Franchising is one of the most lucrative and efficient ways for franchisors to expand their entrepreneurial endeavors. Franchisees can also reduce the risks of starting a new business by leveraging a proven business model after creating an LLC or any other appropriate legal business structure for the additional protection it offers regarding tax benefits, limited liability protection, and more.

In 2023 alone, franchises generated revenue of over $859 billion, with over 8 million people working in the franchise sector. Therefore, franchises are a viable marketing model that businesses, both large and small, use to grow their establishments consistently. When you do it right, it benefits the franchisor, franchisee, and the American economy—it is an all-around win for everyone.

This guide explores the meaning of franchising, provides an overview of franchise laws, outlines the components of franchising, offers practical tips for franchisees, and outlines the benefits of franchising for both the franchisor and the franchisee.

What is Franchising?

Franchising is a business model that permits an individual (the franchisee) to operate a business using the trademark, products, and standard operating systems of another business (the franchisor) for an initial fee and continuous annual royalties.

The franchisee leverages the franchisor’s established brand, support systems, and proven business practices. In contrast, the franchisor expands its market presence and revenue streams with less capital investment and ongoing operational costs.

However, the franchising industry is a regulated sector. Before dabbling in it, you should be adequately informed about it.

Overview of Federal and State Franchise Laws

In the United States, franchise laws are established to ensure transparency, fairness, and protection for the franchisor and the franchisee. These laws are meant to be complied with at both the Federal and State levels.

Federal Regulations

The Federal Trade Commission (FTC) is the body responsible for regulating the “Franchise Rule” that governs franchising at the federal level. The Federal Rule compels franchisors to furnish the franchisee with the Franchise Disclosure Documents (FDD) at least 14 days before signing the Franchise Agreement. 

The FDD document, as contained in the C.F.R 16 §436, consists of 23 detailed information concerning the franchisor and the business to enable the franchisee to make a well-informed decision before buying the franchise. Some of the information contained in the FDD includes:

1. The Franchisor’s Background: The history of the franchisor, executives, and any litigation or bankruptcy history.
2. Initial and Ongoing Fees: A breakdown of the initial franchise fee, royalty fees, and other ongoing costs associated with the franchisor’s assistance, advertising, computer systems, and training.
3. Estimated Initial Investment: A detailed estimate of the total investment required to start the franchise.
4. Territory Rights: Information about the franchisee’s exclusive territory, if any, and conditions for territory changes.
5. Financial Performance Representations: The historical financial data of existing franchises to help assess potential profitability.
6. Intellectual Property Rights: This involves the rights to use the trademark and intellectual property of the franchisor.

State Regulations

The franchisor must adhere to the state’s requirements in which it chooses to sell. Some states require that the FDD be registered, while others want it filed, and other states require no registration or filing before the franchise is sold.

• Registration States: About 13 registration states require franchisors to register their FDD with them for review and approval before the sale of the franchise within the state. Franchisors will register their FDD at a price, submit their franchise information and pay for annual renewals. Some of these states are California, Illinois, New York and Minnesota.
• Filing States: Texas, Georgia, and Florida are among the 11 “business opportunity” states. These states require franchisors to disclose pertinent information to the potential franchisee, although not as comprehensively and extensively as the FDD. They also request that franchisors file their franchise information with either a one-time payment or an annual fee. Some of them require franchisors to have a federally registered trademark. 
• No Filing or Registration States: These 25 states require no further obligations from the franchise, provided all the federal requirements are met. Some of these states include Arizona, Mississippi, and Ohio.

Franchise laws have many moving parts. Before you sign a franchise agreement, you should consult an experienced franchise attorney conversant in franchise law to ensure compliance.

Components of a Franchise Agreement

A franchise agreement is a legally binding contract that defines the relationship between the franchisor and the franchisee without any ambiguities. It clearly outlines the responsibilities and rights of both parties. The main components of a franchise agreement include;

Franchise Fee and Royalty Payments

The agreement should clearly state the initial franchise fee, ongoing royalty payments, and other service charges. These fees are typically based on a percentage of the franchisee’s gross sales and are essential to maintain the franchisor’s brand and support services.

Territorial Rights

This defines the geographical area in which the franchisee operates. This clause protects the franchisee from competition within the same brand and specifies whether the territory is exclusive or non-exclusive.

Duration and Renewal Terms

The agreement must specify the length of the franchise term and the conditions for renewal. Franchise terms usually range from five to twenty years, with options for renewal based on performance and compliance.

Training and Support

One of the primary benefits of franchising is the continued support provided by the franchisor. The franchise agreement should detail the initial training program and ongoing support services like marketing, operations, and product development.

Operational Standards

To maintain brand consistency, the franchisor sets operating standards that franchisees must follow. These standards cover product quality, customer service, and marketing strategies.

Advertising Requirements

Franchisees are often expected to contribute to the advertising fund managed by the franchisor. The franchise agreement should outline the contribution percentage and the scope of advertising activities.

Termination and Transfer Rights

The conditions that can warrant the termination of the franchise agreement should be clearly defined. Additionally, the contract should specify the franchisee’s rights and obligations regarding the transfer or sale of the franchise.

Practical Tips for Aspiring Franchisees

As with everything in life, successfully starting the franchising adventure will require some tips, which include:

Conduct Thorough Research

Before you commit to a franchise, research the franchisor’s history, reputation, and financial health. Speak with current and former franchisees to gain insights into their experiences and satisfaction levels.

Engage a Business Attorney

Hiring a reputable business attorney with expertise in franchising can be beneficial. They can help you understand the legal nuances of the FDD and franchise agreement. They will guide you through the sale or purchase of a franchise and ensure that your interests are protected throughout the process.

Evaluate Financial Projections

Carefully review the financial performance representations in the FDD. Then, compare these projections with independent market research to assess the franchise’s potential profitability.

Understand Your Obligations

Ensure you fully understand the standards of operations and obligations outlined in the franchise agreement. Non-compliance can lead to penalties or termination of the franchise.

Plan for Initial and Ongoing Costs

In addition to the initial franchise fee, you should consider other startup costs such as equipment, inventory, hidden costs, and real estate. You should also factor in ongoing costs like royalties, advertising fees, and operational expenses.

Benefits of Franchising

For Franchisors:

1. Expansion with Reduced Capital Investment: Franchising allows businesses to expand rapidly with less capital investment since the franchisees provide funding for the new locations.
2. Increased Brand Presence: Franchising helps increase the brand’s market presence and reach without the direct overhead costs associated with company-owned locations.
3. Revenue Streams: Instead of spending capital to expand their business, franchisors benefit from initial franchise fees and ongoing royalties, creating a steady revenue stream that increases with the number of franchisees they have.

For Franchisees:

1. Established Brand: Franchisees can benefit from operating under a recognized brand with an established customer base, reducing the risks associated with starting a new business with no existing customer base.
2. Proven Business Model: Franchisees receive a proven business model, reducing the trial-and-error phase typical of startups.
3. Training and Support: Franchisors provide comprehensive training and ongoing support to enable franchisees to effectively manage and grow their business.

Final Thoughts

Franchising is a symbiotic business model that benefits both the franchisor and franchisee significantly. It provides a pathway for rapid business expansion and allows entrepreneurs to operate under a proven brand with extensive support. 

However, it is essential for prospective franchisees to thoroughly research the franchise opportunity, understand the legal and financial commitments, and be prepared to comply with franchise rules, state franchise laws, and the franchisor’s guidelines. With the right approach, franchising can be highly rewarding.

 

Published by: Khy Talara