Can Franchise Be Your Way out of Avoiding Investors’ Conflicts and Sharing of Power?

Can Franchise Be Your Way out of Avoiding Investors’ Conflicts and Sharing of Power? 1

 

A franchise business is a typically a business owned by an entrepreneur or an entrepreneurial group, offering a product or service labeled by a corporation that provides assistance in every aspect of the business. Franchising is based on a marketing concept which can be adopted by an organization as a strategy for business expansion. For entrepreneurs in the 21st century, building a retail business from scratch is daunting and complex. Most franchise operations provide the franchisee with assistance at every step, beginning with informed, experienced location selection; continuing with financing, layout, equipment purchase and guidance including personnel training. Where implemented, a franchisor licenses 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, in some cases they may pay for an annual royalty, based on the contracts.

Once the business is up and running, franchisers continue to monitor and guide the franchisee so that the franchisee may achieve success. . In exchange for gaining the franchise, the franchisee usually pays the franchisor an initial start-up and annual licensing fees. There are two different types of franchising relationships. Business Format Franchising is the type most identifiable. In a business format franchise, the franchisor provides to the franchisee not just its trade name, products and services, but an entire system for operating the business. The franchisee generally receives site selection and development support, operating manuals, training, brand standards, quality control, a marketing strategy and business advisory support from the franchisor.

A continuing relationship in which a franchisor provides a licensed privilege to the franchisee to do business and offers assistance in organizing, training, merchandising, marketing and managing in return for a monetary consideration. Franchising is a form of business by which the owner (franchisor) of a product, service or method obtains distribution through affiliated dealers (franchisees). Generally, the franchiser also will provide sophisticated national promotional and advertising campaigns, which will drive sales.

Many people, when they think of franchising, focus first on the law. While the law is certainly important, it is not the central thing to understand about franchising.  At its core, franchising is about the franchisor’s brand value, how the franchisor supports its franchisees, how the franchisee meets its obligations to deliver the products and services to the system’s brand standards and most importantly – franchising is about the relationship that the franchisor has with its franchisees.

Moreover, a franchise is a type of license that a party (franchisee) acquires to allow them to have access to a business’s (franchisor) proprietary knowledge, processes, and trademarks in order to allow the party to sell a product or provide a service under the business’s name.

A franchisor’s brand is its most valuable asset and consumers decide which business to shop at and how often to frequent that business based on what they know, or think they know, about the brand.  To a certain extent consumers really don’t care who owns the business so long as their brand expectations are met. If you become a franchisee, you will certainly be developing a relationship with your customers to maintain their loyalty, and most certainly customers will choose to purchase from you because of the quality of your services and the personal relationship you establish with them.

Franchise Basics and Regulations

Franchise contracts are complex and vary for each franchisor. Typically, a franchise contract agreement includes three categories of payment that must be made to the franchisor by the franchisee. First, the franchisee must purchase the controlled rights, or trademark from the franchisor business in the form of an upfront fee.

Franchisors provide systems, tools and support so that their franchisees have the ability to live up to the systems brand standards and ensure customer satisfaction.  And, franchisors and all of the other franchisees expect that you will independently manage the day-to-day operation of your businesses so that you will enhance the reputation of the company in your market area.

Second, the franchisor often receives payment for training, equipment, or business advisory services from the franchisee. Lastly, the franchisor receives ongoing royalties or a percentage of the business’s sales.

In the United States, a franchise is a specific type of licensing arrangement defined by the Federal Trade Commission and also by several states. In the United States a franchise generally exists when:

  • The franchisor licenses a franchisee the right to use its trade or service mark;
  • To identify the franchisee’s business in marketing a product or service using the franchisor’s operating methods;
  • The franchisor provides the franchisee with support and exercises certain controls; and,
  • The franchisee pays the franchisor a fee.

 

In the U.S., franchises are regulated by law at the state level. However, there is one federal regulation established in 1979 by the Federal Trade Commission(FTC). The Franchise Rule is a legal disclosure given to a prospective purchaser of a franchise from the franchisor that outlines all of the relevant information in order to fully inform the prospective purchaser of any risks, benefits, or limits of such an investment.

Such information specifically stipulates full disclosure of fees and expenses, any litigation history, a list of suppliers or approved business vendors, even estimated financial performance expectations, and more. This law has gone through various iterations and has previously been known as the Uniform Franchise Offering Circular (UFOC) before it was renamed in 2007 as the current Franchise Disclosure Document.

It is important to note that a franchise contract is temporary, akin to a lease or rental of a business, and does not signify business ownership by the franchisee. Depending on the franchise contract, franchise agreements typically last from five to 30 years, with serious penalties or consequences if a franchisee violates or prematurely terminates the contract.

When selecting a franchise system to invest in, you want to evaluate the types of support you will be provided and how well the franchisor is managing the evolution of the products and services so that it keeps up with changing consumer expectations.  Some of the more common services that franchisors provide to franchisees include:

  • A recognized brand name,
  • Site selection and site development assistance,
  • Training for you and your management team,
  • Research and development of new products and services,
  • Headquarters and field support,
  • Initial and continuing marketing and advertising.

Franchising is not an equal partnership, especially due to the preponderance of the franchisor over the franchisee. But under specific circumstances like transparency, favorable legal conditions, financial means and proper market research, franchising can be a vehicle of success for both franchisor and franchisee.

Essentially, a franchisee pays an initial fee and ongoing royalties to a franchisor; in return, the franchisee gains the use of a trademark, ongoing support from the franchisor, and the right to use the franchisor’s system of doing business and sell its products or services.

You want to select a franchisor that routinely and effectively enforces system standards.  This is important to you as enforcement of brand standards by the franchisor is meant to protect franchisees from the possible bad acts of other franchisees that share the brand with them.  Since customers see franchise systems as a branded chain of operations, great products and services delivered by one franchisee benefits the entire system.

In addition to a well-known brand name, buying a franchise offers many other advantages that aren’t available to the entrepreneur starting a business from scratch. Perhaps the most significant is that you get a proven system of operation and training in how to use it. New franchisees can avoid a lot of the mistakes startup entrepreneurs typically make because the franchisor has already perfected daily operations through trial and error.

While from the public’s vantage point, franchises look like any other chain of branded businesses, they are very different.  In a franchise system, the owner of the brand does not manage and operate the locations that serve consumers their products and services on a day-to-day basis.  Serving the consumer is the role and responsibility of the franchisee.

Finally, franchisees enjoy the benefit of strength in numbers. You’ll gain from economics of scale in buying materials, supplies and services, such as advertising, as well as in negotiating for locations and lease terms. By comparison, independent operators have to negotiate on their own, usually getting less favorable terms. Some suppliers won’t deal with new businesses or will reject your business because your account isn’t big enough.

Franchising is a contractual relationship between a licensor (franchisor) and a licensee (franchisee) that allows the business owner to use the licensor’s brand and method of doing business to distribute products or services to consumers. While every franchise is a license, not every license is a franchise under the law.

From the franchiser’s point of view, franchising enables the business to expand rapidly with fewer capital requirements, because many capital requirements are assumed by the franchisee. Increasingly, in the 21st century franchisees own multiple franchises – and many of them have dozens or even hundreds of franchise locations. For instance, Flynn Restaurant Group, a second-generation family business that grew from one highly profitable Burger King franchise location, now owns more than 800 Applebee’s, Taco Bell and Panera Bread franchise locations. Franchisers welcome this tendency toward large franchisees, in which businesses may gross hundreds of millions of dollars.

The definition of a franchise is not uniform in every state.  Some states for example, may also include a marketing plan or community of interest provision in the definition.  The definition of what is a franchise can vary significantly under the laws in some states and it is important that you don’t simply rely on the federal definition of a franchise in understanding any particular state’s requirements.

In Franchise business, the owners or “franchisors” sell the rights to their business logo, name, and model to third party retail outlets, owned by independent third party operators called “franchisees”. Franchises are an extremely common way of doing business. In fact, it’s difficult to drive more than few blocks in most cities without seeing a franchise business. Examples of well-known franchise business models include McDonald’s, Subway, UPS, and H & R block. In the United States, there are franchise business opportunities available across a wide variety of industries.

Investing in a Franchise Business

To invest in a franchise, the franchisee must pay initial fee for the rights to the business, training, and the equipment required by that particular franchise. Once the business begins operating, the franchisee will generally pay the franchisor an ongoing royalty payment, either on a monthly, quarterly or annual basis. This payment is usually calculated as a percentage of the franchise operation’s gross sales. After the contract has been signed, the franchisee will open a replica of the franchise business, under the direction of the franchisor. The franchisee will not have as much control over the business as he or she should have over their own business model, but may benefit from investing in an already-established, name brand.

Once you’ve decided on a certain franchise through your preliminary research, you need to find out if this opportunity is as good as it sounds. Your next step is to analyze it thoroughly to determine whether it’s really worth buying.

Much of the information you’ll need to gather in order to analyze a franchise will be acquired through the following:

  • Interviews with the franchisor
  • Interviews with existing franchisees
  • Examination of the franchise’s Uniform Franchise Offering Circular (UFOC)
  • Examination of the franchise agreement
  • Examination of the franchise’s audited financial statements
  • An earnings-claim statement or sample unit income (profit-and-loss) statement
  • Trade-area surveys
  • List of current franchisees
  • Newspaper or magazine articles about the franchise
  • A list of the franchisor’s current assets and liabilities

Through this research, you want to find out the following:

  • If the franchisor–as well as the current franchisees–are profitable
  • How well-organized the franchise is
  • If it has national adaptability
  • Whether it has good public acceptance
  • What its unique selling proposition is
  • How good the financial controls of the business are
  • If the franchise is credible
  • What kind of exposure the franchise has received and the public’s reaction to it
  • If the cash requirements are reasonable
  • What the integrity and commitment of the franchisor are
  • If the franchisor has a monitoring system
  • Which goods are proprietary and must be purchased from the franchisor
  • What the success ratio is in the industry

Control of the Franchise

Generally, the franchisor will require that the business model stays the same. For example, the franchisor will require the franchisee to use the uniforms models, business models, and signs or logos particular to the business itself. The franchisee should remember that he or she is not just buying the right to sell the franchisor’s product but is buying the right to use the successful and tested business process.

The franchisee will also usually have to use the same or similar pricing in order to keep the advertising streamlined.  For example, if you saw an advertisement of preparation of well-known tax preparation franchise, you would expect to find this deal at the franchise operation closest to you. Aside from using the business model determined by the franchisor, the franchisee will otherwise remain an independent owner of the franchise.

While there are many benefits to investing in an already-successful franchise business model, there are drawbacks as well. As with any investment you make you should do your research thoroughly before you make any franchise purchasing decisions. If you are considering buying into a franchise, you should contact an experienced franchisee attorney for further assistance.

Pros and Cons of Franchises

There are many advantages to investing in a franchise, and there are also drawbacks. Widely recognized benefits to buying a franchise include a ready-made business operation. A franchise comes with a built-in business formula including products, services, even employee uniforms and well-established brand recognition such as that of McDonald’s. Depending on the franchise, the franchisor company may offer support in training and financial planning, or even with approved suppliers. Whether this is a formula for success is no guarantee.

Disadvantages include heavy start-up costs as well as ongoing royalty costs. To take the McDonald’s example further, the estimated total amount of money it costs to start a McDonald’s franchise ranges from $1 million to $2.2 million.

Franchises, by definition, have ongoing costs to the franchisor company in the form of a percentage of sales or revenue. This percentage can range from 4% to 8%. Other disadvantages include lack of territory control or creativity with your own business, as well as a notable dearth of financing options from the franchisor. Other factors that affect all businesses, such as poor location or management, are also possibilities.

Franchise vs. Startup

If you don’t want to carry on somebody else’s idea for a business, you can start your own. While founding your own company has plenty of potential rewards, both monetary and personal, it is also risky. When you start your own business, you are on your own, and much is unknown. Will the product sell? Will customers like it? Will I make enough money to survive?

Also, the failure rate is high. Statistics show that 25% of startup businesses don’t survive the first year. About half make it to year five, while approximately 30% last ten years. If your business is going to survive, you alone will have to make that happen. To turn your dream into a reality, you can expect to work long, hard hours with no support or expert training. If you try this on your own without any experience, the deck is stacked against you. If this sounds like too big a burden to bear, the franchise route may be a wiser choice.

UNEVEN SHARING OF POWER

The marketing and commercial benefits of franchising help to account for the high level of business success among franchisors and franchisees. The benefits received by both partners from the relationship have long been recognized.

However, the intricacies of that relationship and the balance of power between the franchisor and his or her franchisees have received far less attention.

While a franchisor depends on healthy profits from the franchisees for continued success, the franchisees are much more dependent on the success of the entire system.

One area where the franchisor has significant control over the commercial activities of the company’s outlets is in the franchise agreement.

According to Mr. Peter Sterling, author of a new Australian franchise directory, the franchise contract is “unquestionably slanted” in favor of the franchisor.

“It is true to say that the franchisor holds all the cards in the contractual arrangements.” said Mr. Sterling. Contracts are invariably drawn up by the franchisor. Franchise consultants advise prospective franchisees to check the contract carefully to ensure that the terms are fair.

Consulting director of Franchise Developments Mr. Sergio Alderuccio, said franchisees should examine the trading restrictions to ensure they made good business sense. “For example, McDonald’s have a number of significant restrictions but they argue that they are necessary for a successful franchise.” said Mr. Alderuccio. A franchisor can also control the flow of supplies to its franchisees, Stipulating. For example, where to buy supplies.  Mr. Alderuccio said the franchisor could have “quite an effect” on the prices of supplies and could “negotiate for more competitive rates” through buying power. Managing director of I.F. Consulting Mr. Steve Wilkins, agreed that the balance of power was in the hands of the franchisor but said that was the way it should be.

However, he added that there was concern in the industry that some franchisors were abusing that power by placing unwarranted restrictions on franchisees. The larger franchise groups often have franchisee representatives on advisory boards giving them access to the decision making process. However, other groups have taken more drastic action to redress the balance of power. Franchisees have started banding together to put pressure on the franchisors to change trading practices, and in some cases have taken the companies to court.

People purchase a franchise because the model often works. It offers careful entrepreneurs a stable, tested model for running a successful business. It also requires them to operate on someone else’s business model. For those with a big idea and a solid understanding of how to run a business, launching your own startup presents an opportunity for personal and financial freedom. Deciding which model is right for you is a choice only you can make.

Investing in a franchise or becoming a franchisor can be a great opportunity.  But before you select any franchise investment and sign any franchise agreement, do your homework, understand what the franchise system is offering and get the support of a qualified franchise lawyer.

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