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IN THIS CHAPTER

❯❯ Exploring the history of franchising

❯❯ Defining a franchise and the roles of franchisor and franchisee

❯❯ Getting to know franchise wannabes, and why should you avoid them

❯❯ Understanding the rights you will be granted under a franchise agreement

Three constants have fueled the growth of franchising over its long history: the desire to expand, the limitations on human and financial capital, and the need to overcome distance. Although you may think of franchising mostly in the context of your neighborhood fast food outlets, franchising has transformed how we purchase products and services today. More than 120 distinct industries use franchising today, and because of that it is nearly impossible to drive down any major street in the world and not pass by some business that is part of a franchise network. This chapter begins your exploration of franchising, not by looking at any particular franchise but by giving you some of the basics so you can better understand what franchising is all about.

Tracing the History of Franchising

Franchising seems ageless and omnipresent. It is used commercially today in over 120 industries to deliver to us all types of products and services in a way that allows us to trust in the consistent quality of the franchisor’s brand. It is also now being used by social enterprises such as nongovernmental organizations (NGOs) to bring fresh water, healthcare, education, electricity, and countless other products and services internationally to people living in underdeveloped parts of the world.

Franchising is a way for companies to expand and bring their products and services to consumers without the company owning and operating their locations directly. It is a way to create wealth through the establishment of independent local businesses. In addition to creating jobs at those independently owned locations, franchising is the single largest engine of entrepreneurial training in the world and has consistently been one of the driving forces in creating new entry-level jobs in every market in which franchising exists. It is one of the most productive methods ever adopted for the creation of wealth, capital formation, and a solid middle class.

Franchising is not new and it wasn’t invented by Ray Kroc or McDonald’s. It stems from systems used long ago by governments and by the church. Consider the legends of Robin Hood and Camelot. If you examine the relationships between the kings and the nobles, you can begin to understand the historic impact of franchising. It would have been impossible for the heads of government then to effectively control expansive territories, raise armies, regulate commerce, collect taxes, and provide government services without a structure that provided territory to nobles – who in exchange acted on behalf of the government and shared the local taxes and fees collected. That is, essentially, franchising. Even today, the continuing fee paid by franchisees to franchisors is called a royalty. A similar relationship was used by the churches and effectively still is. Franchising allowed for global exploration and commerce, and companies like the Dutch East India Company and the London Company used it to establish trading areas and explore the globe, including North America.

Franchising was first used commercially by European brewers for the distribution of their products to pubs. The first recorded commercial franchise in North America was created by Benjamin Franklin in 1731 in the British colonies, before the United States became a nation. Benjamin Franklin was the Postmaster for the Colonies under the British, and 45 years before the United States became a nation, he and Thomas Whitmarsh entered into the first franchise, or what they called a “Co-partnership,” for the carrying on of the “Business of Printing in Charlestown in South Carolina.” The printing shop published The South Carolina Gazette and was the local printer of many of Franklin’s writings, including his Poor Richard’s Almanack. Franklin went on to establish other franchises in the colonies and elsewhere in the years before the Revolution. His third franchisee was Elizabeth Timothé – a woman. At a time when commerce was substantially male dominated, Elizabeth Timothé is recognized as the first female publisher in North America.

Franchising also played a major role as the United States began its territorial and technological growth. Governments granted monopolies to franchisors for the development of railroads, ferries, electricity, roads, and trading posts needed for municipal infrastructure.

For more on the history of franchising, check out the companion website (search “Franchise Management” at www.dummies.com).

What Is a Franchise, Anyway?

Franchising is, in a word, a license. It is a system for independently owned businesses to share a common brand, distribute products and services, and expand. It’s a contractual relationship between a brand owner (the franchisor) and an independent local business owner (the franchisee).

For example, Bright Star Care doesn’t “franchise” medical and non-medical home care assistance, FASTSIGNS does not franchise printing, Wetzel’s Pretzels does not franchise pretzel shops and Dat Dog does not franchise hotdogs, sausages, and beer. What each “franchises” is a system that delivers quality branded products and services to consumers. And they do so through a network of independently owned and operated businesses that deliver a consistent customer experience.

“Dat Dog is an experience,” says Bill DiPaola, president and COO of Dat Dog, based in New Orleans. “It is more than simply the great food and expansive assortment of craft beers that make us successful and that will make our franchisees successful. It is our commitment to community, married with the fun and ‘zany’ culture of Dat Dog, that brings our customers back and that is the approach we expect our franchisees to take in each of their restaurants.”

A franchise occurs when a franchisor licenses its trade name and intellectual property – the brand and its operating methods (its system of doing business) – to a person or group who agrees to operate their business to the franchise system’s brand standards. The franchisor defines the brand promise it wants delivered to consumers, provides the franchisee with initial and continuing support, and then ensures compliance by the franchisee on how it delivers on that brand promise. The magic of franchising is that consistent brand standards can be achieved at each location without the franchisor being involved in the day-to-day management of the franchisee’s business.

In exchange, the franchisee pays an initial franchise fee to join the system and a continuing fee known as a royalty to remain a part of the franchise system.

The effects of franchising on modern business

We have grown accustomed to the consistency that comes from shopping at branded locations. From the comfort of knowing exactly what you will find when you check into a Courtyard by Marriott, to the quality of the chicken at a Popeye’s Louisiana Kitchen or a haircut at Sport Clips, people know what they will get when they purchase under a franchisor’s brand. The number of companies and industries bringing goods and services to consumers through franchising is growing, limited only by the imagination of the people who understand its potential application.

The size and impact that franchising has had on the economy in the United States is often unrecognized. According to the Franchise Education and Research Foundation, business-format franchising in 2017 is projected to generated close to 8 million jobs in the U.S., accounting for over $700 billion in economic output and over $425 billion in gross domestic product from more than 744,000 establishments. In a recent survey, more than 76 percent of American consumers favorably viewed shopping at a locally owned franchise business in their neighborhood. That’s the power of franchising today.

The success of franchising for business owners

Franchising creates opportunities for business ownership to create personal wealth and generates local jobs. It also consistently delivers products and services on a global basis to the brand standards established by the franchisor.

As you explore becoming a franchisee or a franchisor, be wary of statistics that talk about the “success rate” in franchising. As late as 2000, the International Franchise Association published statistics that claimed that franchisees had a success rate of 95 percent – versus a failure rate of 85 percent for nonfranchised startups in their first five years in business. Those statistics turned out to be inaccurate and misleading.

The IFA has frequently reminded franchisors to not use those out-of-date and misleading statistics, but unfortunately, some franchisors, franchise brokers, and franchise-packaging firms (one-stop shops that offer “cookie-cutter” franchise advice) continue to use them to attract potential franchisees. What should be important is how well a franchise system is doing, and it is irrelevant in choosing any franchise opportunity whether or not franchising in general is doing well. You should be very wary of working with anyone who still uses invalid claims of franchise industry success statistics. In fact, we recommend strongly that you don’t work with them at all.

Franchising can be a very effective method of getting into business, but that depends on how carefully the franchise system is structured and supported. Even in highly successful franchise systems, locations can fail for a host of reasons. It is up to prospective franchisees to conduct a proper examination of every franchise opportunity that interests them.

What’s the Big Deal with Brands?

The brand is a franchise system’s most valuable asset, because consumers decide what and whether to buy based on what they know, or think they know, about the brand. Unless a consumer has a personal relationship with the local owner of a franchise, they probably don’t give any thought to who owns the local business. In their minds, they are shopping at a branch of a chain. This fact is evident in the signs most franchisors require franchisees to post in their locations notifying the public that the location is owned and operated by a local business owner. In the consumer’s mind, a company’s brand equals its reputation.

“Many brands spend too much time talking about what and how they do things,” says Dawn Kane, CEO of Hot Dish Advertising. “Where brands win is when they connect emotionally to the customer. You can’t build a solid reputation without that emotional connection. It is the emotional connection that drives consumers into a franchisee’s location, and each location’s consistency in meeting that brand promise keeps them coming back.”

Franchisors focus much of their support effort, time, energy, and money ensuring consistency at each of their locations. This promise of consistency is a major advantage for new franchisees because it is meant to assure them a ready flow of customers. A good brand can communicate a positive message to the customer. Equally so, a bad brand experience can paint a negative message for the entire brand. With a great brand, consumers can visualize and almost feel the experience they will receive even before they enter the local business.

A positive brand recognition is what every franchisee hopes for. With a well-known successful brand, new franchisees don’t have to build brand awareness for their business because the franchisor and the other franchisees have already taken care of that. Having a reputation for a positive brand experience is one of the major advantages found in well-established franchise systems.

But brands are not born fully grown. Smaller franchise systems or those with limited brand recognition in markets can’t deliver consumer acceptance until the local franchisee creates a reputation for a positive brand experience in their market. This is an issue for new franchisees because they may be required to build brand recognition by spending more on advertising and promotion than where the franchise system’s brand is well known. When prospective franchisees review the franchisor’s offering, the amount of advertising specified by a franchisor is only the minimum amount they expect will be required – but most certainly is not the maximum amount a new franchisee may need to invest.

Franchise Siblings: Three Types of Franchising

There are three basic types of franchising:

❯❯ Traditional or product-distribution franchising

❯❯ Business-format franchising

❯❯ Social franchising

Traditional franchising

The industries in which you most often find traditional franchising include soft drinks, automobiles and trucks, mobile homes, automobile accessories, and gasoline. The franchisee is typically selling products manufactured by the franchisor. Some examples include Coca-Cola, Ford Motor Company, and John Deere.

Although traditional franchises look a lot like supplier-dealer relationships, the difference is in the degree of the relationship. In a traditional franchise, the franchisee may handle the franchisor’s products on an exclusive or semi-exclusive basis, while the supplier-dealer may handle several products, even competing ones. For example, Tempur-Pedic mattresses may be offered by a national dealer network that also offers other bedding brands in their retail stores.

The traditional franchisee is closely associated with the franchisor’s brand and generally receives more services from its franchisor than a dealer would from its supplier. Frequently the franchisee provides some pre-sale preparation before a product is sold (such as you find with Coca-Cola, where the franchisee manufacturers and bottles the soda) or some additional post-sale servicing (such as you find at a Ford dealer with your periodic maintenance programs).

In a traditional product-distribution franchise, the franchisor licenses its trademark and logo to its franchisees, but it typically does not provide franchisees with an entire system for running their businesses. Measured in total sales, traditional franchising is larger than business-format franchising, covered in the next section.

Business-format franchising

The business-format franchisee gets a complete system for delivering a franchisor’s product or service. The major difference between a traditional franchise and a business-format franchise is that business-format franchisees operate their business based on a business system largely prescribed by the franchisor. The role of the franchisor is to define the business system and establish the brand standards, whereas the role of the franchisee is to independently manage their business on a day-to-day basis to achieve those brand standards.

McDonald’s doesn’t franchise hamburgers, and Domino’s doesn’t franchise pizza. What they provide to their franchisees is a system of delivering their branded products and services. Although traditional franchising is larger than business-format franchising, because the size of the individual transactions is larger, more than 80 percent of all franchise locations in the United States are the business-format type.

It is the franchisee’s execution to a franchisor’s brand standards that produces consistency – the foundation for a business franchisee’s success. Interim Health Care, Sport Clips, PostNet, PuroClean, Twin Peaks, and Firehouse Subs are all examples of business-format franchises. The business-format franchisor provides a detailed system, and the franchisee is trained and supported in their independent management of their business.

The confidential operating and procedures manuals (the how-to guides of every great franchise) provide the franchisee with the information they will need to establish, operate, and manage their businesses. The goal in a franchise system is for customers to get the same brand experience each and every time they shop in one of the franchise’s locations, and the manual is one of the tools to achieve that important goal.

“Successful franchises are usually started and operated by people who have been in that particular business for quite some time, and who have developed proprietary techniques for avoiding pitfalls or dealing with them when the unexpected occurs,” says Gordon Logan, CEO and founder of Sport Clips. “Thoroughly documented operating procedures, marketing plans, and training programs are the hallmarks of the most successful franchises. Great franchises never stop improving their systems, always putting the profitability of their franchisees at the top of their priorities while being relentless about maintaining brand standards. Market domination is always a prime objective.”

Although the franchisor provides a comprehensive business system, it is the franchisee’s responsibility to manage all the day-to-day affairs of the business. After all, the franchisee is an independent business owner simply operating under a license.

Although franchisors may specify uniforms and other brand standards related to how a franchisee’s staff looks (think tattoos, beards, piercing, cleanliness), franchisors don’t generally provide any other human resource requirements. Who a franchisee hires, how much they are paid, what benefits they receive, which hours they work, and how they are promoted and disciplined are all the sole responsibility of the franchisee. Because human resources are the sole and exclusive responsibility of the franchisee and not the franchisor, franchisors and franchisee are generally not considered joint-employers and are not liable for each other’s actions or inactions.

Social franchising

Social franchising is the newest form of franchising. Social franchising is the application of business-format franchising’s techniques and methods to the delivery of products and services to address the needs of people who live at the base of the economic pyramid (BOP). The term BOP refers to the estimated three billion people in the world who live on less than $2.50 per day. Social franchise systems generally focus on the lack of access to basic needs such as safe drinking water, adequate food supply, authentic drugs, quality healthcare, education, sanitation, and energy. These products and services have historically been delivered primarily by governments, churches, and NGOs with mixed results.

According to Julie McBride, senior consultant for social franchising for MSA Worldwide, “Social franchising breaks the cycle of poverty by helping local entrepreneurs develop and expand businesses that solve social needs while at the same time generating profits for the local business owners and creating jobs in the communities they are serving.”

NGOs provide a beneficial and important service in bringing critical products and services to the poor. But traditional methods used to provide this type of support are less sustainable than those found in social franchisors. Traditional methods typically lack the level of brand standards found in franchising, and NGOs usually don’t typically focus their resources on training and supporting local operators as do social franchisors.

The social franchise model is emerging as a powerful tool for the international development community because of its potential to scale (expand). All the elements found in commercial franchising – including agreements, manuals, training, headquarters and field support, consistent supply chains, brand standards, and enforcement – are also found in a social franchise system.

A significant problem facing both social franchisors and NGOs is the frequent inability of consumers to afford the products and services, and the necessary reliance by the system on donations and other financial contributions. Because most NGOs use a top-down structure (the opening of locations), this often leads to an insufficient focus on ensuring that local product and service providers can sustain the standards found in commercial enterprises like social franchising.

Evolution in social franchise systems is generally driven by the same reasons found in commercial franchising – changes in consumers and competition. In an NGO, changes are frequently caused at the direction of donors and the unique products and services they want the NGO’s system to deliver. This, above all else, is one of the reasons that NGOs are not able to achieve the sustainability found in franchising.

The Roles and Goals of Franchisors and Franchisees

The franchisor and franchisee are in distinctly different businesses – they merely share a brand. In a franchise, the franchisor licenses to the franchisee an operating system, and the franchisee provides the products and services to consumers.

As a licensor, the business of a franchisor is to develop, license, support, and expand an indirect system of distribution of its branded products and services. As required under the law, it is the franchisor’s responsibility to establish brand standards and enforce how the franchisee meets those brand standards sufficient to protect consumers. In contrast, the business of a franchisee is to independently manage and operate their business to the brand standards established by the franchisor.

In this interdependent relationship, the franchisor generally has no contractual right to manage or supervise the day-to-day business affairs of its franchisees, and its rights to enforce its standards are limited to those agreed to in the contract between the parties. The franchise relationship effectively runs on trust, as the ability of a franchisor to enforce its brand standards is ultimately limited to its right to default and terminate noncompliant franchisees – a relatively high bar under the law.

Looking at the world through franchisor lenses

Who a franchisor is may vary. It can be a large or small company with a long history of successful operations or it can be a startup with little or no experience. Some examples include the following:

❯❯ Roark Capital is a private equity firm with over $6.5 billion in equity capital. Some of its portfolio companies include 1-800 Radiator, Anytime Fitness, Arby’s, Auntie Anne’s, Batteries Plus Bulbs, Bosley’s, CARSTAR, Carvel, Cinnabon, CKE Restaurants, Corner Bakery Café, Econo Lube & Tune, Great Expressions Dental Centers, Home Service Stores, Il Fornalo, Jimmy John’s, Maaco, Massage Envy, McAlister’s Deli, Meineke, Merlin, Miller’s Ale House, Moe’s Southwest Grill, Naf Naf, Orangetheory Fitness, Pet Supermarket, Pet Valu, Primrose Schools, Pro Oil Change, Schlotzsky’s, Take 5 Oil Change, and Waxing the City.

❯❯ Foumami, Dat Dog, Beverly Hills Rejuvenation Center, and Americas Escape Games are small and relatively new to offering franchises.

❯❯ Firehouse Subs, Sport Clips, FASTSIGNS, Bright Star, and 7-Eleven are larger, well-established franchisors.

All great franchisors provide their franchisees with a uniform operating system and train and support them to independently manage and operate their business. When looking at franchising, consider that new businesses don’t usually fail because their products or services are of low quality – they fail because of unknowns and lack of resources. Established franchisors have made and survived their mistakes, and that is one of the benefits of working with established companies – you can generally avoid a lot of the minefield of blunders that startup businesses usually face.

Franchisors don’t set standards, nor do they provide assistance, out of the kindness of their hearts. It is important to them that their franchisees deliver a consistent, sustainable, and replicable quality of products and services to consumers. They need the system to grow, prosper, make profits, and achieve a solid return on investment at every level, and to achieve that they design their systems so that franchisees can easily execute to their brand standards. If they do that well, franchisees can make money, stay in business, expand, and pay fees. The franchisor’s brand value grows as more people shop at its branded units – and because of everyone’s success, additional investors will want to become franchisees.

The franchisee’s end of the bargain

When you invest in a franchise, you are not buying a franchise. You can’t because all the franchisor is providing to you is a license allowing you to use its brand name and methods to operate your business, and you only get those rights for a specified period of time.

As a franchisee, you own the physical assets of your business: the land, building, equipment, and so forth. You are not buying the franchisor’s brand or systems, and in some franchise system, the franchisor may even retain the right to purchase your assets when the franchise relationship ends.

It may not sound like much of a deal, but here’s what you get when you join a well-established franchise system:

❯❯ Brand standards and enforcement by the franchisor

❯❯ A proven and successful way of doing business

❯❯ A recognized brand name

❯❯ Training and ongoing field and headquarters support

❯❯ Research and development into new products and services

❯❯ Professionally designed local, regional, and national advertising and marketing programs

❯❯ Often, a chance to invest in additional franchises

❯❯ A shortcut around the common mistakes of startup businesses

❯❯ Often, a buying cooperative or negotiated lower costs from suppliers for many of the things you need to run and operate the business (ingredients, advertising, insurance, supplies, and so on)

❯❯ Your fellow franchisees as a network of peer advisors

❯❯ Sometimes a protected market or territory in which to operate your business

Franchisors don’t always provide their franchisees with a defined area around their location in which no other company-owned or franchisee-owned business are allowed to operate. Many do, but even then the market area provided may not be an exclusive territory and may only be a protected territory. An exclusive or protected territory may be defined by the following:

❯❯ The radius or area around the franchisee’s location

❯❯ The number of households or businesses in an area

❯❯ The number of people who live in an area

❯❯ Zip codes

❯❯ Counties

❯❯

Metes and bounds using highways, streets, or other geographic measures

Metes and bounds is an old English term still used in real estate today. A mete defines the measurement or distance, and the bound describes the physical feature like a road or a river. You will see it frequently used to describe territories in franchising.

❯❯ Any other method that defines the area in which no other same-branded location may be established or in which the franchisee has some protection

From the franchisor’s perspective, if the territory is too large, the total market will not contain enough locations to achieve brand recognition. From the franchisee’s perspective if it is too small or if other locations are too close, there may not be enough customers to support the business.

The goal for franchisors when granting any type of territorial protection is to ensure that they have the right to develop sufficient locations in an area to achieve brand penetration – the number of locations in an area sufficient to service the market and to ensure that consumers see the brand frequently.

Even when a franchisee is granted territorial rights, they may not be permanent and may only be provided for a limited period of time. Some franchisors may also require franchisees to reach certain levels of performance to maintain those rights. And in some systems, a protected territory may overlap with another. If you are a prospective franchisee, make sure you read the contract, and consult with a lawyer to make certain you understand the territorial rights the franchise agreement provides.

Nuances of the Franchisor/Franchisee Relationship

The franchise relationship is contractual, and franchisees and franchisors are not partners. Franchisors don’t have a fiduciary responsibility to their franchisees. That means that the franchisor can do things to benefit itself and other franchisees, even if these things aren’t beneficial to all franchisees.

In great systems, franchisors and franchisees frequently discuss issues both one-on-one and communally through franchisee advisory councils (FACs). But it is essential to understand that it is the sole right of the franchisor to make the brand decisions.

FACs give franchisees a voice in the system’s direction and provide the franchisor with advice in evolving and improving its systems. Often, one of the FAC’s functions is to review ideas for new products and services, whether the ideas come from the franchisor or from a franchisee. FACs are also frequently involved in advertising review and menu or product testing, and help the franchisor to make changes to improve the system.

You may often hear franchisees referred to as entrepreneurs, and franchisees may view themselves as entrepreneurs. But franchisees are not true entrepreneurs because if they were they would naturally want to make all the decisions about how the franchise system should operate and would want to break free from the constraints that franchise systems impose on them. Successful franchisees are “formula entrepreneurs” willing and able to invest in a system and follow the system’s direction. To achieve consistency a franchisor has to make decisions about how the business operates globally. Franchisees may think that they have the next great idea, and often they do, but the franchisor must look at those great (and sometimes not-so-great) ideas and make system-wide decisions.

For franchisees who are true entrepreneurs, the restrictions of a franchise system can be overwhelming and may even make the franchisor appear like a dictator. This can lead to disputes and disruptions in the franchise relationship.

If you invest in a franchise, you might not become rich. Not all franchises systems are successful, not all franchisees are profitable, and many franchisors and franchisees fail.

Owning any business is hard and comes with risk. For franchisees, even though you are supposed to get a proven systems and training when you hook up with a solid franchisor, no one guarantees your success. Often, the variable in this equation is you. Business ownership is not a passive investment and it requires long hours and dedication. Even with the best franchise system and the most popular brand name, the franchisee is often the key ingredient to making the business successful.

For emerging franchisors, how they design and develop their franchise system is essential to their ability to grow and support their franchise system successfully. Unfortunately, there is no legal baseline on who can become a franchisor, and how you structure your franchise system is up to you – and no one else.

Have we discouraged you? Scared you? Confused you? Don’t worry. The rest of this book is designed to help you in many ways. Franchising, when done right and entered into with eyes open, can be a profitable, highly enjoyable way to spend your future.