How Does Franchising Work?

Franchising can be a great option for people with an entrepreneurial spirit, but who don’t have the bandwidth or desire to go through the process of starting a business from scratch. But how does franchising work, exactly?

Essentially, a successful business owner (known as the franchisor) franchises their business, enabling franchisees to own and operate separate locations under the franchisor’s name and operating systems. So the franchisor provides the framework for the business, but it’s up to the franchisee to run the business itself—and to make money on it.

But there are so many more nuts and bolts involved in the process of researching, purchasing, and running a franchise. In this article, we’ll run you through the basics about how franchising works, and help you determine whether buying a franchise is the right move for you.

What Is Franchising?

In a franchise arrangement, the franchisor agrees to give the franchisee the right to sell the franchisor’s goods or services, and to use its business name and model. Franchise contracts also include the length of time for which the franchisee retains these rights. Put simply, the franchisor owns the business itself, while the franchisee owns the right to sell the contents of that business. So under this arrangement, the franchisee operates under (and takes advantage of) the franchisor’s existing infrastructure and operating procedures, while retaining responsibility for maintenance and operation of their own branch. 

Buying a franchise requires that the franchisee undergoes extensive training in the franchisor’s business operations, from inventory management to quality control methods to hiring standards and service techniques. Once the franchisee has completed their training, the franchisor entrusts them with a location to own and operate. Just as they would they had started their own business, the franchisee is responsible for their location’s day-to-day operations, maintenance, and management, though they’ll receive ongoing support, direction, and oversight from the franchisor. 

Ultimately, the franchisor has the final word in determining how the franchisee can conduct their business. A few elements that the franchisor may control, according to the FTC, include site approval, design or appearance standards, restrictions on goods or services the franchisee can sell, methods of operation, and limitations on the franchisee’s sales territory.[1] Of course, the franchisee is legally obligated to operate under whatever regulations the franchisor set forth in their franchise contract. That may include non-competes and trade secret protections in addition to standard franchisor controls. We highly recommend that you work with a business attorney before signing any franchise agreement—but we’ll go into more detail about the legal aspects of buying a franchise later.        

Franchise Fees 

In order for the franchisee to retain the rights to the franchisor’s goods or services, they’ll need to pay for it. There are three major franchise fees to look out for, all of which will be outlined in your franchise agreement:

1. Initial Franchise Fee

This is a one-time, upfront fee that the franchisee makes once they’ve signed the franchise agreement. You can think of the initial franchise fee as the franchisee’s “cost of entry”—essentially, with this fee the franchisee is buying the rights to use the franchisor’s name and operating system. In most cases, this fee doesn’t cover necessities like inventory, a hiring budget, tools, and furnishings. 

Initial franchise fees vary depending on industry. According to the FTC Franchise Rule, that fee must be at least $500, but it’s often much higher than that.[2] Most franchise fees are tens of thousands of dollars; but if you’re purchasing a Master Franchise, that fee can be over $100,000. That said, there are lots of low-cost franchises for you to consider with more accessible franchise fees.     

2. Royalty Fees

Franchise royalty fees are ongoing fees that the franchisee pays the franchisor for their continued support. Franchisors usually collect royalty fees on a monthly basis, and they’re often calculated as a percentage of your revenue. Royalty fees typically range from 4% to 12%, but the exact amount varies depending on industry and volume.

3. Advertising Fees

Advertising or marketing fees are exactly what they sound like: It’s a fee that the franchisee pays the franchisor to help fund the franchisor’s advertising budget. This may seem like an extraneous fee, or at least not within the franchisee’s jurisdiction, but ultimately, franchisees reap the benefits of the franchisor’s advertising efforts—after all, that’s where the franchisee’s entire customer base comes from. Marketing fees are also typically calculated as a percentage of monthly revenue, but it’ll be a smaller percentage than royalty fees.     

How to Find the Right Franchise for You

If you’re interested in investing in a franchise, you’ll have to do a good amount of due diligence to determine which company is worth your time and money. Here are just a few considerations to keep in mind as you look into potential franchises to buy. 

Your Finances

In addition to the franchise, royalty, and advertising fees we covered above, purchasing and managing a franchise requires a good amount of capital—just as it takes a good amount of capital to run any other kind of business. And as we mentioned, most franchise fees don’t cover the costs required for necessities, like inventory, supplies and equipment, hiring staff, and potential renovations and build-outs of your franchise location. Spend some time on Franchising.com, where you can search for franchises according to their investment requirements. You can also contact the franchise directly for information about how much cash you’ll need to purchase and run a branch.  

That said, starting and operating a franchise doesn’t need to be totally bootstrapped. Just like any other business, you can seek outside business financing. Take a look at our guide on franchise financing to learn about the potential loans you can apply for to fund your franchise, as well as their approval requirements. Although you may not be eligible for a loan right off the bat, understanding loan eligibility requirements can help you plan your finances ahead of time. 

Name Recognition

As a franchisee, you’re dependent upon the strength of the franchise’s name recognition to make money. Obviously, it’s in your best interest to invest in a franchise with strong branding and a solid reputation, both nation-wide and regionally. The more name recognition your franchise has, the less lift you’ll have to take on in your own marketing efforts to draw in customers. 

Your Location

Along those lines, it makes sense to invest in a franchise that’s popular in your particular area. If there’s no demand for a franchise’s products or services where you live, you’ll need to invest more time and money into marketing than would be necessary if you’d partnered with a franchise that’s more popular with your local demographic. 

Gauge the level of competition in your area, as well. You don’t necessarily want to buy a franchise in an area that’s already saturated with similar businesses; but if there are no franchised locations in your area, that may not bode well for the demand for your potential franchise’s goods or services. 

Training and Support

Look into the level of support and training your franchisor provides, both initial and ongoing. It’s useful to compare all your potential franchisors’ training programs to evaluate their thoroughness. Evaluate whether your background, education, and existing training is conducive to working with this particular franchise, too. Even though the franchisor will provide all the necessary training you’ll need to operate your location, you’ll likely feel more comfortable in your role if you don’t need to contend with a steep learning curve.   

Also, evaluate whether your franchisor has the assets and resources required to continue to support their franchisees over the long term. While a high growth rate bodes well for the success of your franchise, you need to ensure that a potential franchise is stable enough to maintain support and oversight over their existing franchisees as they grow.   

Your Franchisor’s Reputation

It’s crucial that you work with a franchisor who is trustworthy, experienced, and reputable, so take the time to look into other franchisees’ experience working with your potential franchisor, as well as dig into any complaints filed against the company. 

Start by checking the franchisor’s BBB (Better Business Bureau) page. If the franchisor is registered with Dun & Bradstreet, you can request a report for information about their business credit and general financial standing. And if you live in a state that regulates the sale of franchises, get in touch with your state’s franchise authority to make sure the franchise is compliant with state laws, and whether they’ve had any lawsuits or bankruptcies.

Make it a priority to get in touch with other franchisees, as well. This is an excellent opportunity to get a sense of what it’s really like to own a franchise with a particular company. Ask them specific questions about their initial training and setup, ongoing support, and honest feedback about their experiences as a franchise owner. Stick with the franchisors whose investors seem truly satisfied with their decision to work with the franchisor in question, and feel sufficiently supported.  

Your Personal Preferences

Whatever franchise you choose to invest in has to work for your lifestyle. The reality of becoming a franchisee is similar to the reality of starting a business from scratch: It takes a lot of time, effort, and dedication to keep your operation going. You wouldn’t start a business that you weren’t 100% passionate about; same goes for buying into a franchise. Pick an industry that excites you, whose hours suit your routine, and whose particular goals and objectives align with yours.

Choosing a Franchise: The Next Steps

Once you’ve identified the franchises that align with your goals, your next step is to formally evaluate each franchise. First, contact them for an in-depth conversation. You can also request copies of their marketing material, business plan, and operations manuals. The information you glean from speaking with them directly will build off the research you’ve conducted on your own. 

Evaluate the Franchisor’s FDD

If you’re serious about working with a particular franchise, they’ll send you a copy of their franchise disclosure document (FDD). Under the FTC’s Franchise Rule, franchisors must provide potential investors with their FDD at least 14 days before they ask the investor to sign a contract. This gives the investor ample time to evaluate their decision. You have the right to request an FDD well before you submit an application with the franchisor—you’re even entitled to ask for a copy of their FDD before you spend any money on your research into a franchisor.     

The FDD discloses crucial information about the franchisor regarding their financial standing, history, capital requirements, and more. In particular, pay close attention to the following information:

  • The franchisor’s background, competition, and whether the franchisor has any legal, permit, or licensing requirements
  • Litigation history 
  • Bankruptcies
  • Costs required to start and operate a franchise
  • Restrictions on suppliers, and where, what, and how you’re allowed to sell their goods or services
  • Franchising fees
  • Training eligibility and requirements
  • Rules surrounding renewal, transfer, termination, and dispute resolution when your contract ends
  • A list of current and former franchisees and franchisee associations whom you can contact
  • Three most recent audited financial statements

It may feel intimidating to comb through all the fine print included in each franchisor’s FDD, but this document is the most important component of your decision-making process. We urge you to read it thoroughly, take notes, and speak with as many current and former franchisees as possible to ensure you’re making an informed decision.

Consult an Accountant and Lawyer

There’s a ton of research into potential franchises that you can, and should, do on your own. But the process of buying into a franchise involves some complicated financial and legal aspects that can be difficult—or at least inadvisable—to navigate on your own.

Speaking with an accountant can help you make sense of the franchisor’s financial documents and information provided in their FDD, as well as provide you with a clearer understanding of your potential earnings if you choose to invest in that franchise. You accountant can also evaluate your resources and help you pick a franchise that’s a realistic investment for your current financial standing. Finally, your accountant can help you draft a business plan for your franchise, and determine a business structure after you’ve signed your franchise contract.       

Consulting with a lawyer is pretty non-negotiable, especially when you receive your franchise agreement. An attorney who specializes in franchise law can analyze your franchise agreement to ensure that it is aligned with your best interests, and generally break down that contract in plain English. Since franchise contracts can be binding for decades, it’s crucial that you thoroughly understand what you’re signing on for. Lawyers can help you parse the legal aspects of a franchisor’s FDD, too, as well as ensure that you’re compliant with state statutes regarding franchising (if you live in a regulated state) and the FTC’s Franchise Rule. 

Is Franchising Right for You?

To determine whether franchising is right for you, start by evaluating the pros and cons of buying a franchise.

On the plus side, you won’t have to build a business from the ground up. Rather, franchisees can take advantage of the franchisor’s existing framework of operating systems, suppliers, marketing initiatives, name recognition, and business model. That cuts out much of the risk and guesswork involved in starting your own business from scratch. You’ll receive relevant training, too, so you don’t necessarily have to have extensive experience in your franchisor’s industry to succeed as a franchisee (though prior experience always helps, especially when it comes to running a business). A good franchisor will also provide you with the support you need to start your business, as well as ongoing support as you continue to operate your location.    

But there are drawbacks to consider, as well. On a less positive note, franchisees are inherently limited by the franchisor’s rules and regulations. Expect restrictions on your operating procedures, the types of goods and services you can sell, pricing, and how you can decorate and furnish your location, among many other limitations. And as you’re contractually bound to comply with the franchisor’s regulations, straying from that framework can have serious legal implications. 

Ultimately, you’ll need to determine whether you more strongly value the prospect of owning your own business (according to a proven and successful model), or the freedom to build and operate your business however you see fit. And at the risk of sounding like a broken record, it’s in your best interest to consult with an accountant, attorney, and/or other franchise professional as you consider this option. Better to do your due diligence now and make an informed decision than to find yourself bound to a contract with a disreputable franchisor.

Article Sources:

  1. FTC.gov. “A Consumer’s Guide to Buying a Franchise
  2. FTC.gov. “Franchise Rule

Caroline Goldstein

Caroline Goldstein is a contributing writer for Fundera.

Caroline is a freelance writer and editor, specializing in small business and finance. She has covered topics such as lending, credit cards, marketing, and starting a business for Fundera. Her work has appeared in JPMorgan Chase, Prevention, Refinery29, Bustle, Men’s Health, and more.

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