If you have a query about franchising, you might find the solution in one of our frequently asked questions below. If the answer to your question is not here, please feel free to contact us.
The general concept
In simple terms, franchising is the granting of various rights by one party (the franchisor) to another (the franchisee), which are sufficient to enable the franchisee to develop and operate a "clone" of the franchisor's business concept in return for payments to the franchisor. The franchisee then exercises those rights and runs its business under the guidance of the franchisor.
The consumer's perception should be that there is no difference between one of the franchisor's own corporate outlets and a franchised one. The franchisor is licensing the franchisee the right to use its business format; hence the term 'business format franchising'. However, that right to use the business format is for a limited period of time. The franchisee gains no interest in the actual ownership of the format or the associated brand and trade marks. The rights the franchisee enjoys are similar to those of a tenant when leasing a house or commercial property. During the period of the lease the tenant has full enjoyment of the premises, but the day after the expiry of the lease he has no rights over the property at all.
The commercial bargain
In crude commercial terms the reason for both the franchisor and franchisee to enter into a contractual relationship with each other is to make a profit. The franchisee makes a profit from supplying the goods or services to the customer with the benefit of trading under the brand and using the business system. The franchisor makes a profit from the monies it receives for allowing the franchisee to use its business format, package of knowhow and intellectual property rights including the trade marks, and/or from selling products or providing services to the franchisee.
In order to be able to strike a bargain, both parties must have something to offer. The franchisor must have a proven and sustainable business format comprising continually developing knowhow and methods of operation and a package of intellectual property rights, the most important of which are the trade marks. The franchisee must have sufficient capital to invest in the franchise and be of appropriate character and ability. Without these requisite assets, neither party can enter into the bargain.
Ironically, however, as the franchisor's bargaining power grows with the growth of the franchise network, so does the risk of the value of its package being eroded by existing franchisees or third parties seeking to “piggyback” on to the franchisor’s goodwill. If a franchisee starts to experiment of its own accord or a third party attempts to copy the franchisor’s brand or business, the goodwill in the franchise will suffer and decrease in value accordingly. The franchisor must constantly police the franchise, ensure that its standards are carefully maintained and that rogue third parties are swiftly dealt with where possible.
There are four basic ways in which franchising can be used:
(a) Creation of a new business specifically for franchising
An entirely new product, service or business offering can be created specifically for franchising. This has been done with businesses such as Snappy Snaps in the UK, which originally provided 1-hour film processing services and retailed associated products on the high street. Very often a local businessman identifies a successful franchised concept in another market such as the USA, and decides to create a similar concept in his own home market.
(b) Development of an existing business
This is perhaps the most usual way of evolving a franchise. An existing product or service exploited in a company-owned business is further developed and expanded into new markets by use of the franchising method. The franchised outlets thrive in markets where company-owned outlets might not have been established, for various reasons, so significantly expanding the footprint and market penetration of the brand and the scale of the franchisor's business.
(c) Conversion of an existing business to a franchise format
Sometimes an established business decides to convert some of its managed outlets to franchised outlets. Such decisions are usually taken because of a desire to accelerate growth and reduce overheads without sacrificing quality control. Studies have shown that outlets in the hands of independent "owner-operator" franchisees outperform company-owned outlets. Such "re-engineering" of the franchisor's own operations can sometimes radically transform the performance of the franchisor company by a combination of disposing of under-performing assets, slimming down the central overhead required to control and monitor company-owned assets and employees, and by the enhanced performance and financial return of franchisee-operated outlets.
(d) International expansion
Franchising is a very common method of introducing and growing a business concept into new territories. The United States is the biggest exporter of franchise concepts around the world. Brands such as KFC, Holiday Inn, Hilton, Pizza Hut, McDonald's and Budget Rent A Car are all American exports. Body Shop and Mothercare are examples of British brands that have established themselves around the world using franchising.
The key advantage is to expand internationally without requiring or putting at risk significant shareholders' capital. Joint venture or company-owned expansion internationally is fraught with risks and simply cannot be done on a significant multi-country basis because of the resourcing requirements when company funds are at stake. A combination of techniques, with different models for different markets, is often the best solution for strategic reasons.
From the franchisee’s perspective:
(i) The advantages
The franchisee is the owner of its own business and typically owns the tangible assets of the franchise outlet. What it does not own is the goodwill in the business concept. Like any other business proprietor, the franchisee buys materials, pays rent and staff salaries and takes the profit (or loss) of operation, less royalty and service fees. Some franchisors, actually very few, control the real estate from which the franchised outlets operate.
Subject to various restrictions, the franchisee can sell its business when it wishes (usually subject to the franchisor's pre-emption right and on condition that the purchaser is approved by the franchisor). What makes a franchise business different from any other business is that the newly-franchised business gains from the franchisor the entire business concept with full training, assistance in every aspect of setting up and running the business, and access to necessary materials and supplies.
In essence, the franchisee invests in and operates the developed business concept and it is this, and the franchisor's careful selection of the franchisee, that makes failure of the business less likely.
Obviously the franchisee’s start-up costs entail more than paying the franchisor an up-front fee: it must invest in premises, fittings, equipment, materials and provide working capital until the inward cash flow starts. In addition, it must pay continuing fees to the franchisor: typically an initial fee plus ongoing regular payments to the franchisor in the form of royalties or management services fees or, in some cases, an agreed mark-up on supplies obtained from the franchisor. The brand presentation and profile from which the franchisee benefits by joining a franchised network could only rarely be achieved by an individual small business owner.
(ii) The disadvantages
The franchisee is not an entirely independent entrepreneur. The franchisee must adopt the franchisor's business system. In the final analysis the franchisee must follow the franchisor's instructions on how to operate the business and present the brand. The lower risk (of start-up business failure) is off-set by the lower reward for success because of the fees paid to the franchisor. Ultimately, the franchise agreement may not be renewed when it ultimately expires, although franchisees are usually able to realise the value they have built up by selling their businesses during the term of the contract.
From the franchisor’s perspective
Every business is different and must assess, with expert help, the pros and cons of using franchising as an expansion or re-engineering strategy. The short summary here is not comprehensive. Please contact us if you would like more information and an assessment for your business.
(i) The advantages
Franchising allows the franchisor to expand its market penetration for the distribution of its products or services with minimum capital outlay and so accelerate the network's growth and profitability. Major global franchisors have thousands of outlets in many countries. Return on investment ratios tend to be high in well-run international networks, which is one reason why corporates sometimes re-engineer using franchising.
Self-employed individual franchisees are generally more highly motivated and incentivised than salaried managers by the profits from their outlets, and are more likely to produce better results for less expenditure of capital than the franchisor would achieve. Franchisees employ their own staff – which means franchisors' staffs and overheads can be kept leaner, with fewer employment issues. As the franchise network grows it will become easier to handle major national or regional customer accounts.
The local market presence and focus of the franchisee can be critically important – particularly in international expansion into new countries, where a major local company may become the country franchisee, and in territory-based domestic services businesses where franchisees are required to focus on their local patch. Franchisees often come up with excellent business development ideas, and the pooling together of marketing funds enables a group of relatively small businesses to punch significantly above their individual weight in terms of brand promotion and advertising.
(ii) The disadvantages
The franchisor has to control and coordinate a network of semi-independent businesses and ensure that they build and maintain a favourable image for the whole franchised operation. This means that the franchisor's own role changes drastically. It is no longer simply an operator of its own business. Its principal role is to recruit, train and motivate the right franchisees and grow and develop the performance of the entire network.
The policing and monitoring of standards by the franchisor is vital, although franchisees will understand the need for excellent brand presentation. The franchisor will sometimes have to resort to the use of both carrot and stick mechanisms to get franchises to try new techniques or improve under-performance.
The dynamics of the franchisor-franchisee relationship are such that a lack of trust can on occasions creep in, making life more difficult than it should be. This may be due to personality clashes between the franchisee and members of the franchisor's team, perhaps where a particular franchisee business is not performing, or because the franchisee does not find it easy to live within the constraints imposed by a franchise.
It is the franchisor's duty to minimise tensions and conflicts and ensure that they are satisfactorily dealt with. Learning best practice franchisor management skills from experts is essential.
While an individual corporately-owned outlet may be more profitable for the franchisor than an individual franchised outlet, the increased number of franchised outlets and reduced corporate overhead will often mean that the franchised business as a whole will be more profitable than one that is entirely corporately owned.
STEP 1: Can the business work as a franchise?
The subtleties of franchising take time to understand and not all businesses can be successfully franchised. Any business must take a long hard look at its business concept and potential for expansion before jumping into franchising. The failure of a franchise can be disastrous not only for the franchisor but also for the franchisees that have invested and joined its network.
In order for a franchise to stand a chance of succeeding, the basic concept must be a sound one, the franchisor must have sufficient resources to support the growing chain, and the franchisees must be properly managed and supported.
An idea cannot be franchised. In order to franchise a concept it must first be proved to work as a business. The franchisee is paying for the right to use a system that has proved to be successful, not to put someone's bright idea into practice.
Business format franchising can be considered a business system leasing arrangement. The franchisee acquires from the franchisor the licence to duplicate the franchisor's existing and successful system of providing a product or service to the end user. The potential franchisor must therefore ask itself whether or not it has anything worth franchising. The right to sell a particular product by itself is not a business format franchise. It is an agency or distributorship that may well prove to be a profitable business in its own right, but it is not a business format franchise.
For a business to be franchiseable there must be established knowhow and distinct ways of doing things that distinguish the business from others. Each element of the knowhow taken by itself may not be unique: there are for example only a limited number of ways to grill a hamburger, fry chips and make a milk shake. The combination of them, however, may be unique. When coupled with the franchisor's name and trade marks the business system should be identifiable and distinctive. It is this that will create the value of the franchise by drawing in customers.
The knowhow must be carefully identified and easily communicable. Intensive training courses and an operations manual will therefore be necessary. The potential franchisor must ask itself whether or not the concept in question lends itself to this.
STEP 2: The Legal Audit
Once the potential franchisor is satisfied that there is identifiable, communicable knowhow in the business, it must then carry out a legal audit of its intellectual property assets and make certain that the cornerstone of the franchise – the name, trade marks and other intellectual property rights – do in fact belong to it. A franchisor cannot grant its franchisees the right to use a name and trade marks over which it does not have any properly secured rights.
STEP 3: The pilot operation
Once a concept has been developed and its name and marks protected, it follows that it must be tried and tested in the market through a pilot operation. This will further test its profitability as a business for franchisees and allow the potential franchisor to further refine the system on the back of further practical experience.
STEP 4: Funding
Once the concept has been piloted, or indeed before, the potential franchisor must decide how it will make money for itself from franchising the business. Some business modelling with experienced assistance will typically be required. Most banks will fund respectable franchisors and their franchisees with sound concepts and plans.
STEP 5: Legal documentation
Before actively recruiting franchisees, it is essential that good quality legal documentation is prepared by a solicitor experienced in both the legal and commercial subtleties of franchising. This is not just a technical exercise, and a properly thought-through franchise agreement is the foundation of every franchisor's business.
STEP 6: Marketing the opportunity
Once the franchise has been set up, the finances arranged and the appropriate documentation prepared, it is important to arrange the effective marketing of the franchise to potential franchisees. The best franchises require the least marketing effort. Once potential franchisees have seen outlets running and have had the opportunity to speak to happy and successful existing franchisees, the need to actively sell the franchises will be reduced.
STEP 7: Running the network
Finally, the potential franchisor must be aware that its own role will change dramatically. It is no longer at the sharp end of the business, working with customers on a day-to-day basis. It should instead be continually developing and improving the system and its network, planning its strategic growth and nurturing and monitoring the franchisees to ensure that the high standards of the system and those associated with the brand are being maintained. Failure to understand and adapt to this change of role will result in both franchisor and franchisees experiencing unnecessary difficulties.
Yes. The Operations Manual is the embodiment of the knowhow and approach to all key aspects of the operation and marketing of the franchised business. Ultimately it is what the franchisee is paying to see and use. It is therefore of paramount importance that the franchisor invests in creating and developing an Operations Manual that captures all operational aspects of the business and sets out its standards, policies and requirements. It will be used in training the franchisees and regularly referred to by the franchisees and their staff in the operation of the business.
The Operations Manual should identify the core franchise system knowhow and allow franchisees to learn and use the knowhow and any trade secrets. The Operations Manual will also provide copyright protection for the franchisor to the way in which the knowhow is expressed.
There is no set format for an Operations Manual. Some franchisors have multiple volumes – each addressing different aspects of the franchised business – ranging from marketing through to accounting, customer service techniques, shop layout and merchandising. Franchisors are increasingly converting their Operations Manuals into electronic format and making the available to franchisees via a secure page on their franchisee intranet.
If you require assistance in preparing an Operations Manual, please contact one of our team.
Yes. Before launching a new franchised concept it is vital that ideally several pilot operations are established to help ensure that the franchise will work as a viable business for both franchisor and franchisee in different market situations. These provide the test-bed, enabling the franchisor to tweak, perfect, and develop the business concept.
Although much will depend upon the individual market circumstances, these pilot operations should generally run for at least 12 months to establish their viability. Even if the franchisor has had corporate outlets up and running for many years, if they are not exactly the same as the proposed franchised outlets (for example, they have a different product mix, or are turning a concept that has historically been shop-based into a mobile, van-based environment), a pilot operation should be run to ensure that the new business format is viable. After all, the franchisor is selling a proven business blueprint to the franchisees. And if failures result there may be legal liability issues to resolve.
In practice, pilot operations have been found not only to prove the viability of the business but also to identify potential problems and provide solutions to them, in areas such as products and services offered, marketing and promotional methods used, management systems, opening hours, training and support required, shop layout and so on.
Once the concept has been proved by the pilots, it is essential that the franchisor continues running at least some of them. They provide both an excellent barometer of the franchisees' business and an essential laboratory where new services, product ranges, and changes in operations, management and sales techniques can be tested and proved to work before being rolled out to the franchisees.
There is general consensus amongst franchisors that the recruitment of good developers, master franchisees and individual franchisees is the most difficult and most important aspect of franchising a business. It can too easily become a case of marry in haste, repent at leisure. The relationship between a franchisor and its developer, master franchisee or unit franchisee is a long term one. Both parties invest significant time and money. Neither has complete control over the other. If there is a problem, it can become long, drawn out and acrimonious.
There is no perfect answer to recruiting the right franchisee and franchisors use a variety of techniques ranging from home visits, psychometric testing, financial due diligence and references to a basic gut feel. However, there are some basic points that should be taken on board by new franchisors in their recruitment practices. The approach varies somewhat if a major corporate franchisee in an overseas target market is being considered.
The most common mistake made by new franchisors is to be in such a hurry to recruit the first few franchisees that they compromise on the criteria they have decided on for their ideal franchisee profile. Obviously the ideal franchisee profile needs to be realistic and flexible to a degree, but it should not be totally ignored as soon as a potential franchisee with money to invest walks through the door.
It is not unknown for new franchisors to give their first few franchisees sweetheart or honeymoon deals. It is acceptable to recognise the great degree of risk that the first few franchisees take by investing in the franchise, and it may be that there will be some ongoing adjustment to the business concept during this phase with the first one or two franchisees, but it is a mistake to give too good a deal as this may become the cause of friction between the franchisor and later franchisees in the future. Franchisors must at all times strive to be consistent in the way they deal with members of their networks.
It is important that the franchisor knows where the franchisee gets its funding from and the terms of any repayment, so that it can be satisfied that the franchisee’s personal circumstances do not make the franchise an untenable business proposition.
Most people have a comfort zone – a level of income above which they are not sufficiently motivated to increase the turnover and profitability of their business. The franchisor should try to identify whether or not a prospective franchisee's individual comfort zone is too low for the particular franchise.
If a potential franchisee is too entrepreneurial this can cause substantial problems for the franchisor. A real entrepreneur may well find the disciplines and constraints of franchising too strict, making conflict with the franchisor inevitable. Energy and drive is essential in a franchisee, but so is the ability to work within a system.
The type of information franchisors should request from potential franchisees, master franchisees and developers, may include:
career and employment history
details of the type of business(es) previously operated
details of parent, subsidiary and group companies
financial records, accounts, balance sheets, loans, assets – both movable and immovable – and any charges on them, types of creditors, details of bankruptcy/insolvency etc
amount of non-borrowed capital and the ability to outlay for the franchise operation
background on directors, officers, shareholders and key employees
access to a skilled/unskilled workforce (including recruitment policy, training and operational standards)
ability to expand the business
types of services offered, in terms of marketing, advertising, distribution of goods, management skills and ability to obtain all the clearances from authorities to set up the franchise business or outlet
A number of countries have franchise specific and non-franchise specific pre-contract disclosure laws that must be compiled with. It is professional and good business practice to develop an approach to presenting information about the franchisor, its business and performance that will both assist in selling the franchise proposition and help insulate the franchisor from claims in the event that a franchisee's business fails. Many national franchise associations, including the British Franchise Association, and the European Code of Ethics in Franchising require pre-contract disclosure of certain matters to prospective franchisees. For further information, please see our franchising disclosure table.
The type of information franchisors may have to disclose includes:
type of business, its corporate structure including whether it is a part of a group of companies or one company
business experience of the franchisor and its directors and officers domestically and internationally
type of franchise business format, product line etc
accounts and financial status, along with information on any loans, charges on assets, creditors, details, and any bankruptcy/insolvency proceedings to which the franchisor and its directors have been subject
litigation it has been involved in, both in civil and criminal law
reputation of its brand name or goodwill and any public figure who may be associated with it
funds to be paid to the franchisor by franchisees, whether lump sum payments, royalties, technical fees, and other recurring fees and payments
obligations to purchase on the part of the franchisees from the franchisor for goods in question, products or raw materials, equipment, real estate, services provided by the franchisor, signs, fixtures etc
restrictions on the sale, tie-in and buy-back arrangements by the franchisor over the franchisee’s business
training programmes offered by the franchisor and level of supervision involved
assistance with site selection and design of the outlet, and to what extent this needs the approval of the franchisor
details of the right to renew the franchise agreement
what sorts of activities or breaches would result in termination of the franchise contract
The fees charged by a franchisor should reflect the commercial bargain between the two parties. Care should be taken that the business remains financially viable for the franchisee and that any upfront fees do not inadvertently starve the franchise of much needed start-up capital investment. Typical payments include:
Development Fee, Exclusivity Fee or Initial Franchise Fee – an upfront fee for granting territorial exclusivity to the franchisee or the right to operate the franchise.
Store Opening Fee – an upfront fee payable on opening each franchised outlet.
Service Fee or Royalty – a percentage of gross turnover, usually payable monthly over the term of the relationship.
Purchase Price for products, equipment and other items supplied by the franchisor to the franchisee.
Marketing Contribution – usually expressed as a percentage of gross turnover, this is a contribution to local, regional or international marketing campaigns the franchisor will develop and run on behalf of the network. In addition, the franchisee may be required to commit to a minimum spend on its own local marketing campaigns.
Training Fees – an amount charged by the franchisor for training the franchisee to operate the business initially, and possibly for periodic training.
Other fees – for example equipment lease rentals; software licences and support fees.
The franchisor must always be in complete control of the franchise network and be able to choose its master franchisees, developers and individual franchisees at its complete discretion. This means the franchise agreement must always give the franchisor the right to veto the sale of a master franchisee's, developer's or franchisee’s business to an unsuitable third party. Who ultimately controls the franchisee, and so determines how it will behave, is critically important to the franchisor.
The franchisor must always have the ultimate decision on who can join its network and will be concerned that the new party is right for the franchise. The franchisor must always assess the financial status of the potential purchaser and its ability to pay the purchase price to the outgoing franchisee. On the other hand, franchisees will want to be reassured that they have a right to move on and realise the value they have built in their business.
The agreement should therefore contain detailed provisions governing sale of the master franchisee’s, developer’s or individual franchisee’s business that must always be followed. These provisions should be carefully thought through and usually contain pre-emption rights giving the franchisor the right of first refusal to buy the franchisee's business itself. They should also lay down time limits within which these rights can be exercised. It is not uncommon for the franchisor to be entitled to a percentage of any price paid by a third party purchaser, either as a recognition of its contribution to the franchisee's goodwill, or as a finder's fee if it locates a purchaser.
In international networks, franchisors should take specialist legal advice in the relevant country on the consequences of termination of the franchise contract. The franchisor must establish whether franchisees will be protected, for example by local legislation that protects distributors or commercial agents. Such legislation will often establish significant rights on termination for the franchisee if it is held to be a distributor or agent. The legislation will often take precedence over the terms of the franchise agreement, thereby overriding the contract provisions that govern termination procedures and rights and often confer rights to compensation.
Legislation may sometimes apply even on a refusal to renew a limited-duration, fixed-term franchise agreement on its normal expiry. However, many jurisdictions do not have such provisions and recognise that the franchisee's right to operate the business simply expires on the expiry of the contractual term without giving rise to any claim for compensation.
In a domestic UK network, the franchisor must ensure that it has the necessary legal rights to terminate a franchisee who is in default, otherwise it could expose itself to a substantial damages claim.
For more information on termination rights please see our Franchise Disputes page.