What is a Franchise?
A franchise is a license a business grants to another party that allows them to use its trademark, operating methods, processes, and proprietary knowledge. The license may last only a few years or decades.
A franchise includes two parties: the franchisor and the franchisee. The franchisor established the business and its brand, trademarks, and products or services. The franchisee pays the franchisor for the right to operate with those elements of their business.
McDonald’s is one of the biggest and most well-known examples of a franchise. More than 90% of McDonald’s restaurants are operated by franchisees. The franchisees pay the company to run and profit from their individual restaurants using the logo, products, marketing, and more.
The Federal Trade Commission (FTC) provides a definition for a franchise. It includes three elements that must exist for a business to be a franchise under federal law:
- The business must be significantly associated with the franchisor’s trademark.
- The franchisee pays a fee to create the business.
- The franchisor retains authority to control the business or offers assistance.
The federal legal definition of a franchise is important, but it isn’t the only one. Each state also defines franchises, and those definitions vary. Know the elements in your state before buying a franchise or franchising your business.
There are two types of franchises:
- Business format franchise. The franchisor grants the franchisee the right to use their business system and trademark. The franchisor has significant control and provides a lot of assistance. The franchisee must operate strictly under the franchisor’s system. McDonald’s is an example of this, which is why every restaurant is similar even when owned by different franchisees.
- Product franchise. The franchisee sells the franchisor’s products with their trademark. The franchisee must follow the franchisor’s operation methods, but there is less strict adherence to the business system. Examples include auto dealerships and beer distributors.
Which Laws Regulate Franchises?
There is one federal regulation for franchises, known as the Franchise Rule. The FTC established the rule in 1979. It requires franchisors to provide prospective franchisees with a full disclosure of benefits, limitations, and risks. The Franchise Disclosure Document (FDD) includes information about fees, legal history, business vendors, financial expectations, and other details.
Franchise law mostly falls under state jurisdiction, so it’s important to understand your state’s franchising laws before signing an agreement. You must follow state regulations and the FTC Franchise Rule.
Some of the additional regulations states impose include:
- Additional requirements for the FDD
- Prohibited agreement provisions
- Franchise registration obligations
- Offer and sale regulations
- Operational details for the ongoing franchise relationship
What Are Franchising Fees?
The fees associated with purchasing a franchise vary from one business to the next. The typical model requires the franchisee to pay a startup fee and a royalty on revenues. The royalty is usually between 4% and 6%.
These fees that go to the franchisor are not necessarily the only costs of owning a franchise. You may have to pay for common expenditures, like a marketing or advertising fund, that benefits all the franchises.
Franchisees also pay other costs associated with running a business. You may have to pay for rent, any modifications that you must make to the facility, inventory, and equipment. Smaller franchises may cost about $10,000 to start, while a big business like McDonald’s may cost up to $2 million.
What Are the Pros and Cons of Owning a Franchise?
Buying a franchise license is a big decision. It costs money to get started. You enter a contract by which you must abide for a set period of time. Consider all the options, advantages, and disadvantages before entering into a franchise agreement.
For anyone interested in starting a business, there are some definite benefits of doing it through a franchise:
- You get a ready-made business with a proven model, a brand and trademarks, and business systems and processes in place.
- A franchise comes with a record of sales and existing customers who already know and like the market-tested products or services.
- With a franchise, you have support from the franchisor. This may include employee training, operational procedures, plans for modifying a facility, and advertising support.
- Materials cost less when you have a franchise. As compared to a new business, you have the buying power of a large business behind your franchise. The company buys materials in larger amounts, which means you benefit from lower prices.
There are also disadvantages of choosing a franchise over starting your own business from scratch:
- Startup fees can be pretty high. If you don’t have the money, you will have to finance the license costs. You’ll also have to pay part of your profits as royalties for the duration of the license.
- Unlike a business entirely your own, you do not have complete control over a franchise. This limits creativity and flexibility, but it may also limit profitability.
- You’re stuck with the brand of your franchise. If something goes wrong and negatively affects the brand, it also affects your business and profits.
What Should I Do Before Buying a Franchise?
Before buying a franchise, do your research. Know the laws in your state and research the businesses you’re considering. Look at the industry, your target market, the profitability of the business, competition in your local area, and the company’s legal history. Talk to other franchisees about their experiences.
Also, take an honest look at your abilities and suitability for a franchise. Will you feel too restricted by the control of the franchisor? Do you have experience in the industry? Does the business type require training and skills?
Finally, talk to a franchise lawyer before making a deal. They will help you understand the FDD, your obligations, the fees, and the limitations or potential benefits of any agreement you are considering. A lawyer will look out for your interests and provide expert advice on which franchise licenses are better or worse.
If you’re ready to buy a franchise, the franchisor will walk you through the process. Have a franchise lawyer to advise you along the way, and you’ll feel good about the decision to enter the agreement.