Franchise: Definition, Pros, Cons & Examples
What is a Franchise
A franchise provides legal authorisation for a third party to use a business’s brand name and image. The third party is known as the franchisee. The franchisee usually pays some form of royalties and/or annual payment in return for using the brand.
As part of the franchise, the business lending out their brand name will also allow the franchisee access to proprietary knowledge, processes, and trademarks. In other words, they are essentially the same company, but run independently.
In doing so, the business that lends out its brand name, the franchisor, is able to expand rapidly. It does not need to raise the capital to open new stores. Nor does it need to worry about employees, extra costs, or any other associate issues. It is purely able to focus on the processes involved and creating a good product and customer experience.
- A franchise is a legal contract that provides a third party the use a business’s brand name and image.
- The franchisee pays a percentage of their profits to the franchisor.
- The franchise agreement is the legal contract between the franchisor and franchisee that outlines the terms and conditions of the franchise relationship.
How a Franchise Works
When a business wants to grow and expand but is financially restricted, franchising is often the preferred option. This is because factors such as buying land, paying staff, and all the other costs associated with the expansion can become both complex and financially draining.
In turn, the business may offer its brand, processes, and products to entrepreneurs that want to become franchisees. This can be seen as a joint venture between the franchisee and the franchisor. Essentially, the franchisee provides the capital for expansion, whilst the franchisor provides a successful business.
The franchisee pays a license fee to the franchisor for the right to use their businesses’ brand and other associated rights. In return, the franchisor provides support to the franchisee. This often comes in the form of some kind of training to allow the entrepreneur to run the franchise effectively.
Running a business is complex, so the franchisor will offer support and training ranging from technical to sales and marketing, to legal advice. In turn, this makes franchising very popular. The model is tried, tested, and proven, but also, it is in the franchisor’s interest in the franchisee to succeed. So the support provided is often top class, although it will depend on a franchisor by franchisor basis.
Advantages of Franchise
A franchise offers many advantages to both the franchisee, as well as the franchisor. It is a mutually beneficial agreement, if successful. At the same time, the risk of such is equally borne by both parties who will be harmed in different ways. The franchisee through financial means, and the franchisor through its reputation. So it’s in the interest of both parties to make it work, and there are many advantages to both.
Advantages to the Franchisee
1. Franchisor Support
As a franchisee, it may be a bit daunting starting a new business, especially if they have little experience. The franchisor will provide helpful support and training along the way, which makes the experience comparatively easy. Issues such as legal requirements, suppliers, and sales have all been taken care of and considered. So, the franchisee will know exactly what they are doing so they can hit the ground running.
2. No need for business experience
As a result of the franchisor support, it means the franchisee needs little business experience because they will be taught. Everything is set up, from the suppliers to use, to the menus, to the optimal pricing. That leaves the franchisee to think about the day to day management instead of the wider business factors.
With that said, this comes at the cost of flexibility. The franchisee is heavily restricted by what they can do independently. However, this can be appealing to new business owners.
3. High Success Rates
The vast majority of businesses will fail within the first three years. However, franchises are very successful. It is said that around 90 percent of franchises succeed and make a profit, whilst the failure rate of new businesses is 60 percent within the first three years. The reason is fairly simple; they succeed because they are using an established brand with a proven product and business idea.
4. Established Brand
A franchisor is paying for an established brand. With that, it means it doesn’t have to worry about marketing expenses or brand exposure. In other words, it doesn’t have to spend years to build up trust; customers will simply come straight away. For instance, a McDonald’s franchise will find customers on the day it opens, whilst Bob’s Takeaway will find it more difficult.
5. Ease of Credit
By owning a franchise, the franchisee is part of an established brand that works. Financial institutions will look at that favourably and become more lenient on how much they will lend and at what interest. For instance, it is better for Goldman Sachs to lend money to a Starbucks franchise, which is guaranteed custom, as opposed to Carl’s Coffee House.
6. Established Supplier Relations
Although the franchisee may be limited to registered suppliers, they already have established relationships with the brand. That means less time spent looking for a suitable supplier and resolving disputes.
It also allows for a greater negotiation on pricing. As the franchise is part of a wider chain of businesses, the franchisor may be able to negotiate lower rates from their suppliers.
Advantages to the Franchisor
1. Rapid Expansion
Often, the franchisor may want to expand their business, but it is almost impossible to turn one local store into thousands in such a short period. It may take decades to do such.
Franchising allows the firm to bypass the difficulties of raising further credit, buying new land, or hiring new staff. That allows the company to expand at a far faster rate than if the growth was done organically.
2. Easier to manage
The difference between owning 1,000 stores and 1,000 franchises, is that the level of micromanagement is reduced. Instead of 1,000 managers, you have 1,000 entrepreneurs and business owners. Each has a direct incentive to make a profit and create a successful business venture.
At the same time, the day-to-day management is down to the owner. All the management is delegated to each individual store. All the franchisor does is provide guidance on how to run it.
3. Increased Profits
To the franchisor itself, the addition of a new franchise comes at little cost, but high-profit margins. For it takes a percentage of their profits on an annual basis but takes on little of the associated financial risk.
In big franchises, the training programs are already funded and organised. So taking on another franchise comes at almost zero cost, but a huge profit upside.
4. Brand Presence
When customers see more and more franchises opening across the company, it is cheap and effective marketing. You may not have heard of Bob’s Bakery, but after opening 10 franchises in the area, it becomes apparent that it is an established brand. In turn, this increased brand presence may encourage other entrepreneurs to join suit and open their own franchise.
5. Reduce Risk
As opposed to opening individual restaurants, by opening up franchises, the risk of loss is significantly reduced. The start-up costs are borne by the entrepreneur, alongside day-to-day management and maintenance costs. That means if the franchise fails, there are little if any financial penalties to the franchisor, with the exception of any contractual malpractices.
Disadvantages of Franchise
1. Shared Profits
As part of the franchising agreement, there is usually a royalty that is due to the franchisor. This might range from 5 to 20 percent of the profits, perhaps even more, depending on the industry.
For the franchisee, this is a key disadvantage as they are sacrificing profits. The profitability could be much higher if they were to go their own way. However, this is under the assumption that they succeed; which is statistically unlikely.
The franchisee will have a contractual agreement with the franchisor. However, once this term is over, the franchisor is not obligated to extend the agreement. That creates a level of uncertainty to the franchisee, especially if they are underperforming against others. It could mean existing investments are lost as the franchise is transferred to another potential franchisee.
3. No Control
As part of the franchise agreement, the franchisee is limited to the products they can sell, the suppliers they use, and how they operate. For instance, a McDonald’s franchise has to use the contracted cookers, packaging, suppliers, and even what products it offers. They are even obligated to participate in special marketing events.
Although one bad franchise out of a thousand may not tarnish a brand’s image, a small franchise with a few franchises may suffer greatly. For instance, there may be only 5 cafes that operate under the name ‘Carla’s Café’. If one of them develops a bad reputation for bad hygiene or poor service, it may bring the whole franchise down under the same umbrella.
5. Difficulty of Exit
Entrepreneurs that own a franchise are only able to sell the franchise to someone that is approved by the franchisor. That makes it extremely difficult to leave the market.
6. Franchisor goes out of business
Perhaps not an issue for big franchises such as Starbucks or McDonald’s, but smaller franchises may be impacted by the franchisor going bust. As a result, all the existing investment put into the firm is lost.
Franchises are very popular among businesses as they allow them to expand rapidly. Some notable examples of franchises include:
- Pizza Hut
- Dunkin’ Donuts
- Taco Bell
- Baskin Robbins
- Burger King
- Circle K
- Marriott International
FAQs on Franchises
A franchise provides legal authorisation for a third party to use a business’s brand name and image. The franchisee pays a fee to the franchisor in return for using proprietary knowledge, processes, and trademarks. The franchisor also offers support and training in order to meet the same standards and processes as the franchisor.
Some examples of franchises include: KFC, McDonald’s, Starbucks, Burger King, Dunkin’ Donuts, and Wendy’s
There are 3 main advantages of a franchise. They are:
– No need for business experience
– High Success Rates
– Ease of Credit
The franchise agreement is the legal contract between the franchisor and franchisee that outlines the terms and conditions of the franchise relationship.
Franchisors are typically responsible for providing initial training and ongoing support to franchisees to ensure that they operate the business according to the franchisor’s standards.
Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.