A franchise, by definition is a legal agreement that allows one organization with a product, idea, name or trademark to grant certain rights and information about operating a business to an independent business owner. In return, the business owner (franchisee) pays a fee and royalties to the owner. This one-time fee paid by the franchisee to the franchisor is referred to as a franchise fee. The fee pays for the business concept, rights to use trademarks, management assistance and other services from the franchisor. This fee gives the franchisee the right to open and operate a business using the franchisor’s business ideas and products. A royalty fee is a continuous fee paid by the franchisee to the franchisor. The royalty fee is usually a percentage of the gross revenue earned by the franchisee. The Federal Trade Commission (FTC) is authorized by the United States Congress to regulate the franchise business. The Federal Trade Commission oversees the implementation of the Franchise Trade Rule, which requires that franchisors disclose all pertinent information to potential buyers of a franchise, and monitors the activities of franchisors.
There are four basic types of franchises used by businesses in the United States.
Product Franchise: Manufacturers use the product franchise to govern how a retailer distributes their product. The manufacturer grants a store owner the authority to distribute goods by the manufacturer and allows the owner to use the name and trademark owned by the manufacturer. The store owner must pay a fee or purchase a minimum inventory of stock in return for these rights. An example of this type of franchise is a tire store.
Manufacturing Franchise: These types of franchises provide an organization with the right to manufacture a product and sell it to the public, using the franchisor’s name and trademark. This type of franchise if found most often in the food and beverage industry. Most bottlers of soft drinks receive a franchise from a company and must use its ingredients to produce, bottle, and distribute the soft drinks.
Business Opportunity Ventures: These ventures typically require that a business owner purchase and distribute the products for one specific company. The company must provide customers or accounts to the business owner, and, in return, the business owner pays a fee or other consideration as compensation. Examples include vending machine routes and distributorships.
Business Format Franchising: This is the most popular form of franchising. In this approach, a company provides a business owner with a proven method for operating a business using the name and trademark of the company. The company will usually provide a significant amount of assistance to the business owners in starting and managing the company. The business owner pays a fee or royalty in return. Typically, a company also requires the owner to purchase supplies from the company.
The Benefits of Franchising
One of the main benefits of franchising is lower risk. Most business experts agree that a franchise operation has a lower risk of failure than an independent business. A reason for this is that the product or service is already established. A franchisor offers a product or service that has sold successfully. An independent business is based on both an untried idea and operation. Three factors will help you to predict the potential success of a franchise. The first is the number of franchises that are in operation. The second predictor is how long the franchisor and its franchisees have been in operation. A third factor is the number of franchises that have failed; including those bought back by the franchisor. Another benefit of franchising is a large degree of assistance. The most difficult aspect of a new business is start up. Few experienced managers know about how to set up a new business because they only do it a few times. However, a franchisor has a great deal of experience accumulated from helping its franchisees with start up. This experience will help reduce mistakes that are costly in both money and time. Assistance is usually offered once the initial start up is completed. For instance, a franchisor will provide management assistance, such as accounting procedures, personnel management, facility management, etc. Marketing assistance is typically offered as well. A franchisor can prepare and pay for the development of professional advertising campaigns. Regional or national marketing done by the franchisor benefits all franchisees. In addition, the franchisor can provide advice about how to develop effective marketing programs for a local area. This benefit usually has a cost because many franchisors require franchisees to contribute a percentage of their gross income to a co-operative marketing fund.
Costs of Franchising
The benefits to purchasing a franchise explain why more that 50,000 franchise opportunities exist in the United States. However, this compares to almost 14 million independent businesses. There are obviously reasons why not everyone chooses the franchise option. One major drawback to starting a franchise is the initial franchise fee. This can range from a few thousand to several hundred thousand dollars. There are two critical matters that affect your decision about buying a franchise. These are whether you can afford the franchise fee and if you can expect a reasonable return on investment. Franchisors also will typically require a franchise to pay continuous royalty fees. The fees are a percentage of the gross income from the business. Usually the royalty fee is less than ten percent. Some franchisees begin to resent the royalty fees after several years because they have developed experience and built a strong customer base. This success often results in a feeling that the business could continue without the assistance of the franchisor. Besides the royalty fee, franchisors often require a cooperative marketing payment as well. There are other costs involved that are not financial. One example is the conformity to standard operating procedures. It is important to understand that for most franchisors, there is just one way to do things, and it is their way. Success results from proven methods of operation, so the franchisor does not want any variations. A franchisee can become frustrated when he or she believes that there is a better way to do things. The inability to make changes readily is also a problem with franchises. A franchisor may prohibit selling products or services other than those approved by the franchisor. These restrictions are difficult to follow when you believe that there is strong customer demand for a new or different product. There is often a method for making suggestions, but this can sometimes be cumbersome and time-consuming. The franchisee is subject to decisions made in the central office of the franchisor. As a franchisee, you must be willing to limit your independence as an entrepreneur.
The Franchise Agreement
The Franchise Agreement forms the foundation of the relationship between the franchisor and the franchisee. The franchise agreement incorporates all the obligations of the franchisor and franchisee, the rules governing the way the business is conducted, as well as the conditions under which either party may terminate the agreement. It must anticipate all possible difficulties that may arise during the term of the agreement.
This agreement is legally binding. Every line of this document should be scrutinized before any commitment is made. Indeed, it is not only advisable but also essential that professional advice is sought. An experienced franchise attorney should be consulted before any agreement is signed.
A franchise sometimes involves signing two agreements, a purchase agreement and the franchise agreement itself. The purchase agreement is a short document simply stating that, subject to a suitable site being found, the franchisee will enter into the contract set out in the franchise agreement provided, of course, that the franchisee has read and approved the franchise agreement within a reasonable time. Having accepted this condition the franchisee pays the franchisor a deposit which forms part of the initial fee. The search for a suitable site as well as associated research into planning, permitting, viability of the site, etc. can begin. If no suitable site is found, the deposit is usually returned. However, if the franchisee rejects the site or changes his/her mind about the franchise, the deposit is usually forfeited.
The franchise agreement is a far more detailed document and covers the following areas:
1. Nature and name of the activity being franchised
2. Franchise territory
3. Term of the franchise agreement
4. Franchise Fees
5. Obligations of the franchisor and franchisee
6. Selling the business
7. Termination of the agreement
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