Types of Franchising

There are three basic types of franchise; trade name franchise, product distribution franchise and pure franchise.  Trade name franchise involves a brand name such as True Value Hardware or Western Auto.  Here, the franchisee purchases the right to become identified with the franchisers trade name without distributing particular products exclusively under the manufacturers name.  A Product distribution franchise licenses the franchisee to sell specific products under the manufacturers brand name and trademark through a selective, limited distribution network.  This system is commonly used to market automobiles (Chevrolet, Oldsmobile, Chrysler) gasoline products (Exxon, Sunoco, Texaco), soft drinks (Pepsi Cola, Coca-Cola), bicycles (Schwimm), appliances, cosmetics, and other products.

These two distribution systems allow franchisees to acquire some of the parent companys identity.  Franchisees concentrate on the franchisers product line, although not necessarily exclusively.  Since 1972, the number of product and trade name franchises has declined rapidly because of intense competition and general economic conditions.  But the sales of these two franchise systems have climbed steadily since 1972.

A Pure (or comprehensive or business format) franchise provides the franchisee with a complete business format, including a license for a trade name, the products or services to be sold, the physical plant, the methods of operation, a marketing strategy plan, a quality control process, a two-day communications system, and the necessary business services.  That is, the franchisee purchases the right to use all the elements of a fully integrated business operation.  A Pure franchise is the most rapidly growing of all types of franchise and is common among fast-food restaurants, lodging establishment, business service firms, car rental agencies, educational institutions, beauty aid retailers, and other promising growth industries.

The Benefits and Drawbacks of Franchising

Franchising offers a relatively quick way to expand a distribution system with minimum capital.  The franchiser sells the rights to his/her goods or service and the accompanying business system to prospective entrepreneurs, who provide the majority of the capital for expansion.

Another attraction for the franchiser is the ability to grow, without the cost and inconvenience of locating and developing key managers. Of course, the franchiser must screen out those potential entrepreneurs who are unqualified, but the task generally is much simpler than that involved in internal expansion.

Franchisers also receive income from franchises through franchise fees and ongoing royalties.  For example, fast-food champion McDonalds collects a royalty fee of 11.5 percent from its eleven thousand franchises, totaling a whopping $3.024 billion each year!

A franchiser can grab a share of a regional or national market relatively quickly without having to invest huge amounts of her own money and to be paid while she does it.  Growth is not always explosive, however.  The average franchise company sells only three franchises in its first year, four in the third year.  The growth rate accelerates after that, but it still averages less than ten franchises a year for the first decade.

Benefits for the Franchisee

A franchisee is able to claim ownership of a small business relatively quickly, and because of its identification with an established product and brand name, it often reaches the break-even point faster than a traditional form of ownership would.  Still, most new franchise outlets dont break even for at least six to eighteen months.  Franchisees also benefit from the franchisers business experience.  Many entrepreneurs go into business by themselves and make many costly mistakes.  But given the thin margin for error in a start-up, a new business owner cannot afford to make many mistakes.

Franchisees also earn a great deal of satisfaction from their work.  According to a recent study by Comprehensive Communications, Inc., 82 percent of franchisees said they were somewhat satisfied to very satisfied with their work, and 76 percent said they would purchase their franchises again if given the opportunity.  With this in mind, let us investigate the specific advantages of franchising to the franchisee.

The Advantages of a Franchise

Before jumping at a franchise opportunity, an entrepreneur should consider carefully the question What can a franchise do for me that I cannot do for myself?  The answer will depend on the individuals particular situation and is as important as the systematic evaluation of the franchise opportunity.  After careful deliberation, the franchisee may conclude that the franchise offers nothing that he could not do independently; on the other hand, it may turn out that the franchise is the key to success as an entrepreneur.

Management Training and Support.  The most common cause of business failure is incompetent management.  Franchisers are well aware of this, and in an attempt to reduce the number of franchise casualties, they offer managerial training programs to franchisees before opening a new outlet.  Many franchisers, especially the well established ones, also provide follow-up training and counseling services.  This service is vital, especially because most franchisers do not require a franchisee to have experience in the business.

Training programs vary in their degree of formality and comprehensiveness.  Some franchisers rely almost exclusively on manuals and booklets, with very little personal interaction or instruction.  Other franchisers provide extensive programs at a company location, using classroom training, discussion groups, simulations, and other techniques to familiarize the franchisee with the basic operation of the business.

The range of topics covered in training programs is quite varied.  Standard subjects include store layout and design, equipment purchasing and operation, insurance needs, inventory control, advertising techniques, accounting methods, employee selection and training, and store management.

To ensure a franchisees success, some franchisers supplement the start-up training with continuous guidance and instruction.  Some programs feature refresher courses, manuals and audiovisual aids, and travelling consultants.  Franchisers offer these training programs because they realize that their ultimate success depends on the franchisees success.

Despite the positive features of training, there are dangers inherent in the trainer-trainee relationship.  Every would-be franchisee should be aware that in some cases, assistance from the franchiser tends to drift into control over the franchisees business.  Also, some franchisers charge fees for their training services, so franchisees should know exactly what they are agreeing to and what it costs.

Brand Name Appeal.  A licensed franchisee purchases the right to use a nationally known and advertised brand name for a product or service.  Thus the franchisee has the advantage of identifying his business with a widely recognized name, which usually provided a great deal of drawing power.  Customers recognize the identifying trademark, the standard symbols, the store design, and the products of an established franchise.  For example, nearly everyone is familiar with the golden arches of McDonalds and the standard products and quality offered there.  A customer can be confident that the quality and content of a meal at McDonaldss in Fort Lauderdale, will be consistent with a meal at a San Francisco McDonalds.

Standardised Quality Goods/Services.  Because a franchisee purchases a license to sell the franchisers product or service and the privilege of using the associated brand name, the quality of the goods or service sold determines the franchisers reputation.  Although building a sound reputation in business is achieved only gradually, destroying a good reputation takes no time at all.  If some franchisees were allowed to operate at substandard levels, the image of the entire chain would suffer irreparable damage; therefore, franchisers normally demand compliance with uniform standards of quality and service throughout the entire chain.  In many cases, the franchiser conducts periodic inspections of local facilities, to assist in maintaining acceptable levels of performance.  Indeed, maintaining quality is so important that most franchisers retain the right to terminate the franchise contract and to repurchase the outlet if the franchisee fails to comply with established standards.  In turn, the individual franchisees business is enhanced by the franchisers focus on ensuring consistent, quality establishment Franchisees also benefit from ongoing product research and development conducted by the franchiser.

National Advertising Programs.  An effective advertising program is essential to the success of virtually all franchise operations.  Marketing a brand name product or service over a wide geographic area requires a far-reaching advertising program therefore benefits all franchisees.  For example, every Jiffy Lube franchisee draws customers when the franchiser advertises Let Jiffy Lube do it!

Normally, such an advertising campaign is organized and controlled by the franchiser, and it is financed by each franchisees percentage of monthly sales contribution, usually around 1 to 5 percent or a flat monthly fee.  For example, Kentucky Fried Chicken franchisees must pay 1.5 percent of their gross revenues to the KFC national advertising program.  These funds are pooled and used for a cooperative advertising program, which offers synergistic benefits to the entire franchise.

Many franchisers also require franchisees to spend a minimum amount on local advertising.  Some franchisers help each franchisee design and produce its local ads.  Many companies also help franchisees create promotional plans and provide press releases and advertisements for grand opening.  By requiring franchisees to contribute to national and local advertising campaigns, franchisers ensure adequate public exposure of the product or service and the associated brand name.

Financial Assistance.  Because they rely on their franchisees money to grow their businesses, franchisers typically do not provide any extensive financial help for franchisees.  Franchisers rarely make loans to enable franchisees to pay the initial franchise fee.  However, once a franchiser locates a suitable prospective franchisee, he may offer the qualified candidate direct financial assistance in specific areas, such as purchasing equipment, inventory, or even the franchise fee.  Because the start-up costs of some franchises are already at breathtaking levels more and more franchisers are offering direct financial assistance.

Because the nature of the franchiser-provided financial assistance varies, a would-be franchisee should completely understand the help that he could receive.  Although some franchisers offer no financial assistance, many will help franchisees prepare a loan package to present to lending institutions; others will sell inventory and equipment on credit, and still others may cosign notes or make direct loans to qualified candidates.  Generally, the larger and more established franchisers are less likely to offer direct financial assistance to franchisees than are the smaller, upstart franchisers.

Proven Products and Business Formats.  What a franchisee essentially is purchasing is the franchisers experience, expertise, and products.  That is, a franchise owner does not have to build the business from scratch.  Instead of being forced to rely solely on personal ability to establish a business and attract a clientele, the franchisee can depend on the methods and techniques of an established business.  These standardized procedures and operations greatly enhance the franchisees chances of success and avoid the most inefficient type of learning trial and error.

Centralized Buying Power.  A significant advantage that a franchisee has over the independent small business owner is participation in the franchisers centralized and large-volume buying power.  In many cases, the franchisers  passes on to the franchisee the cost savings from quantity discounts.  For example, it is unlikely that a small, independent ice-cream parlor could match the buying power of Baskin-Robbins with its three thousand retail ice-cream stores.  In many instances, economies of scale simply prelude the independent owner from competing head to head with a franchise operation.

Territorial Protection.  A proper location is critical to the success of any small business, and franchises are no exception.  In fact, franchise experts consider the three most important factors in franchising to be location, location, and location.  Becoming affiliated with a franchiser may be the best way to get into prime locations.  Many franchisers make an extensive location analysis for each new outlet, including studies, and population density.  McDonalds, for example is well known for its ability to obtain prime locations in high traffic areas.

Location is today probably the biggest obstacle facing the entire franchise industry.  Most of the traditional, high volume locations have already been taken, a fact that will slow the franchising growth rate in the future.  Indeed, to obtain prime locations, some franchisees have bought and converted existing franchise outlets.

Franchisers also may offer a franchisee territorial protection, which gives the franchisee the right to exclusive distribution of brand name goods or services within a particular geographic area.  The size of a franchisees territory varies from industry to industry.

Greater Chance for Success.  Investing in a franchise is not risk free.  In fact, the typical franchise does not reach the break even point until six to eighteen months after its inception, and so the owner must be prepared to withstand the losses incurred during this time.

Some franchises do not survive.  But available statistics indicate that a franchise is less risky than building a business from the group up.  Approximately 24 percent of new businesses fail by the second year of operation; in contrast, only about 7 percent of all franchises fail by the second year.  After six years, 84 percent of franchises are still in business, compared with just 63 percent of independent businesses.  This impressive success rate for franchises is attributed to the broad range of services, assistance, and guidelines that the franchiser provides.  These statistics must be interpreted carefully, however, because when a franchise is in danger of failing, the franchiser often repurchases or relocates the outlet and does not report it as a failure.

The risk of purchasing a franchise is two pronged; success or failure and depends on both the entrepreneurs managerial skills and the franchisers business experience and system.  Many owners are convinced that franchising has been a crucial part of their success.

The Drawbacks of the Franchise model

Obviously, the benefits of a franchise can mean the difference between success and failure for a small business, although the franchisee must sacrifice some freedom of action and decision making to the franchiser.  The prospective franchisee therefore should explore other limitations of franchising before undertaking this form of ownership.

Franchise Fees and Profit Sharing.  Virtually all franchisers impose some type of fees and demand a share of the franchisees sales revenues in return for the use of the franchises name, products or services, and business system.  The fees and the initial capital requirements vary among the different franchisers.  The Commerce Department reports that total investments for franchises range from $1,000 for business service up to $10 million for hotel and motel franchises.  For example,  H & R Block requires a capital investment of $2,000 to $3,000;  I Cant Believe Its Yogurt requires $55,000 to $60,000 in equity capital; and McDonalds requires an investment of $325,000 to $350,000 (but McDonalds owns the land and the building).

Start-up costs for franchises often include numerous additional fees.  Most franchises impose a franchise fee up front for the right to use the company name.  Wendys International, for example, charges a $20,000 technical assistance fee for each restaurant that a franchisee opens.  Other additional start-up costs may include site purchase and preparation, construction, signs, fixtures, equipment, management assistance, and training.  Before signing any contract, a prospective franchisee should determine the total cost of a franchise.  For example, R David Thomas, founder of Wendys International, states that a franchisee must have about $700,000 in credit and $150,000 in liquid assets to launch a Wendys restaurant.  Holiday Inns, Inc., gives prospective franchisees the estimates of start-up costs for a one-hundred room, two storey hotel.

Franchisers also impose continuing royalty fees as profit sharing devices.  The royalty fee is a percentage of gross sales with a required minimum, or a flat level fee levied on the franchise.  Royalty fees typically range from 1 to 11 percent and can significantly increase the franchisees overhead expenses.  Variable royalty fees that rise as sales increase are popular among some franchises.

Wendys and Kentucky Fried Chicken each receive a 4 percent royalty on gross sales.  Some franchisers impose other types of continuing fees, such as those for advertising, rent, advisory services, and technical assistance.  A franchisee must find out what fees are required (some are merely recommended) and then determine what services and benefits the fees cover.  One of the best ways to do this is to itemize what you are getting for your money and then determine whether the cost corresponds to the benefits, provided.  Be sure to get the details on all expenses, amount, time of payment and financing arrangements, and find out which items, if any, are included in the initial franchisee fee and which ones are extra.

Strict Adherence to Standardised Operations.  Although, the franchisee owns the business, she does not have the autonomy of an independent owner.  To protect its public image, the franchiser requires that the franchisee maintain certain operating standards.  If a franchise constantly fails to meet the minimum standards established for the business, its license may be terminated.  Compliance with standards is usually determined by periodic inspections.  At times, a burden to the franchisee.  The owner may believe that the written reports the franchiser demands require an excessive amount of time.  In other instances, the owner may be required to enforce specific rules even though she believes they are inappropriate or unfair.

Restrictions on Purchasing.  In the interest of maintaining quality standards, the franchisee often is required to purchase products or special equipment from the franchiser and perhaps other items from an approved supplier.  For example, Kentucky Fried Chicken requires that franchisees use only seasonings blended by a particular company, because a poor image could result from the use of inferior products in order to cut costs.  Under some conditions, such purchase arrangements may be challenged in court as a violation of antitrust laws, but generally the franchiser has a legal right to see that its franchisees maintain acceptable quality standards.  A franchiser may set the prices paid for such product but may not establish the retail prices to be charged on products sold by the franchisee.  A franchiser can legally suggest retail prices but cannot force the franchisee to abide by them.

Limited Product Line.  In most cases, the franchise agreement stipulates that the franchise can sell only those products approved by the franchiser.  Unless willing to risk cancellation of his license, a franchisee must avoid selling any unapproved products through the franchise.

A franchise may be required by the franchise agreement to carry an unpopular product or be prevented from introducing a desirable one.  In this way, the freedom to adapt a product line to local market conditions is restricted.  But some franchisers solicit product suggestions from their franchisees.  In fact, it was McDonalds franchisees that came up with the highly successful Big Mac and Egg McMuffin.

Unsatisfactory Training Programs.  Every would-be franchisee must be wary of the unscrupulous franchiser who promises extensive services, advice, and assistance but delivers nothing.  For example, one owner relied on the franchiser to provide what had been described as an extensive, rigorous training program after paying a handsome technical assistance fee.  The program was nothing but a set of pamphlets and do-it-yourself study guides.  Other examples include those impatient entrepreneurs who paid initial franchise fees without investigating the business and never heard from the franchiser again.  Although disclosure rules have reduced the severity of the problem, dishonest characters still thrive on unprepared prospective franchisees.

Less Freedom.  When a franchisee signs a contract, he agrees to sell the franchisers product or service by following its prescribed formula.  When McDonalds introduces a new national product, for instance, all franchisees must put it on their menus.  Franchisers want to ensure success, and most closely monitor their franchisees performances.  Strict uniformity is the rule rather than the exception.  Entrepreneurs who want to be their own bosses thus may be disappointed with a franchise.

SUMMARY

Each form of business ownership has specific advantages and disadvantages.  Every partnership should draw up a partnership agreement before beginning business.  Review the items suggested in the chapter that should be included in a partnership agreement, and become familiar with the rights and obligations of partners as specified in the Uniform Partnership Act.

All corporations require a Certificate of incorporation or charter.  Become familiar with the items that must be included when filing for incorporation.

Review the special forms of ownership the joint venture, limited partnership, professional corporation, and S Corporation to determine which would be best in your situation.  Before you make a choice, consult both an attorney and an accountant/

Franchising is not a new method of conducting business.  Even though automobile dealerships and gasoline stations account for over three-fourths of all franchise sales, virtually every type of product and service is sold through franchises.

A Franchise is a method of doing business involving a continuous relationship between a franchiser and a franchisee.  The franchiser retains possession of the distribution system, and the franchisee assumes all of the normal daily operating functions of the business.  There are three basic types of a franchise; trade name a franchise, in which the franchisee purchases only the right to use a brand name; product distribution of a franchise, which grants a license to sell specific products under a brand name; and pure franchising, which provides a franchisee with a complete business system.  The last type is growing the most rapidly.

Franchising has been a successful business format in part because of the mutual benefits it provides.  The franchiser has the benefits it provides.  The franchiser has the benefits of expanding his business on limited capital and growing without developing key managers internally.  The franchisee also receives many key benefits: management training and counseling, customer appeal of a brand name, standardized quality of goods and services, national advertising programs, financial assistance, proven products and business formats, centralized buying power, territorial protection, and greater chances for success.  Before deciding on any franchise, the entrepreneur should be aware of its disadvantages: franchise fees and profit sharing, strict adherence to standardized operations, restrictions on purchasing, limited product lines, possible ineffective training programs, and less freedom.

Resource: Essentials of Small Business Management by Thomas W. Zimmerer and Norman M. Scarborough