How Franchising Works

Imagine that you're opening your own McDonald's. To do this, you have to buy a McDonald's franchise. In order to qualify for a conventional franchise, you have to have $250,000 (not borrowed). Your total costs to open the restaurant, however, will be anywhere from $685,750 to $1,504,000, which goes to paying for the building, equipment, etc. Forty percent of this cost has to be from your own (non-borrowed) funds.

You'll pay an initial franchise fee of $45,000 directly to McDonald's. The other costs go to suppliers, so this is the only upfront fee you pay to McDonald's. Then, you'll go through a rigorous nine-month training period where you'll learn about the McDonald's way of doing things -- things like their standards for quality, service, value, formulas and specifications for menu items, their method of operation, and inventory control techniques. You'll have to agree to operate the restaurant from a single location, usually for 20 years, following their guidelines for decor, signage, layout and everything else that makes McDonald's McDonald's.

Once you've completed training and are ready to go, McDonalds will offer you a location they've already developed. The exterior of the building will be complete, but you will have to take care of interior additions such as kitchen equipment, seating and landscaping. You'll get constant support from a McDonald's Field Consultant, who can advise you on details and will visit regularly. You'll pay McDonald's a monthly fee of 4 percent of your sales, and either a flat base rent or a percentage rent of at least 8.5 percent of your sales. How much money you make depends on many things, including the location and its popularity, the efficiency of your operating costs, and your ability to manage and control the business.

Think of franchising as paying someone for his or her business strategy, marketing strategy, operations strategy, and the use of his or her name. That's pretty much what franchising is -- you are establishing a relationship with a successful business so you can use its systems and capitalize on its existing brand awareness in order to get a quicker return on your own investment. You are using its proven system and name, and running it by its rules.

Are you still your own boss? In some respects, no. You still have to answer to someone else and follow his or her direction. You don't really own the business; you own the assets you've purchased in order to establish the business.

According to the article "What is Franchising" by Robert Gappa, on the Franchise UPDATE Web site, there are over 2,500 franchise systems in the United States with over 600,000 units. This comes out to about 3.2 percent of all businesses, and 35 percent of all retail and service revenue in the United States.

The biggest advantage of franchising appears to be the reduction of risk you will be taking for your investment. This is because franchises typically get up and running faster, and are profitable more quickly. This can be a result of better management as well as a well-known name. According to the Small Business Administration (SBA), most small businesses fail because of weak management. It is in this area that the franchising option shines the most. When you lease a franchise, you are leasing that managerial know-how.

You also usually get better deals on supplies because the franchise company can purchase goods and supplies in bulk for the entire chain, and then pass that savings on to you and the other franchise units.

The often-instant recognition from customers is also a big plus. Customers are dealing with a "known" rather than an "unknown." Think about it: If you are driving through a town you've never visited before and have the choice of a "Billy Bob's Fried Chicken" or a "Kentucky Fried Chicken," which one are you more likely to stop at? Until you know that Billy Bob's is THE place for fried chicken, you may not want to take the chance.

For the customer, the advantages of a franchise include the comfort of knowing what you're getting. You know that the quality of the product or service at one location will be comparable to that of another location. You know what they have and you already know what you like about it. The questions for you as a potential franchisee are: Are you looking for something that is uniquely yours? Or do you simply want to run the show, regardless if it's by someone else's rules?

Before you answer those questions, let's go into a little more detail about how the franchise actually works.

There are two groups involved in a franchise, the franchisor (the person or company leasing the rights to the business name and system) and the franchisee (the person who purchases it).

The right to the franchise is sold by the franchisor to the franchisee for an initial sum of money, often called the up-front entry fee, or franchise fee. This money will be paid once the contract has been signed. The contract (franchise agreement) details the responsibilities of both the franchisor and the franchisee, and is usually for a specific length of time (typically several years). Once the contract expires, it must be renewed. State laws often have an impact on the options for this renewal.

This initial franchise fee doesn't include anything except the rights to use the name and system, and sometimes training, procedures, manuals, and other assistance like site selection. It doesn't include any of the necessary inventory, fixtures, furniture or real estate.

In addition to the franchise fee, the franchisee must pay the franchisor royalty fees, or other on-going payments. These payments are usually taken as a percentage of sales, but can also be set up as a fixed amount or on a sliding scale. The terms of these fees will be spelled out in the franchise agreement. These payments are for the on-going services and support that the franchisor provides. Franchisors may also sell supplies directly to their franchisees.

Advertising funds are also paid periodically. These funds are usually put into a general account and used for national and regional promotion for the entire chain.

The success of most franchises is based on the operating systems, methods, and products produced. For this reason, franchisors must protect their proprietary information and trade marks. In order to do this, they establish restrictive covenants for their franchisees. These covenants govern the things a franchisee can do.

For example, one restrictive covenant may state that the franchisee cannot operate another similar business that would compete with the franchised business during the term of the franchise agreement. These are called in-term non-competition covenants. There may also be post-term non-competition covenants that prohibit the franchisee from operating a similar business even after the terms of the franchise have expired. Each state, however, has its own laws regarding the enforcement of non-competition covenants. Often, in-term covenants can be more readily enforced than post-term covenants.

A business's trade secrets are often vital to its success. It is an understood rule that franchisees will keep trade secrets strictly confidential. This not only protects the franchise, but it also protects the franchisee's individual investment.

Most states have adopted some version of the Uniform Trade Secrets Act, which helps identify the parts of the franchise system that may constitute a trade secret. To see a list of those states that have adopted it, U.S. Trade Secret Protection by State. Proprietary systems and franchise information that doesn't fall under the category of a "trade secret" should be treated as such regardless, because it may still be protected under the restrictive covenants of the franchise agreement.

How do you select the business franchise that fits your needs, skills and desires best, while also making sure you're joining a top-notch organization? There are some steps to take to begin the weeding-out process. So put on your inspector's hat and begin formulating a game plan.

First of all, think about the work environment you are interested in, and the requirements that running businesses in various industries will have. For example, do you like working late (and long) hours, hiring and managing employees, and dealing with the public? If so, you could consider the food service industry. Think long and hard about what "fits" your lifestyle. Involve your family and any friends or associates you may want to pull into the business. Write down your objectives. Sometimes, just the act of writing things down helps you more clearly identify what you really want.

Once you have identified the general category of business you want enter into, visit some of the franchising Web sites we have listed at the end of this article. On most of these sites, you can search for franchises based on investment levels, type of business, and sometimes geographic region. Some even give you estimated breakdowns of what your total investments will be, as well as the ongoing royalty and advertising payments. You can also use a franchising consultant to help narrow down your choices.

When you get a list put together, begin contacting the franchisors for additional information. One thing to keep in mind throughout this process is that while you're shopping for a franchise, those franchises are also out there shopping for franchisees. You'll be interrogated as much as you interrogate them. You both have to agree that it's a good match in order to proceed.

Once you contact a franchisor for more information, these are the steps that will typically follow:

The franchisor will send you brochures and other materials, and most likely request that you complete a questionnaire. You will proceed based on the outcome of that exchange of information.

The next step will be your evaluation of the company's Uniform Franchise Offering Circular (UFOC). The Federal Trade Commission (FTC) requires this document be provided to disclose detailed information about the franchisor at least 10 days prior to any franchise purchase. That information includes:

For more information about deciphering the UFOC, visit Franchise411.com.

Visit as many of the franchisor's existing franchisees as you can. Meet directly with the owner of each establishment, and pay close attention to opinions of the franchisor. Ask the owners about the support they get on an ongoing basis, as well as the training and assistance they received when they first purchased the franchise. Did the franchisor help them with the location decision, and assist with initial set-up? What about the promotional efforts of the franchisor? Does the individual franchisees benefit from their investment? Do they get any say in how the advertising dollars are spent or allocated? Are their earnings living up to their expectations? Did their total investment stay in line with what they were expecting?

Ask specifically if they would do it again knowing what they know now. These opinions are very important to your research into each franchise. Look for trends that might indicate overall dissatisfaction with the company -- and avoid those like the plague!

Review the franchisor's business plan, operations manuals, and market analysis. Try to meet with the franchisor in person. Make a point to meet the franchising operations personnel with whom you will be dealing. Keep these questions in mind while you are meeting with them:

Take careful notes about each franchise opportunity you are investigating. Make sure you understand all of their policies and have a good feel for the level of satisfaction their existing franchisees have. Then use this information to make your final decision.

Most likely, when you set out to buy a franchise you will need a business loan of some sort. To get a business loan, you will also need a business plan. Writing a business plan for a franchise, however, is slightly different from writing one for your own new business startup. Not only do you have to detail the business strategy and projections of the franchise, you also have to detail the reasons why you are qualified to run the business.

While the franchisors may provide some assistance in helping you get the financing you need, they probably won't provide much in the way of helping to write a business plan. This is because they can't take the liability risk of helping you make projections on sales. If those projections fall short, there is the chance of a lawsuit. You may be provided with a template for a business plan, but this is usually provided after you have signed the agreement and gone into their training program. The template will still not provide any information about projected financial information.

That leaves you doing as much research into the market, and particularly the competition, as you can. Visit How Business Plans Work for some advice and assistance in writing a complete business plan.

Some of the differences you'll have to adjust for include building the franchise fee, royalties, advertising fees, and other franchise-related payments into the financial documents. Your accountant should be able to provide valuable assistance in this area.

There are many elements of the franchise agreement, as well as the franchise deal itself, that can benefit from the advice of an attorney. These can include:

Your best bet is to use an attorney who specializes in franchises. The ABA Forum on Franchising is the association that publishes the Franchise Law Journal and also maintains a list of Who's Who among franchise attorneys. Make sure your selected attorney is a member of this organization, not because it screens them in any way (there are no membership requirements), but because the organization itself stays on top of franchise law and offers seminars and other current franchise information for members. Using an attorney who is a member would be a benefit.

Even though you may use an attorney for these areas, you may still want to brush up on the laws yourself. The Federal Trade Commission (FTC) enforces franchising regulations and investigates any complaints. The Franchise Rule deals with the franchising contract and requires that the franchisor give full disclosure of earnings, company history, litigation, and key-officer experience levels. It also requires that contact information be provided for existing franchised units. The rule does not, however, cover anything that happens after the contract is signed, such as problems with product availability, site selection, and placement of other units within the same geographical market.

There are some groups pushing for uniform standards of conduct once the franchise agreement has been signed. The Asian American Hotel Owners' Association (AAHOA) is one that has actually created its own 12 Points of Fair Franchising in order to improve relationships. The agreement deals with issues like who pays for brand reimaging, new signage, dispute resolution and database information.

National fair franchising legislation was also introduced. HR 3308, also known as the Small Business Franchise Act, was introduced in 1999 by representatives Howard Coble, R-NC, and John Conyers, D-MI. The legislation would provide franchisees with a right of action in federal court in the event that the corporate franchise violates any provision of HR 3308. It was sent to the House Subcommittee on November 17, 1999. It was tabled during the 106th Congress, but is slated for reintroduction in the 107th Congress. There is bipartisan opposition to the bill in the Congress; however, organizations such as the American Franchisee Association highly support it. Opposition states that the bill tries to establish a "one size fits all" model to franchising, and that simply won't work with the many differences in franchise businesses and systems.

In addition to this, 16 states have their own franchise relationship law.

Part of the franchise agreement will cover what happens at the end of the term. Many franchise systems offer renewal options for the franchisee. In some cases, however, the franchise company will try to deny the renewal. There are 16 states that have franchise relationship laws in place. If the franchisor tries to deny renewal in one of these states, it may be violating state law. The focus of the laws in these 16 states is on regulation of the renewal and termination of franchises. Nearly all franchise statutes that address renewal issues require specific franchisee misconduct for a franchisor to be able to deny renewal. There are, however, some states (California and Wisconsin) that permit a franchise to deny renewal for economic reasons, such as a company-wide decision to discontinue franchising.

The conditions for any of these non-renewal situations would be a part of the original franchise agreement.

Transfer of Ownership

Transferring ownership of a franchise may also be more difficult than you might think. There may be provisions and restrictions in the franchise agreement that prohibit it, or at least restrict it. It is a difficult situation because the franchisee owns the assets of the business, but the franchisor owns the brand and trademark.

Ownership transfer elements of franchise agreements often include these types of statements:

Three of the 16 states with franchise relationship laws (Iowa, Michigan, and Wisconsin) also have provisions that directly relate to franchise transfers.

For more information on franchising and related topics, check out the links on the next page.