rise to 805,436 in 2023, contributing over $500 billion. Examples include McDonald's, Taco Bell, Dairy Queen, Denny's, Jimmy John's, Dunkin', Hampton by Hilton, Days Inn, 7-Eleven, and Anytime Fitness.
Franchise Basics and Regulations
Franchise contracts are complex and differ by franchisor, but they typically include three payment categories to the franchisor. First, you purchase the controlled rights or trademark via an upfront fee. Second, the franchisor gets paid for training, equipment, or advisory services. Finally, they receive ongoing royalties or a percentage of your sales.
These contracts are temporary, like a lease, not ownership. They last 5 to 30 years, with penalties for violations or early termination.
In the U.S., franchises are regulated at the state level, but the FTC's 1979 Franchise Rule requires franchisors to disclose risks, benefits, and limits to you as a prospective buyer. This covers fees, expenses, litigation history, approved vendors, performance expectations, and more. It was formerly the Uniform Franchise Offering Circular, renamed in 2007.
Advantages and Disadvantages of Franchises
Investing in a franchise has advantages and drawbacks. Benefits include a ready-made business formula, market-tested products and services, and often established brand recognition. For instance, as a McDonald's franchisee, decisions on products, store layout, and uniforms are already set. Some franchisors provide training, financial planning, or approved supplier lists. However, success isn't guaranteed despite the formula and track record.
Drawbacks include high startup costs and ongoing royalties. For McDonald's, total costs range from $1.3 million to $2.3 million, plus $500,000 in liquid capital. Royalties are 4.6% to 12.5% of sales or revenue.
Emerging brands may publicize unproven ratings or awards, leading you to pay high amounts for low value. You lack control over territory or business creativity. Financing can be hard to obtain, and factors like poor location or management affect all businesses.
Pros and Cons
- Pros: Ready-made business formula, market-tested products and services, established brand recognition, large decisions already made, list of approved suppliers, training and financial planning provided.
- Cons: Success not guaranteed, large startup costs, ongoing fees, lack of territory choice, lack of creative control.
Franchise vs. Startup
If you don't want to follow someone else's idea, start your own business, but it's risky with potential monetary and personal rewards. You're on your own, facing unknowns like whether your product will sell or if you'll make enough to survive.
New business failure rates are high: two-thirds survive two years, half survive five. To succeed, you must make it happen alone, working long hours without support or training. With little experience, it's tough.
People buy franchises for the success stories and stable, tested model. For entrepreneurs with big ideas and business know-how, a startup offers freedom. The choice is yours.
What Are the Advantages of Franchises?
Advantages include a ready-made formula, market-tested products, and brand recognition. Decisions are pre-made, with possible training and suppliers, but success isn't guaranteed.
What Are the Risks of Franchises?
Risks involve high startup and ongoing fees (4.6% to 12.5%). You might get inaccurate information, pay for low value, lack control over territory or creativity, face financing difficulties, and suffer from poor location or management.
How Does the Franchisor Make Money?
Franchisors earn through upfront fees for trademarks, payments for training or services, and ongoing royalties from sales.
The Bottom Line
A franchise lets you enter entrepreneurship using an established business and brand. For fees and startup costs, you can be your own boss in a potentially lucrative career, but success requires hard work and isn't guaranteed.
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