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Franchising is the practice of using another person's business model. The franchisor grants the independent operator the right to distribute its products, techniques, and trademarks for a percentage of gross monthly sales and a royalty fee. Various tangibles and intangibles such as national or international advertising, training, and other support services are commonly made available by the franchisor. Agreements typically last from five to thirty years, with premature cancellations or terminations of most contracts bearing serious consequences for franchisees.

Franchising has been around for many centuries but did not come to prominence until the 1930s in the United Statesmarker, when the establishment of electricity, vehicles, and, in the 1950s, the Interstate Highway system helped propel modern franchising, most notably franchise-based food service establishments. According to the International Franchise Association approximately 4% of all businesses in the United States are franchises.

Overview

The term "franchise" is used to describe business systems which may or may not fall into the legal definition provided above. For example, a vending machine operator may receive a franchise for a particular kind of vending machine, including a trademark and a royalty, but no method of doing business. This is called "product franchising" or "trade name franchising".

Cancellations or terminations of franchise agreements before the completion of the contract have serious consequences for franchisees. Franchise agreement terms typically result in a loss of the sunk costs of the first-owner franchisees who build out the branded physical units and who lease the branded name, marks, and business plan from the franchisors if the franchise is canceled or terminated for any reason before the expiration of the entire term of the contract. (Item 15 of the Rule of the Federal Trade Commission requires disclosure of terms that cover termination of the franchise agreement and the terms substantiate this statement)

History

Franchising dates back to at least the 1850s; Isaac Singer, who made improvements to an existing model of a sewing machine, wanted to increase the distribution of his sewing machines. His effort, though unsuccessful in the long run, was among the first franchising efforts in the United States. A later example of franchising was John S. Pemberton's successful franchising of Coca-Cola. Early American examples include the telegraph system, which was operated by various railroad companies but controlled by Western Union, and exclusive agreements between automobile manufacturers and operators of local dealer. Earlier models of product franchising collected royalties or fees on a product basis and not on the gross sales of the business operations of the franchisees.

Modern franchising came to prominence with the rise of franchise-based food service establishments. This trend started before 1933 with quick service restaurants such as A&W Root Beer. In 1935, Howard Deering Johnson teamed up with Reginald Sprague to establish the first modern restaurant franchise. The idea was to let independent operators use the same name, food, supplies, logo and even building design in exchange for a fee.

The growth in franchises picked up steam in the 1930s when such chains as Howard Johnson's started franchising motels. The 1950s saw a boom of franchise chains in conjunction with the development of the U.S. interstate highway system. Fast food restaurants, diners and motel chains exploded. In regard to contemporary franchise chains, McDonald's is arguably the most successful worldwide with more restaurant units than any other franchise network.

According to Franchising in the Economy, 1991-1993, a study done by the University of Louisvillemarker, franchising helped to lead America out of its economic downturn at the time. Franchising is a unique business model that has encouraged the growth of franchised chain formula units because the franchisors collect royalties on the gross sales of these units and not on the profits. Conversely, when good jobs are lost in the economy, franchising picks up because potential franchisees are looking to buy jobs and to earn profits from the purchase of franchise rights. The manager of the United States Small Business Administration's Franchise Registry concludes that franchising there is continuing to grow and that franchising is growing in the national economy.

Franchising is a business model used in more than 70 industries and that generates more than $1 trillion in U.S. sales annually.

Businesses for which franchising works best

Businesses for which franchising is said to work best have the following characteristics:

  • Businesses with a good track record of profitability.
  • Businesses built around a unique or unusual concept.
  • Businesses with broad geographic appeal.
  • Businesses which are relatively easy to operate.
  • Businesses which are relatively inexpensive to operate.
  • Businesses which are easily duplicated.


Advantages

For franchisors

Expansion

Franchising is one of the only means available to access venture investment capital without the need to give up control of the operation of the chain in the process. After the brand and formula are carefully designed and properly executed, franchisors are able to sell franchises and expand rapidly across countries and continents using the capital and resources of their franchisees, and can earn profits commensurate with their contribution to those societies while greatly reducing the risk and expense that would be inherent in conventional chain operations

Additionally, the franchisor may choose to leverage the franchisee to build a distribution network.

Legal considerations

The franchisor is relieved of many of the mundane duties necessary to start a new outlet, such as obtaining the necessary licenses and permits. In some jurisdictions, certain permits (especially alcohol licenses) are more easily obtained by locally based, owner-operator type applicants while companies based outside the jurisdiction (and especially if they originate in another country) find it difficult if not impossible to get such licences issued to them directly. For this reason, hotel and restaurant chains that sell alcohol often have no viable option but to franchise if they wish to expand to another state or province.

Additionally, the franchisor is relieved of the obligation to carry liability insurance on the independently owned franchise units that produce the gross sales of the franchised system because this is the obligation and responsibility of the franchisees under the franchise agreement. As long as the franchisor's operational manuals are efficient and followed by the franchisees, the franchisors are generally almost always protected from any liability for any incident that occurs on the property of the franchisee.

Franchisors can sell franchises without making any representations as to success or failure of the units in the written franchise disclosure documents and in the written franchise agreements. Therefore, franchisors are generally protected from lawsuits from their franchisee because of the non-negotiable contracts that require franchisees to acknowledge, in effect, that they are buying the franchise knowing that there is risk, and that they have not been promised success or profits by the franchisor.

Operational considerations

Franchisees are said to have a greater incentive than direct employees to operate their businesses successfully because they have a direct stake in the start up of the branded business and the tangible assets that wear the brand name. The need of franchisors to closely scrutinize the day to day operations of franchisees (compared to directly-owned outlets) is greatly reduced.

Franchisors can maximize their profits on the gross sales of the franchisees and avoid the operational expenses for the physical units that wear their brand names. Franchisors can minimize their risk and thus increase their profits because their franchisees bear the expense of operating the units and the expense of being employers, in compliance with existing city, state, and federal laws.

For franchisees

Employment

Opening a franchise is a way of owning a business.

Quick start

As practiced in retailing, franchising offers franchisees the advantage of starting up a new business quickly based on a proven trademark and formula of doing business, as opposed to having to build a new business and brand from scratch (often in the face of aggressive competition from franchise operators). A well run franchise would offer a turnkey business: from site selection to lease negotiation, training, mentoring and ongoing support as well as statutory requirements and troubleshooting.

Expansion

With the help of the expertise provided by the franchisors, the franchisees may be able to take their franchised businesses to a level which they wouldn't have been able to without the expert guidance of their franchisors.

Training

Franchisors often offer franchisees significant training, which is not available for free to individuals starting their own business. Although training is not always free for franchisees, it is sometimes supported through the traditional franchise fee that the franchisor collects and tailored to the business that is being started. When training fees and travel expenses, etc.. are required beyond the initial franchise fee, these fees are deductible as part of the startup expenses of the business.

Many franchisors nowadays also have an online Corporate University to help franchisees with both initial and ongoing training. An online Corporate University has the advantage of enabling anytime, anywhere learning and is generally made available free of charge to the franchisee.

Disadvantages

For franchisors

Limited pool of viable franchisees

In any city or region there may be only a limited pool of prospects who have both the financial resources and the desire to purchase and start up a franchised business, as compared to the pool of individuals who can be hired and trained to competently manage directly-owned businesses, as paid employees. However, in periods of recession where traditional good jobs are in short supply, this disadvantage disappears because those who can't find good jobs are willing to invest money in a franchise as a means of self-employment.

Control

Successful franchising necessitates a much more careful vetting process when evaluating the limited number of potential franchisees than would be required in the hiring of direct employees who may have experience in the concept sector. An incompetent manager of a directly-owned outlet can easily be replaced, while, regardless of the local laws and agreements in place, removing an incompetent franchisee who owns the tangible assets of the business is much more difficult. Incompetent franchisees can easily damage the public's goodwill towards the franchisor's brand by providing inferior goods and services. If a franchisee is cited for legal violations, (s)he will probably face the legal consequences alone but the franchisor's reputation could still be damaged.

For franchisees

No guarantee

Usually, there is no guarantee of financial success for the franchisee made by the franchisor in the written disclosure circular and the actual franchise agreement. While the estimated startup costs of the franchise are an implied "earnings claim" some businesses do fail, including franchised outlets. Unfortunately, the unit financial performance statistics are not required to be disclosed to new buyers of franchises under Federal Regulatory Policy, the FTC Rule, and this omission makes it impossible for new buyers of franchises to assess the odds of success and failure of their investment in the franchise in terms of profitability and failure as experienced on a unit basis of the franchise system. (See article in American Business Law Journal, 1 January 2003, entitled Franchising Fraud: the continuing need for reform, 1 January 2003, published on the Internet in mid 2008.)

Control

For franchisees, the main disadvantage of franchising is a loss of control. While they gain the use of a system, trademarks, assistance, training, marketing, the franchisee is required to follow the system and get approval for changes from the franchisor. For these reasons, franchisees and entrepreneurs are very different. The United States Office of Advocacy of the SBA indicates that a franchisee "is merely a temporary business investment where he may be one of several investors during the lifetime of the franchise. In other words, he is "renting or leasing" the opportunity, not "buying a business for the purpose of true ownership." Additionally, "A franchise purchase consists of both intrinsic value and time value. A franchise is a wasting asset due to the finite term: the franchisor is only obliged to renew the franchise if it chooses to contract for that obligation."

Price

Starting and operating a franchise business carries expenses. In choosing to adopt the standards set by the franchisor, the franchisee often has no further choice as to signage, shop fitting, uniforms etc. The franchisee may not be allowed to source less expensive alternatives. Added to that is the franchise fee and ongoing royalties and advertising contributions. The contract may also bind the franchisee to such alterations as demanded by the franchisor from time to time. (As required to be disclosed in the state disclosure document and the franchise agreement under the FTC Franchise Rule)

Conflicts

The franchisor/franchisee relationship can easily cause conflict if either side is incompetent (or acting in bad faith). An incompetent franchisor can destroy its franchisees by failing to promote the brand properly or by squeezing them too aggressively for profits. Franchise agreements are unilateral contracts or contracts of adhesion wherein the contract terms generally are advantageous to the franchisor when there is conflict in the relationship. Additionally, the legal publishing website Nolo.com listed the "Lack of Legal Recourse" as one of Ten Good Reasons Not to Buy a Franchise:

Legal aspects

Australia

In Australia, franchising is regulated by the Franchising Code of Conduct, a mandatory code of conduct made under the Trade Practices Act 1974.

The Code requires franchisors to produce a disclosure document which must be given to a prospective franchisee at least 14 days before the franchise agreement is entered into.

The Code also regulates the content of franchise agreements, for example in relation to marketing funds, a cooling-off period, termination and the resolution of disputes by mediation.

The federal government is currently considering recommended changes to the Code of Conduct contained in the report, 'Opportunity not Opportunism: Improving conduct in Australian Franchising' tabled by a Parliamentary inquiry into franchising on 4 December 2008.

Some experts have warned that any push to increase regulation of the franchising sector, could make it a less attractive means of doing business.

United States

In the United Statesmarker, franchising falls under the jurisdiction of a number of state and federal laws. Franchisors are required by the Federal Trade Commission to provide a Franchise Disclosure Document to disclose essential information to potential franchisees about their purchase. States may require the FDD to contain specific requirements but the requirements in the State disclosure documents must be in compliance with the Federal Rule that governs federal regulatory policy. There is no private right of action under the FTC Rule for franchisor violation of the rule but fifteen or more of the States have passed statutes that provide a private right of action to franchisees when fraud can be proved under these special statutes.

The franchise agreement is the essential contract signed by the franchisee and the franchisor that formalizes and specifies the terms of the business arrangement. It also details many issues discussed in less depth in the FDD. Unlike the FDD, the franchise agreement is a fluid document, crafted to meet the specific needs of the franchise, with each having its own set of standards and requirements. But much like a lease, there are elements commonly found in every agreement. "There is a difference between a discrete contract and a relational contract, and franchise contracts are a distinct subset of relational contracts." Franchise contracts form a unique and ongoing relationship between the parties. "Unlike a traditional contract, franchise contracts establish a relationship where the stronger party can unilaterally alter the fundamental nature of the obligations of the weaker party......." Because the franchise agreement is a complex legal document that obligates both the franchisor and the franchisee to perform a variety of duties, each party generally consults extensively with an attorney before entering into a franchise agreement.

There is no federal registry of franchises or any federal filing requirements for information. States are the primary collectors of data on franchising companies, and enforce laws and regulations regarding their presence and their spread in their jurisdictions. In response to the soaring popularity of franchising, an increasing number of communities are taking steps to limit these chain businesses and reduce displacement of independent businesses through limits on "formula businesses."

The majority of franchisors have inserted mandatory arbitration clauses into their agreements with their franchisees. Since 1980, the U.S.marker Supreme Courtmarker has dealt with cases involving direct franchisor/franchisee conflicts at least four times, and three of those cases involved a franchisee who was resisting the franchisor's motion to compel arbitration. Two of the latter cases involved large, well-known restaurant chains (Burger King in Burger King v. Rudzewicz and Subway in 517 US 681 (1996) Doctor's Associates, Inc. v. Casarotto); the third involved Southland Corporation, the parent company of 7-Eleven in Southland Corp. v. Keating, 465 US 1 (1984).

Russia

In Russia, under chapter 54 of the Civil Code (passed 1996), franchise agreements are invalid unless written and registered, and franchisors cannot set standards or limits on the prices of the franchisee’s goods. Enforcement of laws and resolution of contractual disputes is a problem: Dunkin' Donuts chose to terminate its contract with Russian franchisees that were selling vodka and meat patties contrary to their contracts, rather than pursue legal remedies.

UK

In the United Kingdom, there are no franchise-specific laws; franchises are subject to the same laws that govern other businesses. For example, franchise agreements are produced under regular contract law and do not have to conform to any further legislation or guidelines. There is some self-regulation through the British Franchise Association (BFA). However there are many franchise businesses which do not become members, and many businesses that refer to themselves as franchisors that do not conform to these rules. There are several people and organisations in the industry calling for the creation of a framework to help reduce the number of "cowboy" franchises and help the industry clean up its image.

On 22 May 2007, hearings were held in the UK Parliament concerning citizen initiated petitions for special regulation of franchising by the government of the UK due to losses of citizens who had invested in franchises. The Minister of Industry, Margaret Hodge, conducted hearings but resisted any government regulation of franchising with the advice that government regulation of franchising might lull the public into a false sense of security. The Minister of Industry indicated that if due diligence were performed by the investors and the banks, the current laws governing business contracts in the UK offered sufficient protection for the public and the banks.

Social franchises

In recent years, the idea of franchising has been picked up by the social enterprise sector, which hopes to simplify and expedite the process of setting up new businesses. A number of business ideas, such as soap making, wholefood retailing, aquarium maintenance, and hotel operation, have been identified as suitable for adoption by social firms employing disabled and disadvantaged people.

The most successful example is probably the CAP Markets, a steadily growing chain of some 50 neighborhood supermarkets in Germanymarker. Other examples are the St. Mary's Place Hotel in Edinburghmarker and the Hotel Tritone in Triestemarker.

Social franchising also refers to a technique used by governments and aid donors to provide essential clinical health services in the developing world.

Event franchising

Event franchising is the duplication of public events in other geographical areas, while retaining the original brand (logo), mission, concept and format of the event. As in classic franchising, event franchising is built on precisely copying successful events. Good example of event franchising is the World Economic Forum, or just Davosmarker forum which has regional event franchisees in Chinamarker, Latin America etc. Likewise, the alter-globalist World Social Forum has launched many national events.

See also



References

External links






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