What is Franchising?
Franchising is a legal relationship that exists between one person (a ‘Franchisor’) and another person (the ‘Franchisee’), pursuant to which the Franchisor grants to a Franchisee a licence to trade as their own business under the name or brand of the Franchisor.
It is commonly referred to as 'business format franchising’ because it involves the Franchisee following a proven business model of the Franchisor. The Franchisor usually provides a Franchisee with a business package, comprising of initial and on-going training, a business operations manual, marketing support and other elements necessary to enable a Franchisee to establish a previously untrained person in the business and to run it with continual assistance on a predetermined basis for an agreed length of time with a right to renew. The Franchisor will usually exercise significant control over how the Franchisee runs the franchised business.
What is a Franchise agreement?
A Franchise agreement is the document which sets out the terms and conditions of the arrangement between a Franchisor and a Franchisee.
A typical Franchise arrangement will usually have the following 5 key elements. Firstly, the Franchisor allows the Franchisee to use the whole or part of the Franchisor’s name or a name or brand which is associated with the Franchisor for the term of the Franchise. Secondly, the Franchisor exercises a continuing control over the Franchisee and various aspects of its business (for example, quality control). Thirdly, the Franchisor provides assistance to the Franchisee in various forms (for example, training, marketing and operational issues). Fourthly, the Franchisee has to make payments to the Franchisor, typically consisting of an initial payment and regular periodic payments. Fifthly, there is usually a right for a Franchisee to renew the Franchise at the end of the term of the Franchise agreement.
Franchising is typically used as a comparatively low risk means of expanding a business into new markets or territories.
Why do Franchisors franchise their businesses?
There are numerous potential benefits and risks for a Franchisor in franchising its business. Often advantages may include the increased speed of expansion of the Franchisor’s business, the ability for the Franchisor to expand without the requirement for capital investment, reciprocal incentives for the Franchisor and Franchisee, the opportunity for the Franchisor to reduce costs, and the possibility for the Franchisor of spreading risk with Franchisees.
Increased speed of expansion of the Franchisor’s business – Expanding a business organically usually takes a significant amount of time. By franchising its business, a Franchisor may be able expand more rapidly by securing a greater distribution for its products or services more quickly than would be the case if the franchisor tried to expand organically. It will spread some of the time, effort and costs associated with matters such as recruiting and training employees, developing its own internal marketing, sales and distribution organisation and external marketing, sales and distribution.
Ability for the Franchisor to expand without the requirement for capital investment – A Franchisor may not have access to or the ability to secure the amount of capital investment necessary to expand rapidly. By using the capital of its Franchisees to facilitate the expansion of a network, the Franchisor may be able to expand its business more quickly than would be the case if the franchisor had to fund the expansion itself directly or via third party funding.
Reciprocal incentives for the Franchisor and Franchisee – Businesses often seek to incentivise employees who are involved in selling or supplying goods or services through bonus structures so that the financial well-being of the relevant employees is (at least, in part) linked to the success of the business. Franchising uses a similar approach but extends it by linking the financial well-being of each Franchisee's business (and, therefore, each Franchisee) to the success of the Franchisor's business.
Opportunity for the Franchisor to reduce costs – As a business grows it is often able to obtain various financial advantages such as increased purchasing power. By increasing its Franchise network, a Franchisor may be able to reduce the average price it pays for goods and/or services and minimise any increase in its central overheads associated with organic growth.
Possibility for the Franchisor to spread its risks with Franchisees – Whilst a Franchise arrangement will need to ensure that the Franchisor and Franchisees benefit financially in order for it to succeed, the Franchisor will usually also reduce its business risks by franchising its business. In particular, it may be that franchised businesses are more likely to survive or even thrive in a recession than non-franchised businesses because of the positive and negative incentives for each Franchisee to succeed during the term of the Franchise.
Why do franchisees acquire a Franchise?
There are several potential advantages and disadvantages for Franchisees in acquiring a Franchise from a Franchisor. The advantages may include the fact that it is usually a comparatively easy way for an individual (or group of individuals) to start a business when compared to developing one’s own business, the opportunity it provides for the prospective Franchisee to profit from an existing proven business model, the time it takes to start a business and achieve profitability, the comparative ease of obtaining finance as against starting one’s own business, the reduced risk of failure, the potential benefits of enhanced Franchise network purchasing power, the sharing of the marketing and advertising burden with the Franchisor and other Franchisees, and the support available from the Franchisor.
Comparatively easy way for an individual (or group of individuals) to start a business - It is usually considered to be a relatively easy way for an individual (or group of individuals) to start a business compared to developing one’s own business. This is particularly the case where an individual has not owned or managed a business previously. It has been suggested by research that as many as 50% of Franchisees would not have become self-employed if they had not been able to start a business by way of franchising.
Opportunity to profit from an existing proven business model - It is often the case that prospective Franchisees do not have a significant amount of experience in managing a business before becoming a Franchisee. The Franchise model allows individuals without specialised knowledge in the proposed Franchise business activity the opportunity to start, operate and succeed in running a business.
Faster to start a business and achieve profitability - As the Franchise model provides a ready-made system for running a business, the time it takes to start a business and achieve profitability is often shorter. A Franchisee is able to utilise the name and reputation of the Franchisor to help launch, operate and generate customers and revenue. This may reduce the Franchisee's working capital requirements.
Comparative ease of obtaining finance - It is often easier for prospective Franchisee to obtain finance (and or better terms) from a lender for a proposed new Franchise than it is for an individual to obtain similar finance for a non-franchised new business. This is due to the lender’s likely perception of risk. The more well-known and successful the Franchise model, the easier it is likely to be to obtain finance. The larger lenders will often have specialist departments dealing with franchising.
Relatively low risk of failure - A significant number of businesses close every year, often within a year or 2 of their start date. This may be due to a number of factors such as the experience and ability of the business owner, the difficulty of launching a new product or service or lack of funding. As a Franchise is normally based on a tried and tested formula, the risk of failure for a Franchisee is usually reduced substantially.
Potential benefits of Enhanced Franchise network purchasing power - The Franchisee may be able to make use of the additional purchasing power of the Franchisor and Franchisee network generally. As the Franchisee network grows, its purchasing power should become greater. In addition, there may be other benefits relating to the size of the franchisor's operation and the extent of the Franchisee network.
Shared marketing and advertising burden with the Franchisor and other Franchisees - National marketing and advertising is undertaken by the Franchisor for the benefit of the Franchisees. In addition, the combined marketing and advertising of the Franchise network may help a Franchisee.
Support from the Franchisor - The Franchisor may be able to assist a Franchisee with a range of business support issues as part of the Franchise arrangement or via third party suppliers at a lower cost than the Franchisee would be able to obtain. In addition, the Franchisor usually assists with training throughout the term of the Franchise.