A franchise is a mutually beneficial contract arrangement between two business entities. The concept is said to date back to the 1850s when Isaac Singer invented his sewing machine. He then found that he needed help teaching buyers how to use it after he realized a way to raise enough money to manufacture the machines in large numbers. The first franchise was born when Singer came up with the idea to sell local businesses the rights to sell his machine in order to achieve these goals.
Then came McDonald’s a century or so later, followed by a flurry of other fast-food restaurants, motels and other service businesses. About 3,800 franchise systems were up and running in the U.S. by early 2019, according to Franchise Direct. They employ about 8 million Americans in more than 745,000 locations.
What Is a Franchise?
A franchise is a marketing partnership between the owner of an existing business – the franchisor – and other individuals referred to as franchisees, who are granted the right to sell the franchisor’s product, services and/or intellectual property as part of a licensing agreement.
A trademark or brand is typically involved. The franchisee isn’t just selling any old hamburger. It’s selling a McDonald’s hamburger, and it's doing so beneath those big golden arches. The franchisee has contracted the right to use the McDonald’s name and its business operating system. According to Merriam-Webster, the definition of a franchise is “the right or license granted to an individual or group to market a company's goods or services in a particular territory.”
The franchisor is more or less hands-off when it comes to actually running the business. Day-to-day operations are under the exclusive control of the franchisee, from hiring and firing employees to deciding how much they should be paid. The franchisor and franchisee are effectively two separate businesses. The franchisee isn’t an employee of the franchisor, nor is it an independent contractor. They’re each independent operators and business owners in their own right, operating under the terms of a franchise agreement.
In addition to McDonald’s, some well-known franchises that you might do business with on a pretty regular basis include H&R Block tax services, Hampton Inns & Suites, Subway and that 7-Eleven convenience store where you grab your coffee to go on your way to work in the morning.
The Franchising Agreement
This franchise business relationship is governed by a license or agreement. The document sets forth multiple conditions for the franchising relationship, and it delineates who is obligated to do what.
The franchisee must contractually agree to prominently advertise and display the franchisor’s logo. Certain employee issues might be governed as well, such as the type of uniform workers must wear and franchise rules for the quality of customer service. Other rules may be put in place to ensure that every business that has contracted with the franchisor follows the operating methods specified and provides the same quality features to consumers, protecting the franchisor’s brand name. The franchisor is bound to provide operational support and guidance to assist the franchisee in achieving a thriving business and in meeting the contractual guidelines.
Straying from any of these contractual provisions would typically be considered a breach of the franchising agreement, terminating it for lack of due diligence. Franchising agreements are typically for a set period of time and can be renewed by the agreement of the parties.
Types of Franchise Businesses
Franchise arrangements aren’t all identical. They tend to fall into one of three categories, with slightly different terms.
A business format franchise gives the franchisee the right to use the franchisor’s trademark, services or products, and it also grants the use of the franchisor’s entire business system. This might include training procedures for employees, location selection based on market research, marketing and quality control. This type of franchise is most often associated with ongoing advisory guidance, and most franchises fall into this category.
A product distribution franchise tends to be simpler in structure, yet it can produce far more in total sales volume. The franchisor supplies the franchisee with the product in this type of arrangement, and it grants the franchisee the right to sell or distribute it. This type of franchise generally doesn’t include operating system support.
The third type of franchise includes enterprises such as auto manufacturing and other businesses that produce products under the brand name, such as clothing or sports equipment.
How Much Does a Franchise Cost?
A franchise is an ongoing source of revenue for the franchisor or parent company, and it’s an ongoing financial commitment for the franchisee. Franchisees pay ongoing royalties to franchisors for the right to continue using their name, logo and/or franchise business model. An initial, upfront fee payable at the time the franchise agreement is entered into typical as well.
Franchisors don’t take a percentage of the franchisee's profits. Royalties and the initial fee are set in advance, so it’s the franchisee’s good luck if business booms after the agreement is entered into. They don’t have to share that bounty, too.
Exactly how much all this works out to in dollars and cents comes down to case-by-case negotiation. There’s no legally mandated franchise fee or royalty fee, such as the U.S. or state-based minimum wage. A franchisor is within its rights to demand top-notch fees and royalties, or it can virtually give franchises away in the early years in order to get their business enterprise off the ground. The franchisee has the right to pay that fee and those royalties or look into another franchise opportunity or business type.
What’s in It for Franchisors?
Franchisors have a bit more to gain from this contractual relationship than ongoing royalty fees. The franchise tool enables them to expand to new locations at a more rapid pace than would normally be possible, while additionally collecting those fees. Their other option would be to personally set up their own businesses in these locations, which could be prohibitively expensive.
The franchise arrangement allows for growth at the expense of the franchisee, without sacrificing any actual ownership in the parent business. Franchisors can expand their empires without dealing with the day-to-day headaches of running a small business and the associated costs. By the same token, they give up some measure of control over those locations.
What’s in It for Franchisees?
Franchisees gain the significant benefit of selling or providing a product or service that’s already a brand name. They don’t have to market it. Consumers already trust it. This can virtually guarantee a new business’s success without much of the extensive risk and elbow grease that would normally be involved.
The start-up costs can be steep, but franchisees don’t have to begin at square one to create their own famous hamburger if they enter into a franchise agreement to operate under those golden arches. Of course, they must produce a burger of the quality that customers have come to expect from McDonald’s, but they effectively save the cost of developing that business model or idea.
Of course, all this guidance comes at the expense of some loss of control over their business plan. Those rules contained in the franchise agreement must be followed, or they’ll no longer have a franchise.
Another significant advantage for franchisees is that ongoing support from the franchisor. This can include purchasing products, equipment and supplies from the franchisor’s business network rather than establishing and negotiating with their own suppliers, which might end up costing more. The franchise agreement often includes marketing assistance, which can be a real boon for a franchisee who’s venturing forth into a startup business without a great deal of experience to fall back on. They can avoid the trial-and-error pitfalls that can come with launching their own business idea.
- HG.org Legal Resources: Franchising Law
- International Franchise Association: What Is a Franchise?
- Franchise Direct: Franchising Explained. Definition and Meaning
- MSA Worldwide: What Is a Franchise? Franchising and How It Works
- Entrepreneur: Franchising
- U.S. Small Business Administration: Franchise Businesses
- Merriam-Webster: Franchise
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.