What is franchising?
A franchise is a type of business relationship, where the franchisee operates its business under the franchisor's trade name or trade mark so that to the outside world the franchisee is the franchisor.
The franchisor will usually exercise continuing quality control over the franchisee and provide assistance to the franchisee. In return, the franchisee periodically has to make payments to the franchisor.
Setting up a franchising system
When a business wants to start a franchising system, the franchisor will normally enter into individual franchise agreements with franchisees, granting a franchise in relation to a specific geographical area.
A franchising system will typically comprise of:
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a successful existing business which it wishes to expand
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a newly formed business or an existing business with little or no experience of a proposed area of business activity that wants to enter this business area
Key considerations
Operations manual
The operations manual will regulate the terms on which a franchisee operates the franchise business. This document will set out the day-to-day operational instructions to the franchisee.
Intellectual property
Intellectual property rights in a franchising context can have particular significance because a franchisor will have built up a substantial amount of know-how and brand awareness, which it will seek to protect.
Trade marks will be of great significance, because of the importance of brand names and images. The franchisor may require their franchisees to enter into separate licence agreements when registered trade marks are being licensed.
Both sides will want the intellectual property to be protected. However, the franchisor will want to ensure that the value of its intellectual property is not affected by the business practices of the franchisee.
The franchisee will want to make sure that the franchisor has valid and valuable intellectual property rights.
The franchisor will want to consider:
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Payment - this needs to take into account that it is not in its interest to squeeze its franchisees excessively. Usually, an upfront fee is negotiated for the initial grant of rights, and afterwards, a continuing monthly or quarterly fee, usually based on a percentage of the franchisee's turnover.
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Operations manual - it is important to any franchisor that the franchisee complies with the operations manual and the licences of intellectual property rights so that customers receive the same quality of support at every outlet of the branded business
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Confidentiality - The franchisor will not allow the franchisee to use the franchisor's confidential know-how to operate a similar business, either during or after the term of the agreement.
The franchisee will want to make sure that:
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It has a realistic idea of the potential performance of the business that it will carry on under the franchise agreement.
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It receives enough support from the franchisor in terms of advertising and training to succeed.
All of these issues will usually be dealt with in the franchise agreement between the two parties. Usually, there will also be a detailed Non-disclosure agreement. For more information, read Non-disclosure agreements.
What is the difference between franchising and distribution?
The difference is in the nature of the relationship between the two parties and their obligations. A franchisor would be able to exercise a much greater level of control over the franchisee and its operation than a supplier would a distributor.
Usually, under a franchise agreement, the franchisor will have continual quality control over the franchisee (through an operations manual, marketing plans, inspections, etc) and a franchisee will be making periodic payments to the franchisor (known as royalties) in exchange for the right to use the brand and any know-how.
In contrast, under a Distribution agreement, a supplier grants a distributor the right to resell its products in a given territory. There may be some sort of regulation for the distributor, but often suppliers do not seek to regulate the operation of the distributor's business.
Under this type of agreement it is common for the distributor to pay a supplier a fixed fee to purchase the products written down in the agreement, and then resell those products in the territory. The distributor usually keeps any profit made from the re-sale (depending on the commercial terms of the agreement) and is not required to pay any ongoing fees to the supplier for the right to sell the products under the brand.
For more information, read Competition law and distribution agreements.
Advantages and disadvantages of a franchise
Franchising is a useful concept in helping businesses expand into new areas and foreign markets. The franchisor does not normally have to bear the start-up costs and risks associated with setting up in a foreign market. The franchisee will usually be responsible to bear its own costs. Through franchising, a reputable business has the potential of establishing a global or international presence. Some franchisors will offer training and financial planning, which could help offset some of the franchisee's initial investment. Furthermore, the franchisee will often face diminished risks in relation to their initial investment, as their business product has already been chosen by virtue of the franchisor’s brand.
However, one key disadvantage of franchising is quality control. Whilst an operations manual can assist in ensuring quality is kept to a high standard, the franchisor will still want to keep the company's name and reputation consistent. This can be difficult as consumers could perceive a bad experience or product at one franchise to be indicative of other franchises and locations. International locations could make it difficult for companies to detect whether or not a particular franchise is performing poorly or are of low quality. Additionally, franchisees should keep in mind the ongoing royalty payments to the franchisor and the amount of capital required to initially open a franchise store, which is usually proportional to the size and popularity of the franchisor.
