Franchising Your Business

Part I: Introduction to Franchising

By The Franchising Law Group of Piper Rudnick and Kenneth Franklin, Franchise Developments, Inc.

What is Franchising?

There are many definitions of a franchise. They all essentially describe a comprehensive relationship in which one party (the franchisor) grants to another party (the franchisee) the right to operate a business selling products and/or services produced or developed by the franchisor, under the franchisor's business format and identified by the franchisor's trademark.

Franchising can also be thought of as a pooling of resources and capabilities. The Franchisor contributes the initial capital investment, know-how and experience, and the franchisee contributes the supplemental capital investment, motivated effort and operating experience in a variety of markets. A modern franchise includes a format for the conduct of a business, a management system for operating the business and a shared trade identity.

Franchising is a business method and relationship, not an industry. Franchising is the predominant business relationship in many industries and business segments and is becoming more common in others. The industries and types of businesses utilizing franchising as a method of distribution are listed in IFA's Franchise Opportunities Guide. Franchising is a comprehensive business relationship, not just a buyer-seller relationship. There is considerable interdependence between the franchisor and the franchisee.

Origins of Modern Franchising

Modern franchising began with the development after the First World War of gasoline service stations and automobile dealerships. The growth of franchising into the economic force it has become began after the Second World War and has paralleled growth in service industries since 1945.

Importance of Franchising

In the United States, franchising constitutes more than 1/3 of retail sales; there are more than 2,000 franchising companies and more than 500,000 franchisee and franchisor operated outlets. Franchising companies and their franchisees employ more than 8,000,000 persons. Working in a franchised business is the first job for many young people.

Franchising is growing in significance in other countries. Franchising is already a strong economic force in Canada, Japan, Western Europe, Pacific basin countries and Australia. Franchising is developing in Mexico, Brazil, Argentina, Chile, South Africa, Turkey, Saudi Arabia, United Arab Emirates, Kuwait, Indonesia, Malaysia, Poland, Czech Republic and Hungary. It is likely that franchising will develop in the next century in China, India, Pakistan, Russia, other countries of Asia, South America and East Europe, and Africa.

Types of Franchise Relationships

In the product distribution franchise, the franchisor typically is a manufacturer selling a finished or semi-finished product to a franchised dealer. The franchised dealers are willing to furnish presale and post-sale service to customers, concentrate on the sale of the franchisor's products and refrain from selling competitive products. There is substantial interdependence between the franchisor and its franchised dealers.

In the business format franchise, the franchisor licenses a business format, operating system and trademark to its franchisees and may or may not sell tangible products to them. Examples of business format franchising are found in food service, lodging services, automobile maintenance (e.g., muffler and brake replacement, tune-up, oil change, cleaning and waxing), convenience stores, automobile and truck rental, business services (e.g., bookkeeping, accounting, temporary and permanent employment) and consumer services (e.g., home cleaning and repair, lawn care, day care and educational services for children, tax return preparation and real estate brokerage).

Conversion franchising is considered a separate type of franchising because it involves the conversion of independent dealers or unaffiliated businesses to franchises. Existing businesses are willing to surrender some degree of independence and agree to pay fees in order to gain a stronger trade identity, regional and national marketing and the economic advantage of combined purchases of goods and services. The best examples of conversion franchising are the real estate brokerage networks (e.g., Century 21, Re/Max and Coldwell Banker).

Components of a Franchise Network

A franchise network consists of a franchisor (the grantor of the franchise) and one or more types of franchisees (the operator of the franchised business). The most common type of franchisee, usually called a "single unit franchisee", owns and operates from one to three franchised businesses. Typically, the franchises for these businesses were acquired at different times.

The second type of franchisee is called an "area franchisee." There are two general types of area franchises, a "development franchise" and a "master franchise." The development franchise grants to the area franchisee the right to develop and operate a specific number (or an unlimited number) of franchised businesses located within an exclusive territory. The franchisee typically commits to develop a minimum number of businesses during each development period (usually a one year period), referred to as a development quota. The development franchisee signs a separate unit franchise agreement for each such business.

The master franchise differs from a development franchise primarily with respect to the rights granted by the franchisor to the master franchisee to grant subfranchises to third parties to develop and operate the franchised business within the master franchisee's exclusive territory. In some master franchise relationships, the unit franchise agreement is signed by all three parties - the franchisor, the master franchisee and the subfranchisee. However, in most networks, the subfranchise agreement is between the master franchisee and the subfranchisee, and the franchisor has no direct contractual relationship with the subfranchisee and only such rights vis-à-vis the subfranchisee as are reserved in the master franchise and subfranchise agreements. The master franchisee charges fees to the subfranchisees and pays a portion of those fees to the franchisor. Though master franchising has been used effectively by several franchisors to develop franchise networks in the United States, the master franchise relationship is more common in international franchising.

Several franchisors have developed a category of franchise relationship, sometimes referred to as an area director, in which a person is granted rights to develop a territory by soliciting the sale of franchises on behalf of the franchisor and locating sites for the establishment of franchised businesses. The area director may also have responsibility for training, continuing assistance and quality control supervision of the franchisees in his area. The area director has a contractual relationship with the franchisor, but not with the franchisees. The area director generally receives a portion (1/4 to 1/3) of the initial franchisee fee paid by the franchisee and a similar share of the continuing fees paid by the franchisee. The area director structure has elements of single unit franchising, development franchising and master franchising. It has been used effectively by several franchising companies (e.g., Subway) to rapidly expand their networks.

Other Relationships of Franchisors and Franchisees

The franchise relationship is actually a composite of several relationships. The franchisor is a supplier of intellectual property, granting to the franchisee the right to use trademarks, trade dress, confidential information, a business format and an operating system. The franchisor is a trainer of and an advisor to the franchisee. Generally, the franchisor furnishes marketing services to its franchisees by collecting and pooling advertising contributions and administering a marketing program that develops advertising and marketing programs and materials and conducts market research and public relations. Finally, franchisors supply research and development services to their franchisees.

In addition to these typical relationships, franchisors and their franchisees frequently have additional relationships. In some franchise networks, the franchisor will be the franchisee's landlord, either leasing to the franchisee a site owned by the franchisor or subleasing to the franchisee a site that the franchisor has leased. Generally, only large, well financed franchisors are able to act as landlords to their franchisees and this relationship is most common in food service and in franchise networks that lease sites in regional malls (where the franchisor will usually be a more acceptable tenant).

Some franchisors, as manufacturers or wholesalers, supply equipment to their franchisees. Franchisors also sell finished products to their franchisees for resale (e.g., automobiles, computers, gasoline, and inventory carried by convenience stores) or supply components and ingredients that the franchisee uses to make a product and/or perform a service (e.g., food products for a food service business and parts for an automotive repair business). The franchisor may be the exclusive supplier of certain equipment and products or merely an approved supplier along with other suppliers from whom franchisees may purchase. The franchisor may serve or act as a supplier entirely for quality control or trade secret protection purposes, or to establish a convenient and low cost supply source for its franchisees (charging only small mark-ups on goods sold to franchisees and relying on fees for its franchising revenue) or may structure its supply program as a profit center (in lieu of or in addition to fee revenue).

It has become more common in recent years for franchisors to be a direct or indirect source of financing for their franchisees. Financing may be provided directly, indirectly through general or limited guarantees or inventory buy-back arrangements with third party lenders, by leasing a business facility to the franchisee or by other means. In some cases, the franchisor will receive rights to buy equity interests in the franchisee's business as part of the consideration for loans made to the franchisee. Generally, only larger franchised networks are able to develop financing programs for their franchisees. Such networks use franchising primarily to put in place highly motivated owner-managers in their retail outlets and only secondarily for the capital contributions that franchisees make to network expansion.

Alternative Methods to Expand a Business

Franchising is certainly not the only method for expanding a business. Though franchising offers some unique advantages over other methods, no company should decide to develop a franchise expansion program without first considering other methods.

1. Company-owned outlets
The most commonly used alternative is the development of additional outlets owned and operated by the company. This form of expansion gives a company somewhat greater control over the development of its network and higher revenues from each outlet that it opens (assuming they are profitable), but it has several disadvantages. First, the company will need to raise substantial capital to expand its network. For example, if each outlet requires capital of $100,000, 100 outlets will require a capital investment of $10 million. A small company is able to acquire that amount of capital only over an extended period and frequently is required to sell a substantial part of its ownership to acquire a sufficient capital base.

Second, a company growing its network with owned outlets will face two distinct manpower problems: finding sufficient outlet managers and field service staff to supervise its outlets and devising compensation programs to motivate managers. A number of companies require outlet managers to make an investment to secure an outlet managerial position and compensate them with both a base salary and a share of outlet profits or cash flow. Such compensation structures undoubtedly enhance the motivation of managers, but it is doubtful that they equal the motivation enhancement inherent in the risk and reward characteristics of ownership of a business as a franchisee.

2. Joint ventures
A business may also be expanded by developing joint venture relationships. Two types of joint ventures can be used. In one type, the sponsoring company manages each outlet and the joint venture partner is a passive investor that contributes capital. Many such relationships are found in the lodging industry. The hotel management company contributes know-how, development plans, its reservation system, its trademark and management services, and its joint venture partner(s) contributes capital to develop, equip and staff the hotel and operate it until it produces a positive cash flow. The hotel management company will generally receive a base fee and will share profits with the joint venture partner(s).

In a less common form of joint venture, the sponsoring company acts as a passive investor, furnishing capital for outlet development, along with its joint venture partner. The latter has responsibility for the management of the outlet. This relationship differs from a company-owned outlet whose manager shares in profit or cash flow only in that the joint venture manager will have an actual ownership interest in the outlet he manages, not just a compensation package that includes a share of profits.

3. Independent dealerships
Some companies can effectively expand their distribution network with nonexclusive, independent dealerships (or distributorships). Such dealerships may carry other, including competitive, products and the network will not have the degree of interdependence found in a franchise network. This type of distribution network is suitable for a manufacturer, particularly a producer of a relatively low cost product with minimum pre-sale and post-sale services, or a product that consumers are used to buying at a retail outlet that carries multiple brands of the same product (e.g., appliances). For such products, a wide range of distribution outlets may be the best marketing strategy. Non-exclusive, independent dealers are rarely utilized for the distribution of a service.

4. Member-owned cooperative associations
Member-owned cooperative associations are found in the grocery and hardware store industry and in bedding products manufacturing. A member-owned cooperative would be an alternative structure to a conversion franchise. Cooperatives are difficult organizations to manage because members of the board of directors have potentially conflicting interests: the interests of the cooperative and its members and the interests of their individual businesses. Cooperatives are also subject to more stringent antitrust rules than are franchised networks.