Understanding the Franchise business model

The dictionary definition for the term franchising varies considerably and, in many Restaurants to Railwayscases does not adequately or accurately define the term. For example ‘InvestorWords.com’ suggest that franchising is “A form of business organization in which a firm which already has a successful product or service (the franchisor) enters into a continuing contractual relationship with other businesses (franchisees) operating under the franchisor’s trade name and usually with the franchisor’s guidance, in exchange for a fee.”

However, to some extent this definition might be unwittingly misleading. For example, there are cases where franchise opportunities are offered that have no proven record of accomplishment, being simply an idea that an entrepreneur is endeavouring to roll out across a wide geographical area within a limited timeframe, therefore using other people/businesses to aid rapid expansion of market penetration and share. Equally, with lower cost franchise opportunities, often the franchisor will enter into a contract with an individual who has no prior business experience or expertise. Finally, it should also be noted that the cost is not restricted to the ingoing fee as there will also be ongoing royalties and other fees attached to owning a franchise.

The basics of a franchise

A franchise offers the opportunity for a business or individual to operate under the Franchisor brand, using the systems and processes of that brand within a pre-determined geographical area. For example, in the US, it could be a specific state or part thereof and in the UK, the same conditions might apply to a county boundary. Depending upon the type of franchise, the geographical boundaries could be even more restrictive, such as confined to town or city limits. In the international environment, a master franchise opportunity may be offered, the holder of which will usually be responsible for the development of the franchise network within their domestic location, but this requires a considerable capital investment.

The contract
In addition to the geographical conditions previously explained, the franchise contract usually contains a number of conditions that the potential franchisee is required to agree to prior to their acceptance by the franchisor. In this respect, the following are the key elements that are normally included:

1) Term
In most cases, the franchise contract places a predetermined time period within the contract, for example ten years. At the end of this period, the contract would need to be renegotiated for a further period. If the franchisee does not wish to negotiate an extension, then their business either has to be rebranded or cease to trade.

2) Restrictions
The contract usually directs that the majority of the products sold by the franchisee have to be purchased from the franchisor or from suppliers that they designate. Similarly, whether it is a product or service based franchise, the systems and processes used within the business are required to follow those laid down by the franchisor. This requirement can also in some cases be extended to other areas of the business, such as stationery and advertising. Any changes that the franchisee wishes to make in these areas, or innovative ideas they might have, need to have the agreement of the franchisor before they can be implemented.

3) Costs
In addition to the ingoing franchise fee which, dependent upon the franchise being purchased, can range from £10,000 to £250,000 and beyond, the majority of franchisees attract a royalty fee, which is normally calculated as a percentage of the business revenue. Some will also require a contribution to the promotional campaigns run by the franchise business on a regional and/or national basis. Furthermore, once the original contract term has expired a fee might be payable for continuation of the franchise agreement for a further period.

It should also be noted that owners of many of the larger franchises often require the prospective franchisee to provide proof that they have sufficient working capital available to commence the business. This requirement can run into several hundreds of thousands of pounds/dollars if one is considering purchasing a McDonalds, Pizza Hut or similar sized franchise opportunity.

Benefits and disadvantages

One of the main benefits of the franchise business model is that, particularly with larger Fast foodsbrands,McDonalds, Pizza Hut and other fast food chains, the brand is already established and has the relationship with the consumer. In other words, the theory is that as the product/service is already well known and has been proven to be attractive to the consumer or business community it is targeting, thus making market entry easier for a new franchisee.

In addition, the franchisee will, in most cases, have the support of a large organisation and network, which has the expertise and competences to be able to assist with the franchisees development of the business, an area of service that is reflected within the size of the franchise and royaly fees.

The disadvantages are that the business operated by the franchisee will be strictly controlled by the franchisor, which means that the opportunity for innovation is more limited than it would be in an owner-controlled business. In addition, the geographical limits set for the franchise denies the franchisee the opportunity to expand the business outside of the boundaries set within the contract. Finally, it should also be noted that, despite the perception of some observers that a franchise business is more likely to survive and prosper than any other form of small and start up business venture, research conducted and statistics available in the UK and US indicate that up to 50% of franchise operations are still likely to fail within a ten year period.

Conclusion

Opting for a franchise opportunity as a mode of entry into business does have the advantage of the support of a proven business and brand in most cases. However, as has been discussed there are costs and limitations to these opportunities. Therefore, before making a commitment to the franchisor, it is important for the person/business considering this option should seek expert advice from both their legal and financial representatives.

Paul is the writing team leader at Re&d, and has other business content published at   wikinut.

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