What is a Franchise: How Do Franchises Work?
By Michael Seid, Managing Director, MSA Worldwide
Most of us are familiar with the term “franchise”, and we should be. It’s rare that a day goes by when you or someone in your family doesn’t interact with a franchise at some level, either directly through a business transaction or indirectly through marketing or advertising. Franchises are a huge part of the American business landscape. But what exactly is a “franchise”? From a legal point of view, it is simply a type of license. At its core, though, franchising is about the relationship the franchisor has with its franchisees. The franchisor licenses its trade name and its operating methods (its system of doing business) to a franchisee; the franchisee agrees, as part of the bargain, to operate their business according to the terms of the license.
At its heart, franchising is based on a relationship between the brand owner and the local operator. When done correctly it allows a brand to skillfully and successfully expand. While both the franchisor and franchisees share a common brand, each is in a different business in a legal and practical sense. The franchisor’s job is to expand its business and support its franchisees; the franchisee’s job is to manage and operate their business to the terms of the agreements.
The franchisor provides the franchisee with support, and exercises some control over some elements of the franchisee’s operations necessary to protect the franchisor’s brand and ensure that the franchisee is adhering to its operational guidelines. In exchange, the franchisee pays the franchisor franchise fees. The franchise fees usually include a one-time initial fee (franchise fee) and a continuing fee (royalty fee) for the use of the franchisor’s trade name and operating methods.
- The franchisor has little or no role in the day-to-day management of the franchisee’s business, because the franchisee is an independent operator and not joint-employers with the franchisor. For example, while uniforms and the like are part of the system’s brand standards, the rate of pay or the hours scheduled are not.
- While the franchisor may provide some guidance and information on human resources best practices, the franchisee is free to hire, compensate, schedule, set employment standards and practices, and discipline their staff without any input from the franchisor.
How is franchising different from other chain businesses?
Franchising stands apart from other chain businesses due to its unique contractual relationship between a franchisor and a franchisee. In this arrangement, the franchisor grants the franchisee the rights to utilize the licensor’s brand and established business practices in distributing products or services to consumers. Unlike traditional chain businesses, where the brand owner manages and operates all locations, in a franchise system, the franchisee takes on the responsibility of serving customers on a daily basis. They are essentially independent business owners, managing their independent franchise locations.
One significant distinction is that in franchising, the franchisee typically pays both an initial fee, known as the franchise fee, and an ongoing royalty fee to the franchisor. The franchise fee grants the franchisee the initial rights and access to the brand, while the royalty fee is a continuing payment for the ongoing use of the franchisor’s trade name, operating methods, and support systems. Franchising distinguishes itself by providing a unique business model that combines brand recognition and support from the franchisor with the entrepreneurial freedom and ownership of the franchisee.
When is a license a franchise?
While every franchise is a license, not every license is a franchise under the law. In the United States a license becomes a franchise when three specific elements are in place:
- The franchisee’s business is substantially associated with the franchisor’s trademark;
- The franchisee pays an initial and/or continuing fee for the right to enter and remain in the business; and
- The franchisor exercises control or provides assistance to the franchisee.
It is important when analyzing your business – whether or not it is a franchise – that you don’t simply rely on the federal definition of a franchise. The legal definition of a franchise can vary significantly in some states, and may include other definitional elements including, but not limited to, the franchisor providing a marketing plan or maintaining a community of interest with the franchisee.
Most experienced and competent franchise lawyers or consultants can help you determine whether or not you need to franchise. Interestingly, because care is not always taken in selecting the right lawyers or consultants, in our practice at MSA we have come across many businesses over the years that either never needed to franchise to expand, or expanded without meeting the requirements of the franchise laws. Both mistakes are costly and unnecessary.
The Federal Trade Commission’s definition of a franchise is provided in Section 436.1(h) of the Franchise Rule as follows:
A “Franchise means any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify, or the franchise seller promises or represents, orally or in writing, that:
(1) The franchisee will obtain the right to operate a business that is identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark;
(2) The franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and
(3) As a condition of obtaining or commencing operation of the franchise, the franchisee makes a requirement payment or commits to make a required payment to the franchisor or its affiliate.”
Under a Business Format Franchise (the type of franchising most identifiable to the average person), the franchise relationship includes the entire business format and not simply the franchisor’s trade name, products and services. The franchisor generally provides operating manuals, training, brand standards, quality control, marketing strategy, etc. For example, McDonald’s doesn’t franchise hamburgers, and Jiffy Lube doesn’t franchise oil changes: both companies license their intellectual property, including their marks and business systems. As you can see from the history of both brands, their products and services have dramatically changed over the years — one of the benefits of a business format franchise is that they can.
There are many types of franchises in an ever-growing range of industries. It’s estimated that over 120 different industries use franchising. Restaurants and food offerings still make up the largest part, but today franchising is even used in home health care and for medical services.
The Power of the Franchisor’s Brand
A franchisor’s brand is its most valuable asset. Customers 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. Consumers really don’t care who owns the assets of the business; they are simply looking to obtain the products and services the brand is known for. Franchising allows “formula entrepreneurs” to operate a business under identified brands and, when working with a great franchisor, franchisees receive the tools and support they need to live up to system standards and ensure customer satisfaction.
Consistent execution to brand standards is expected in each franchise location, regardless of whether the location is company-owned or franchisee-owned. Franchisors invest a lot of time, energy, and financial resources in developing and supporting their brands: in the consumer’s mind, a franchisor’s brand equals the company’s reputation.
Great franchisors enforce system standards with franchisees because they want to ensure that customers are satisfied each and every time they shop at a franchised location, and to protect the equity of the other franchisees sharing the brand. Franchisors provide not only the menu of established products and services, but also an operational system and brand that are already in place. In great franchise systems, franchisor and franchisee work together for mutual success.
Do you have questions about growing your business through franchising?
MSA Worldwide provides guidance on how to develop a great franchising system for sustainable success. Contact us today for a complimentary consultation.
