What is Franchising

Franchising is the practice of licensing a philosophy of business and its associated brand names by a franchisor to a franchisee, in exchange for a share in sales and a franchise royalty fee. Chain stores and chain restaurants are the franchises best known to the public, and McDonalds is the most successful franchise network in the world. In the United States, the rise of franchises paralleled the growth of the interstate highway system and the sense of America as a nationwide culture rather than a conglomeration of regional cultures. Though not uniquely American, franchising is a distinctly American practice, at once appealing to the small business owner and representing the success of the national or international corporation.
United States
In the United States, franchising is governed by both state and federal laws. The Federal Trade Commission requires that franchisors provide a Franchise Disclosure Document (FDD) to potential franchisees, at least 14 days before the franchisee signs a contract.
The FDD replaces the Uniform Franchise Offering Circular, a similar document that was required until the FTC revised its franchising-related regulations; the new regulations went into effect in July of 2008. The FDD consists of 20 items, in addition to the franchisor’s financial statements, the franchise contract, and a receipt; no government agency audits a franchisor’s FDD to ensure its accuracy, and a potential franchisee is expected to perform due diligence in doing so, but a franchisor misrepresenting itself is certainly liable to fraud charges.
The 20 items of the FDD are as follows:
1.    The franchisor and any parents, predecessors, or affiliates.
2.    Business experience. In this section, the directors, trustees, general partners, and officers of the franchisor are listed, along with any previous employment in the past five years.
3.    Litigation. This section discloses any pending litigation against the parties in (1), any litigation from the previous fiscal year, and any convictions, nolo contendere pleas, or civil suit liabilities from the previous ten years.
4.    Bankruptcy. Discloses whether the franchisor has filed for bankruptcy in the previous 10 years.
5.    Initial fees.
6.    Other fees.
7.    Estimated initial investment. This includes not simply the fees paid to the franchisor, but the expenses the franchisor anticipates the franchisee will need to make, such as purchasing or leasing real estate and equipment, training employees, and purchasing inventory. One of the benefits of becoming a franchisee is that you are pursuing a business model that has been successfully pursued before, and can learn from your fellow franchisees’ experience; the information disclosed in item (7) ideally reflects that collective wisdom.
8.    Restrictions on sources of products and services. Some franchises require that the franchisee purchase some or all of its inventory from the franchisor, which provides the franchisor with additional revenue streams; in some cases this is true even when the inventory provided by the franchisor is not distinctly different from that which the franchisee could purchase elsewhere (such as Heinz ketchup for a fast food franchise).
9.    Franchisee’s obligations. Types of obligation can include site selection and acquisition, pre-opening purchases, site development, employee training, opening, fees, standards/policies compliance, trademarks and proprietary information, product restrictions, warranties and customer service, territorial development, ongoing purchases, maintenance, insurance, advertising, indemnification, management and staffing, records and reports, inspections, transfer, renewal, post-termination obligations, non-competition convenants, and dispute resolution. The combination of post-termination and non-competition obligations are especially important to a potential franchisee, because a franchise contract is typically long term five and 10 year contracts are common with a penalty for early termination. A franchisee unhappy with his franchise may find that his only alternative is not simply a new business but a new industry.
10.  Financing.
11.  Franchisor’s assistance, advertising, computer systems, and training. The complement to item (9), this section discloses the extent of the franchisor’s participation.
12.  Territory. Franchisees don’t generally want to compete directly with fellow franchisees of the same franchise. This section discloses whether the franchise agreement grants exclusive territory, and other items related to the issue of territory.
13.  Trademarks.
14.  Patents, copyrights, and any proprietary information.
15.  Obligation to participate in the actual operation of the franchise business. Some franchisor’s require that if the franchisee is an individual, he must be on-premises for the operation of the franchise business; others let him hire a supervisor to run the business, as is common in franchises in which franchisees may own multiple locations. When supervisors are an option, there maybe optional or mandatory training programs offered by the franchisor. The supervisor may also be bound by restrictions similar to those of the franchisee such as non-competition or maintaining the integrity of trade secrets.
16.  Restrictions on what the franchisee may sell. Franchisors generally want to preserve their brand identity, which may lead them to preclude a franchisee from selling anything not on a specific list of options. Or there may be some binding agreement with a third party, such as a fast food franchise’s contract with Coca-Cola or PepsiCo to provide only the soft drinks from that company and not from its competitor.
17.  Renewal, termination, transfer, and dispute resolution. This section lays out the franchise relationship not only the length of the term of contract, but provisions for termination by the franchisee or franchisor, provisions for transfer of the franchise to another franchisee, provisions for death or disability, and an agreement pertaining to methods of dispute resolution should the need arise.
18.  Public figures. Discloses any information about public figures’ involvement with the franchise.
19.  Financial performance representations.
20.  Outlets and franchisee information.
The FDD offers as complete a picture as possible of the franchising experience, much like the prospectus given to potential investors in a new business. Although the FTC requires the FDD, there are no federal filing requirements; often, state laws will require franchisors to file or register at the state level, and in the 21st century there is an increasing likelihood of municipalities passing ordinances restricting franchise businesses, out of the fear that Big Business will arrive to displace mom-and-pop shops.
Several notable Supreme Court cases have dealt with conflicts between franchisees and franchisors. Burger King v. Rudzewicz, 471 U.S. 462 (1985) was brought before the court when Burger King (based in Florida) sued John Rudzewicz and Brian MacShara of Michigan for failing to make their monthly payments to the franchise, because of an economic downturn and lack of cash flow. The reason the case came to the Supreme Court’s attention was because of the matter of jurisdiction; though the United States District Court ruled that Florida’s jurisdiction extended to anyone who breached a contract in that state, the Eleventh Circuit Court of Appeals overturned that finding on the belief that the exercise of such jurisdiction violated the Fourteenth Amendment’s prescription of due process. The Supreme Court upheld the District Courts decision, finding in favor of Burger King (and establishing precedent important to franchisors who might otherwise have reason to be reluctant to do business with franchisees in other states).
Franchise Validation
There are many factors to consider in entering into a franchise contract, particularly now that so many markets are filled with competing franchises, some of which seem to offer nearly identical experiences. The FDD includes a list of current franchisees, and potential franchisees typically use the list during a process called “franchise validation.” During validation, potential franchisees arrange to interview current franchisees about their experience. Questions cover financial details, the relationship with the franchisor, the way marketing and promotion (typically funded by a pool into which all franchisees pay) are handled, and the availability of support and information from the franchisor after opening. Franchisees don’t have to answer questions, of course, but will often be open about their experiences, and those who are unhappy with their franchisor but are stuck by the terms of their contract have no reason not to air their complaints.
But franchise validation is a time-consuming process, and potential franchisees don’t always know the right questions to ask, or the right way to follow up on the answers. Franchise consulting has become a niche industry, a professional service that consults with potential franchisees and identifies a good fit for their needs, amidst the many franchise opportunities available. Franchise consulting is an industry subject to little regulation, and many franchise brokers refer to themselves as franchise consultants, which can muddy the view of the industry. Properly speaking, a franchise consultant works for a fee, paid by the franchisee. A franchise broker will advertise his services as free, but works much like a realtor does, taking a fee from the “seller” (the franchisor) in exchange for finding a “buyer” (the franchisee). Not every franchisor is willing to pay the brokerage fee, and so the options available to a franchisee working with a broker are fewer than those working with a franchise consultant. Franchise consultants, some of whom may also be franchise lawyers with a working knowledge of contract law, can also help potential franchisees understand the language of the lengthy FDD, which can be cumbersome and oblique through no fault of the franchisor. (Attorneys cannot work as franchise brokers, because state laws would find their fee from the franchisor a conflict of interest.)
History
Franchising began with the Industrial Revolution. Historian Robert Wiebe identifies the late 19th century through World War I what is sometimes called the Progressive Era, overlapping with the Gilded Age of the post-Reconstruction years as an organizational period in American history, when the emphasis began to shift from regional identity to national identity. This wasn’t reflected simply in how people talked about themselves, or in the shift from “the United States are” to “the United States is.” It was a practical change, as national professional organizations like the American Medical Association and the American Bar Organization were formed; national labor unions formed around the nuclei of local unions; magazines and newspapers began producing content that was distributed nationally; and more and more commercial products were produced not just for local consumers but for consumers across the nation. Radio, when it arrived at the tail end of this period, adopted a national mindset almost immediately, with broadcast corporations distributing their programming nationwide a precursor to the model the television networks would follow.
Coca-Cola is one of the first early examples of franchising success; after Asa Candler bought the rights to the name and formula of the soft drink developed by Atlanta pharmacist John Pemberton, he licensed the syrup both to bottlers and to drugstore soda fountains. Rather than simply selling the syrup and allowing the retailer to do as they liked with it, Candler attached conditions to the sale and presentation of Coca-Cola; it had to be sold under that name, for instance, and he fought hard against the use of the nickname “Coke” out of fears that it would jeopardize the product’s trademark. (Copycat products with names like Koke were cropping up everywhere.) He discouraged adulteration, including the addition of other flavors like cherry, lime, or coffee, despite their widespread popularity-first and foremost in his mind was the protection of the brand identity, and with a strong enough brand identity the product would outsell all in its class. It was a unique approach for the time, and must have been instrumental in the success of the company and the brand; certainly Candler s approach was aped by the soft drink companies that followed.
Coca-Cola, though, was the franchise of a single product, much simpler than the modern franchise system. It was drug store owner Louis Liggett of Boston who popularized the franchise store in 1902. He talked 40 of his fellow drug store owners into pooling money together to form a collective, which would pay for advertising and marketing, bargain with wholesalers for cheaper prices, and benefit from a unified brand name Rexall. After World War I, the company began granting franchise rights to new stores, and it later sponsored the Amos ‘ri Andy radio show.
The first restaurant franchise followed in 1932 with Howard Johnson’s, which expanded quickly despite the ongoing Great Depression. Much of Howard Johnsons success came from bidding on the exclusive rights to build restaurants at the gas station turnoffs on major northeastern and mid-Atlantic turnpikes. The growth of the highway system would provide many opportunities for franchises throughout the next few decades, into the 1970s, as companies like McDonald’s, Kentucky Fried Chicken, and Taco Bell depended on the strength of nationwide advertising and the lure of familiarity to build chains of restaurants attended by family and business travelers. As it became more common for Americans to move to different parts of the country for work or school, the existence of nationwide franchises had a somewhat homogenizing effect, providing familiarity to strangers. You may not know the local mechanic, but your past experiences provide positive associations for the Meineke brand name.
Types of Franchises
There are four broad types of franchises. Product franchises are similar to Asa Candler’s handling of Coca-Cola. With a product franchise, a manufacturer enters into an agreement with a retailer to distribute his products, one that is more complicated than a simple sales transaction. The agreement may call for a minimum number of purchases per quarter or fiscal year, or may require a certain type of display; it may require that the manufacturers competitors not be available at the same outlet.
Manufacturing franchises are like those granted to soft drink bottlers. The franchise grants the license to produce and sell a product under a particular trademark. This may also involve purchasing the equipment or materials to make the product from the owner.
Business opportunity franchises generally involve the distribution of another company’s products in a particular franchised fashion for instance, vending machine distribution is often franchised.
The most common type of franchise is the business format franchise, which includes McDonalds and other fast food restaurants, Meineke and many other auto repair business chains, Gold’s Gym and Curves, and so on. The FDD is constructed with the business format franchise in mind, because this is the franchise relationship with the most potential complication.