A contractual business agreement in which a franchisor licenses a brand

Author: Matthew Retzloff
Matthew Retzloff
Matthew Retzloff
Investment Banking | Corporate Development

Matthew started his finance career working as an investment banking analyst for Falcon Capital Partners, a healthcare IT boutique, before moving on to work for Raymond James Financial, Inc in their specialty finance coverage group in Atlanta. Matthew then started in a role in corporate development at Babcock & Wilcox before moving to a corporate development associate role with Caesars Entertainment Corporation where he currently is. Matthew provides support to Caesars' M&A processes including evaluating inbound teasers/CIMs to identify possible acquisition targets, due diligence, constructing financial models, corporate valuation, and interacting with potential acquisition targets.

Matthew has a Bachelor of Science in Accounting and Business Administration and a Bachelor of Arts in German from University of North Carolina.

Reviewed By: Himanshu Singh
Himanshu Singh
Himanshu Singh
Investment Banking | Private Equity

Prior to joining UBS as an Investment Banker, Himanshu worked as an Investment Associate for Exin Capital Partners Limited, participating in all aspects of the investment process, including identifying new investment opportunities, detailed due diligence, financial modeling & LBO valuation and presenting investment recommendations internally.

Himanshu holds an MBA in Finance from the Indian Institute of Management and a Bachelor of Engineering from Netaji Subhas Institute of Technology.

Last Updated:September 1, 2023

What Is A Franchise?

A franchise (or franchising) is a contractual business agreement in which a franchisor licenses its brand, intellectual property, trademarks, and business knowledge to a franchisee, who can then sell products under that brand or trademark.

It is a joint venture between a franchisor and a franchisee. 

A franchisor is an individual or corporation that owns the business model and brand trademarks and can license their use to a franchisee, which is an individual or small business that purchases the right to use an existing company’s trademarks and business knowledge.

Franchising is a relatively simple method of becoming a business owner and is becoming increasingly popular. 

The International Franchise Association released statistics stating that franchising is responsible for over 800,000 businesses at a gross value of more than $2 trillion a year.

The United States has been a leader in franchising for decades. The Singer Company is widely recognized as the first commercial franchiser. The McCormick Harvesting Machine Company was also one of the first companies to use a business model similar to franchising.

The Industrial Revolution boosted the popularity of franchising, with mass manufacturing becoming common. Simultaneously, the increase in consumer demand required manufacturers to reinvent their business models to sell and distribute goods more efficiently.

Today, franchising accounts for more than 18 million jobs in the United States of America. Franchising is also becoming increasingly popular in emerging countries such as:

  • China
  • Indonesia
  • Vietnam
  • India

As businesses that are often established in America grow and expand overseas. 

It is important to note, however, that different countries have different regulations with respect to franchising. A helpful (but not exhaustive) page outlining the regulations can be found here.

Key Takeaways

  • Franchising is a popular business agreement where a franchisor licenses its brand and knowledge to a franchisee.
  • There are five types of franchising: job, product, business format, investment, and conversion.
  • Franchising is prevalent globally, including in emerging markets.
  • Franchisees benefit from a proven business model, customer base, and support from the parent company.
  • Franchisors gain expansion opportunities and increased brand awareness, but there can be challenges and potential legal disputes.

Types of franchises

Franchising is a relatively broad business prospect and there are a variety of businesses that can be franchised. As a result, different types or levels of franchising have been established.

These are based on factors such as:

  • The franchisor’s strategy
  • The level of financial investment
  • The relationship between the franchisor and franchisee

There are five main types of franchising:

1. Job

This is a low-investment or home-based business that is usually solely operated by an individual or with the assistance of a small staff (usually fewer than five people). 

There are low start-up costs, which allows individuals to venture into business without large overhead costs or property leases. The franchisee only needs to pay the franchising fee, and the cost of necessary equipment or a vehicle.

Services, rather than goods, usually fall into this category. Some examples of industries or services included are:

  • Pool Maintenance

  • Lawn Maintenance

  • Plumbing

  • Cleaning Services

  • Children’s Services

  • Real Estate Service

  • Event Planning

  • Travel Agency

  • Delivery Services

  • Electronic Repairs

2. Product

In this type, the franchisee distributes the parent company’s product, and possibly any related service. 

The franchisor usually only licenses the trademark and does not share their entire business system. In some cases, the license includes the manufacturing process, such as franchises within the soft drink industry.

This type of franchising, also known as distribution franchising, makes up the largest percentage of retail sales in the United States.

Product distribution franchising includes the following types of companies:

  • Large Equipment

  • Appliances

  • Computers

  • Cars and automobile parts

  • Bicycles

  • Petroleum

3. Business Format

Under this system, the franchisee gets access to the parent company’s trademark, as well as their business system, including how to operate and market the product or service. 

Services provided by the parent company may include:

  • Business plans
  • Training
  • Advertising
  • Quality control
  • Continued support 

Business format franchising is the most popular type of franchising and makes up nearly three-fourths of all franchised businesses in the United States. 

Some examples of business format franchising include:

  • Fast Food

  • Restaurant Chains

  • Retail Stores

  • Fitness Centers/ Gyms

4. Investment

In this type of franchising, the franchisee invests money in a large-scale business but is likely not involved in the day-to-day activities. They may, however, employ a management team. This type includes significant financial contributions.  

This type of investment is popular with investors with large amounts of capital looking for a return on their investment. A common example of investment franchising is the funding of hotels.

5. Conversion

This type of franchising is used mainly by growing businesses. A franchise system will convert other existing independent companies in the same industry into a franchise unit. The franchisee will then adopt all trademarks, marketing, and procedures. 

This system is beneficial as it allows businesses to grow rapidly since the other existing companies have established clients and experience in the industry. 

Examples of industries that commonly use conversion franchising include:

  • Florists

  • Professional Services

  • Home Services

  • Real Estate Services 

Examples of a franchise

The most common examples include chains such as:

  • McDonald’s
  • Dunkin Donuts
  • Starbucks
  • Planet Fitness

The top 10 global franchises are shown in the table below.

Rank Name Industry
1 McDonald’s Food
2 KFC Food
3 Burger King Food
4 7-Eleven Retail
5 Domino’s Food
6 Ace Hardware Corporation Home Services
7 Century 21 Real Estate
8 Papa John’s Food
9 Taco Bell Food
10 Pizza Hut Food

An example of recent news regarding franchising is the exit of numerous franchises from Russia. Recently, Russia launched an invasion of Ukraine, which has caused thousands of people harm. 

According to Reuters, almost 50,000 people have died, over 15 million have been displaced and billions of dollars worth of damage have been caused.

In support of Ukraine, various companies have suspended services in Russia. Recently, two major companies, McDonald’s, and Starbucks have completely withdrawn from the country, closing down all units.

This can have serious repercussions on the economy of Russia. While the withdrawal of several multinational corporations negatively impacts Russia’s GDP, on a smaller scale, it impacts the owners of franchise units.

These small business owners have been stripped of their livelihood as stores and operations are shut down. Since they do not have a say in the parent company’s decision-making, they cannot control any aspect of this decision.

For more details, you can read these articles about the situation by Forbes and the New York Times.

Advantages of franchises

Franchising has emerged as a popular business model in various industries worldwide, offering both franchisors and franchisees multiple benefits. 

This structure allows individuals to launch their businesses under the umbrella of a well-established brand, often providing the support and resources needed for success. 

Franchising can be a very beneficial business endeavor, and there are numerous reasons why it is undertaken. 

Understanding these advantages can help you make informed decisions on this exciting business venture if you're considering becoming a franchisee or looking to grow your brand.

For the franchisors or the parent companies, franchising provides an efficient, cost-effective means of expanding their brand and market presence without the significant capital expenditure associated with traditional expansion. 

The franchisees, or the individual business owners, can start their entrepreneurial journey with a recognized brand, ongoing support, tried-and-tested business models, and a network of fellow franchisees. This significantly reduces the risks typically associated with starting a business.

Pros for franchisee

Being a franchisee means you're not alone in your business venture; you have the backing of a recognized brand, a proven business model, and support from a network of fellow franchisees. 

1. Access to Proven Business Model

The franchisee gets access to an established company’s trademarks and business model.

The parent company has already set up a successful system, which has been tested in the market. This, therefore, allows individuals to venture into owning their own business with lower risk. 

Additionally, being a part of a proven business may give franchisees access to lower interest rates for loans and fewer administrative barriers to entry.

2. Customer Base

Established brands already have a loyal customer base, and most people already understand the products or services sold by the company. This enhances the business’s chances of success.

3. Benefits from Parent Company

Franchisees commonly have access to support from their franchisor in various ways such as technical support, training, marketing strategy, or even equipment.

In some cases, the parent company is also able to negotiate better deals on supplies and other factors of production. They then pass on these lower costs. 

This business knowledge and support is extremely helpful for the success of the business and additionally lowers start-up and long-run costs.

4. Business Ownership

It is a convenient way for an individual to own a business with lower risk and cost as compared to an individual business. Franchisees often have control over their unit(s) and can make decisions on factors such as staffing, and management.

Additionally, they are their boss and have some control over their schedule, work flexibility, etc.

5. High Profits

Franchising can be highly profitable, depending on the parent company and the type of franchising.

In general, franchising is more profitable as a business venture as compared to setting up an independent business. Therefore, franchisees can get a high return on their investment. 

Pros for franchisor

The decision to franchise a business opens doors to growth, innovation, and market penetration that might otherwise be challenging.

1. Lower Costs and Reduced Risk

Expanding a business requires a significant financial commitment in the form of purchasing equipment, renting land, hiring more workers, etc. 

Through franchising, the business owner can expand his business with lower costs as the franchisee absorbs a large portion of the costs. The business owner, therefore, does not have to take loans or give up a portion of their company’s equity. 

Consequently, there is also minimal risk involved. To protect themselves further, franchisors often outline the terms of liability in the agreement. 

2. Expansion Opportunities

The franchisor has the opportunity to expand its business. Usually setting up a second location or extension of a business is costly and time-consuming. Franchising can make a business’ expansion a simpler process.

3. High Return on Investment

Franchisors usually receive a significant return on investment. Since the business model is tried and tested, new locations of an existing business are usually successful.

The business owner receives a portion of the revenues or profits according to the agreement. Additionally, franchisors usually receive franchise fees or royalty payments.

4. Increased Brand Awareness

One of the most significant benefits of franchising is increased brand awareness. With more locations, the brand can attract more customers and develop a larger customer base. As a result, the business is likely to be more successful and more profitable. 

Disadvantages of franchises

Whether as a franchisor or franchisee, the decision to engage in a franchise must be carefully made considering possible disadvantages.

For potential franchisees, issues such as limited autonomy, ongoing fees, and the risk of the franchisor's business failing may pose significant concerns. 

On the other hand, Franchisors need to help maintain brand consistency, manage complex relationships, or potentially dilute their brand value.

While franchising has numerous advantages, there are certain drawbacks for both parties involved. One should evaluate both the positives and negatives before making a business decision.

Cons for franchisee

While the prospect of operating under a well-known brand may seem appealing, franchisees often have to navigate challenges such as:

1. High Costs

The initial costs might be high for the franchisee, especially with larger, more established parent companies. Although the cost may be less than the startup costs for a new business, it might still be a strain for people looking at venturing into franchising.

Additionally, they likely have to pay ongoing royalty payments and a percentage of profits. These amounts can be extremely high in some cases.

2. Lack of Control 

While franchisees do have certain freedoms that come with owning a business, they have to adhere to rules and decisions by the parent company. 

This limits their ability to make decisions and might be frustrating for them, especially in the case of a difference of opinion or disagreement.

The regulation from the parent company can come in various forms such as:

  • Location
  • Operating house
  • Prices
  • Products sold
  • Services provided
  • Advertising or marketing
  • Holidays
  • Store design

3. Negative Influence on Other Units

If customers are unhappy with one unit, they might associate the negative experience with other units. This negatively impacts the profits of other units. 

This is especially common in the food industry, when one unit may not meet the health and safety standards required of them.

Cons for franchisor

Understanding these disadvantages is vital for any organization considering leveraging the franchise model.

1. Management Costs

While startup costs are lower than starting a new business (since the financial burden is shared), the franchisor still has to undertake certain costs such as a lawyer, a consultant, and any startup costs.

Additionally, the parent company may have to pay for things such as:

  • Training costs
  • Advertising
  • Marketing costs
  • Cost of technical and other support 

2. Lack of Control

An individual business has complete autonomy and can make its own decisions. In the case of franchising, while the parent company does maintain a degree of control over the business units to maintain uniformity, they do not have complete control. Franchisees make smaller decisions, and no two units will be identical. 

Moreover, the parent company cannot oversee employees, the quality of products, and the service of employees to a large extent.

3. Negative Influence of Other Units

A negative experience with one unit can ruin the reputation of the parent company, thus harming business and profits.

4. Legal Disputes

It is likely for disagreements to happen between the franchisor and franchisee, which leads to a possibility of legal disputes.  Additionally, some franchisees may try and take advantage of loopholes in the agreement. 

These legal disputes have to be resolved through legal mediation and can be costly, and negatively impact the company’s reputation.

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