How To Develop A Franchise System: Part 7: Types of Franchises
There is a wide variety of types of franchise structures used in the industry today. There are two main types of franchising, known as Product Distribution Franchising (Traditional Franchising) and Business Format Franchising, which are conducted under a variety of franchise relationships. We'll go over these different types of franchising structures and how they differentiate from each other.
Franchising is an alternative method of distribution. It is important to understand each type of franchising structure to choose the best fit for your franchising system. Establish where your franchise system best fits
Video Transcript:
There are basically two types of franchises. There’s Product Distribution Franchising (or what’s really called traditional franchising), and there’s Business Format Franchising, which most people recognize as franchising. Surprisingly, as an industry size, as a volume size, traditional franchising is actually a larger portion of franchising than the business format franchising. Traditional franchising are franchisors that are really tied to the products more directly, the products are typically made by the franchisor, the sale by the franchisee. Generally those products require some type of preparation or post-sale services. There’s strong identification with the brand, so think about things like soft drinks, beer, bottling companies, automotive, trucks, mobile homes, auto accessories, all of these types of products are manufactured by the franchisor, sold by the franchisee, and need some type of pre-sale or post-sale work.
The difference between the traditional franchise and a business format franchise is that in a business format franchise - the McDonald’s, the Marriotts, and brands like that - you’re delivering to the franchisee a level, a system of delivery which is more important than the products. Though if you start to look at most restaurant franchises, they can add and delete products all the time, it’s the system of how they’re doing it. McDonald’s is not a hamburger franchise, it’s a system of delivering food products to customers. Same with the way that Midas Muffler is not a muffler franchise; today they’re delivering all different types of services to their customers. So if you think about business format franchising, it’s a system of product delivery, and you’re going to find that over 120 industries from restaurant to hospitality to parts stores to automotive aftermarket to travel, consumer products and services, all over.
In a franchise system we have different classes of franchisees with different ownership structures. There’s a single-unit franchise, the classic way of franchising that goes back in the United States to the 1700s, and it’s a single location owned by an operator that generally runs that business. It’s the most common type of franchise relationship, it’s mom and pop franchising. When you look at single-unit franchising there’s a single franchise agreement that is signed between the franchisor and the franchisee. The obligations run directly between the franchisor and franchisee, the revenue runs, the fee structure runs directly between the two, the franchisee pays the franchisor, and there are responsibilities between the parties. Very simple, very basic type of structure.
Another type of development, of franchise strategy, is a multi-unit franchisee, you’ll sometimes hear it called an area developer franchisee. Here what you have is somebody comes to you, and they want to open up multiple locations in an area. They’ll define the area, they’ll define how many locations they want to open with you, you will take a fee for taking that defined market off the market. Generally that fee is applied to the individual franchise fees as they’re opening them on some basis, not always, but generally they are. So this development agreement has rights and obligations for both parties. The obligation of the franchisor generally is to take that market, that area, off the market while the franchisee or the developer develops it. For the developer, they’re going to agree to open up a set number of locations in a fixed period of time, generally but not always in a defined area. You may exclude from that area certain things, like baseball stadiums or arenas, universities, what we call mass gathering locations, because likely the franchisee is not going to be able to get into the ballpark or the university because those contracts are generally owned by concession houses that have signed agreements with those institutions.
If you’re looking at a typical development relationship, what you’ll notice is that the franchisor is going to sign - just like was done with a mom and pop franchisee - individual unit franchise agreements. But they’re also going to sign this very key and important development agreement which obligates the developer to meet a number of locations in the period of time that takes place. Interestingly, though, and it’s a difference in franchising from many other agreements, that development agreement is going to be running over a couple of years. And the franchise system may have changed their agreements between the first year and the last year of that development agreement. Oftentimes the developer will be signing individual franchise agreements that are different. It’s one of the reasons that we recommend franchisees, when they’re entering into any type of relationship, have lawyers, because good franchisee lawyers will understand that and will mitigate any risks for that developer of the agreements changing too radically. People really don’t want to sign agreements or agree to sign agreements which they haven’t read or that haven’t even been written yet.
Another type of franchising - and we don’t use it as much in the United States any more, and the truth is we’re using it less and less internationally, but it’s still probably the dominant way to go into international franchising - is master franchising. What you have in a master franchise relationship is, I sell you a market to become me. You actually become the franchisor in that market. So you pay me a fee, and I grant you the right to open up in that market your own franchise locations, you go out and you find your own franchisees, you train them, you support them. But again, just like an area developer, you’re going to tell me how many locations at a minimum you’re going to open, over what period of time, and we are very much going to define the area, and it is generally going to be exclusive. So we are going to train the master franchisee to be a franchisor. They are going to then locate their own franchisees, they’re going to then support their own franchisees. They will contract directly with their franchisees - not always will the franchisor even sign an agreement with their sub-franchisees, because those sub-franchisees are working directly with the master franchisee.
As the fees are collected by the master franchisee from its franchisees, it will share those fees in some pre-agreed formula with the franchisor. That could be 20-80, 40-60, 50-50, it really depends upon the relationship, it depends upon what the brand is valued at, it depends upon a lot of things, but it is not a fixed percentage, so don’t look at one business and think that every business does it the same way.
Typically, what the sub-franchisee is getting is training, site selection, field support, all of the same things that a franchisor would give its direct franchisees are now coming from the master franchisee. What you have in that relationship is the franchisor signs a master franchise agreement directly with its master franchisee. Money flows, contractual obligations are in place. The master franchisee, just like a franchisor would, goes out and finds its single- or multi-unit franchisees to meet its contractual requirements to the franchisor under the master franchise agreement.
Notice, though, that there is no direct relationship in most master franchise agreements between the franchisor and the sub-franchisee. Sometimes, if the master franchise relationship falls apart, that could be a problem; lots of ways that we get around that problem, lots of ways that the lawyers deal with those issues, but you’ll notice that the franchisor and the sub-franchisee do not have a direct relationship. The master franchisee is their franchisor.
Another form of franchising is what we call an area representative. Think of an area representative as a commissioned salesperson and a commissioned field support person. So I come to you and I want the Dade County market, just like the master franchisee might. The difference here is I will still pay you an initial fee for the right to be in the market, I will still go out and find franchisees, I will still support the franchisee with training and site development and field support, but the area representative does not sign an agreement with the franchisee. That agreement is a direct relationship between the franchisor and the franchisee. All the area representative is, is a commissioned salesperson and a commissioned support person. It is a very fast way of growing and systems like Subway have used it, Firehouse Subs has used it, and Mailboxes Etc. which is now UPS Store used to use it, many systems use it. It is not used by the majority of franchises because it has some real problems. Part of the problem is you often will see a higher turnover rate in those systems, you’ll see some issues that will take place. It’s a model to review and it’s right for some businesses, but it’s not necessarily right for most businesses.
What you see in those relationships is, very similar to a master franchise, there is an agreement between the franchisor and the area representative, an area representative agreement, the area representative is going to pay money to the franchisor for the right to sell franchises and support franchisees in that market. They will split fees, you’ll notice that the area representative, while they solicit and support the franchise and provide the franchisee with services, there’s no contractual relationship between the area representative and the franchisees. All they are is a commissioned salesperson and a commissioned support person. That agreement is signed between the single- and multi-unit franchisee, directly between them, the franchisor and the franchisee.
Other types of downstream strategies to look at, look at joint ventures. Joint venture is just another fancy word for a partnership. So the franchisor will go into a joint venture partnership with an operator; the operator will generally operate the location or the partnership which the franchisor has formed with them. Many brands use a JV, there are issues around a JV that mainly structure into how do you get out of them, there are some real issues there, but JV relationships, some people will think they can enter a JV or joint venture relationship and somehow they’re avoiding a franchise relationship. In many, many situations, a joint venture relationship is a franchise relationship, though if your lawyers are looking at joint venture and saying yeah, you don’t have to franchise, talk to a franchise lawyer first. Depending upon the state, depending upon the structure, depending upon what people are entering into the business, whether they are leveraging capital or just leveraging intellectual property, what are they donating to that partnership? That will determine whether or not it’s a joint venture partnership or whether it’s really a franchise relationship.
So you’re going to have some upside and downside if the relationship is successful, some of the terms that have to be negotiated in a joint venture relationship are ownership percentages, profit percentages, voting percentages, what’s the equity and who’s contributing what, financing obligations, what are the restrictions on either party. Often as not what you’ll find is a restriction on the operating partner is they can’t sell the assets, because the assets may have been contributed by the franchisor as part of the deal, and they don’t want those assets to go away. There may be restrictions on who can get debt, how debt is brought into it. A joint venture agreement is a separate agreement from any franchise agreement because the joint venture partners, even though the franchisor may be one of those partners, he’s going to sign a franchise agreement with the franchisor. So in essence, the franchisor is its own franchisee. It’s an interesting structure, it’s used quite a bit, and it can be very beneficial in certain situations.
Another type of franchising is conversion franchising. It’s one of my favorites, actually. You’re going to go to an independent person that’s in your industry and convince them that joining your system is going to be beneficial to them. What’s the advantages? I can walk into their business and know how well they treat their own brand. They may not be the best operator in the market, but if they’re treating their own brand with respect, if the business is well maintained, if they have a loyal following even if it’s not big enough to support the business at the level they want, that’s a relationship with somebody I want.
Downside to them? They have every bad habit in the world and we’re going to have to teach that person, who may truly be an entrepreneur, how to be a formula entrepreneur. But they have a location, that location exists, I don’t have to spend months finding the location or helping the franchisee find the location. So there are some real advantages to the conversion model. Part of that disadvantage, though, the franchisee is coming into this relationship with an established business, they may have assets that still have lifespan to them, and the franchisee may not want to convert fully over to your brand the first day, that’s fairly typical. So there is a phase-in period with most conversion franchisees where the brand is changed, there are changes to the interior, and over time things like the IT system, the furniture, the equipment, all phase out. And they’ll phase into the franchisor’s brand.
You’ll also have some issues around the fees, they’re different generally than a greenfield franchisee, greenfield being a new franchisee, and that business already has sales, and for you to go to that conversion franchisee and say “I’d like my royalty on dollar one” - they may not be willing to do that and there’s good reason they would not, because if they already have half a million dollars in sales, they want to go into the relationship with you because you’re going to add onto their sales. So there’s a phase-in period that generally takes place where your royalties will come from first growth of the franchisee’s business, and then later on it will phase down to the entire business.
Dual branding - it’s not really a different relationship, there’s a different structure. You’ll see it where two or more brands will share the same real estate. They’re doing it because they may utilize labor more efficiently, it may give them a better return on their real estate, it expands their day part and allows for the sharing of common space. You’ll see it today in concepts like Kentucky Fried Chicken and Taco Bell. You’ll see it with Baskin Robbins and Dunkin Donuts, where Dunkin Donuts and Baskin Robbins generally have different day parts, day parts meaning do I come in for breakfast lunch dinner or snacks, early morning or late night. You can now bring additional business into that location.
Dual branding has some really good benefits, but understand it also has some weaknesses. Some brands are doing better on the way to work, some brands do better on the way coming home. It may not sound like a big idea or a big problem but it can be in the real retail world if you’re expecting customers to cross over three lanes of traffic to get to your location. So make certain that if you’re going to be looking at dual branding that they are compatible brands with similar standards, and then it can work extremely well, but if not it can be a real hassle or problem.
Looking at nontraditional locations, think of the carve-outs in the market, these are generally ballpark stadiums, arenas, food courts, kiosks, mobile trucks, places where people are generally going not for your brand, but because there’s something else there and then they get hungry. So kids are not going to colleges to buy that hot dog, but they get hungry at college. They’re not going to an airport to pick up a McDonald’s, but they’re going to want to have some food or they’re going to pick up some Chili’s, or they’re going to go to Chili’s too at the airport. Those types of mass gathering locations need to be carved out and they have different relationships, generally you don’t sign the same type of franchise agreement with a nontraditional location as you would with an individual franchisee.
Retrofranchising is a strategy we use as a reorg strategy. We take company-owned locations and we sell them to franchisees at a going concern value. We take that money and what we may do with it is pay down debt, we may reshuffle our inventory of company-owned locations so that we now will take that money and build additional company locations in markets in which we don’t have enough critical mass. It is a great tool and a lot of companies will use it once they go from a company-owned system to a franchise system.
Remember that franchising is just a form of licensing. Licensing is fine if you use it appropriately. You don’t have the same controls over the business that you have under a franchise, but the licensor will own all the marks and just like in a franchise setting, the licensor will give a license to the franchisee in exchange for fees, just in the same way the licensor will control certain aspects of the business, but they don’t retain the same types of significant control that comes over that grey line that makes them a franchise. It really depends upon the structure of the business and how you’re coming to market, and good franchise consultants and good franchise lawyers can look at the relationship and tell you whether you’re going to be able to go to market as a license, meaning you can avoid many of the aspects of franchising, or whether you’re truly a franchise. It’s not easy. There are some very good places in franchising where there are exemptions that take place that keep you out of certain settings. Don’t walk away from licensing, but make certain that what you really are looking at is truly a license relationship.
For instance, in licensing you’re not going to be getting involved really in site approval most of the time, operating plans and rules, personnel policies, a lot of training is not going to take place, you’re generally not going to have an updated operations manual, lots of aspects in a license relationship. But you can, in certain situations, avoid franchise disclosure. Part of it is not collecting a fee for six months, be real careful on what you’re considering in the fee, first of all it’s not effective in certain states like Illinois, not effective in other states because the definition of a franchise is different. But when we say a fee in franchising, we don’t necessarily mean that you’re writing a check for the initial fee or getting a check for the royalty. Selling the franchisee something at above bona fide wholesale and making a profit on it. Selling the franchisee advertising material, selling the franchisee racks, many of those things will trigger the fee aspect of a franchise. There are federal exemptions, there are exemptions for franchisees over a certain size or exemptions for franchisees where it’s going to be a one-time transaction.
When you’re looking at franchising, sitting down with a good franchise lawyer or consultant, we can look at whether there are exemptions available for you, it’s not something that I would count on, but with larger franchise systems, with larger franchisees there are exemptions that keep you away from disclosure.
And just remember where we started all this. All franchising is, is an alternative method of distribution. You should always consider company-owned, cooperatives, management agreements, licensing, e-commerce, telemarketing, all of those should function within a system that may include franchising, but none of them take you out of franchising, they’re just an alternative method of distribution.