Chapter 8 Franchising – a growth strategy

What is Franchising and how does it work? When to Franchise?

Selecting and developing Effective Franchising? Advantages and disadvantages of Franchising as a growth strategy

Buying a Franchise

What is Franchising and how does it work?

Franchising is a form of business organization in which a firm that already has a successful product or service (franchisor) licenses itstrademark and method of doing business to other businesses(franchisees) in exchange for an initial franchise fee and anongoing royalty.

Franchising is a business growth that allows a business to get itsproducts or services to market through the effort of businesspartners called franchisees.

Franchising as a business growth strategy increased its popularityin the whole world.Example: In the USA 1/3 from the retail is conducted by companiescreated through franchising. However many companies createdthrough franchising have reached insolvency because they workedin industries with strong competition.

Many service companies and retail companies consider franchising as being an attractive method which facilitatesbusiness growth. Some industries such as restaurants, hotels, carservice are dominated by companies founded by franchising. Inother branches, although it began to manifest, franchising is lesscommon: internet providers, furniture restoration, service formobile phones.

In some cases, franchising is not suitable.Example: new technologies are not introduced throughfranchising, especially when the technology is being kept secret oris complex. This is because the franchising requires the spreadingof knowledge from the franchisor to the franchisee, issue thatinvolves many people. The invention of new technologies usuallyinvolve a small number of people in order to keep the informationsecret.

There are different types of franchise systems:

Product and trademark franchise is an arrangement under which the franchisor grants to the franchisee the right to buy its products and use its trade name. This approach typically connects a single manufacturer with a network of dealers or distributors.

Example: General Motors has established a network of dealers thatsell GM cars and use the GM trademark in their advertising; BritishPetroleum (BP) has established a network of franchisee – ownedgasoline stations to distribute BP gasoline; other examples includeagricultural machinery dealers, soft – drink bottlers, and beerdistributorships.

This type of franchising offers the franchisee the possibility to operateautonomously because the franchisor is mainly concerned withpreserving the identity of its products and only secondly withmonitoring the activity of the franchisee. In this type of franchising,franchisors get most of its revenue from selling its products to dealersor distributors.

Business format franchise is by far the more popular approach to franchising and is more commonly used by entrepreneurial firms. In a business format franchise, the franchisor provides a formula for doing business to the franchisee along with training, advertising, and other forms of assistance.

Example: fast-food restaurants, convenience stores, Internet Serviceproviders, and consulting services. This type of franchising canbecome very rigid and demanding. For example fast-food restaurantssuch as McDonald’s teach their franchisees every detail of how to runtheir restaurant, from how many seconds to cook French fries to theexact words their employees should use when they greet customers.In this type of franchising franchisors obtain the majority of theirrevenues from their franchisees in the form of royalties and franchisefees.

The franchisor-franchisee relationship can take one of the following forms of a franchise agreement:

Individual franchise agreement is the most common form offranchise agreement and involves the sale of a single franchise fora specific location.

Area franchise agreement allows a franchisee to own andoperate a specific number of outlets in a particular geographic area.

Master franchise agreement is similar to area franchiseagreement, with one major difference. A master franchisee has theright to offer and sell the franchise to other people in its area. ThePeople who buy franchises from master franchisees are typicallycalled subfranchisees.

When to Franchise?

The alternatives of a business that aims to grow are:

To built company-owned outlets. This choice presents a companywith the challenge of raising the money to fund its expansion, whichis not easy for a start-up venture.

Franchising is especially attractive to young firms in that themajority of the money needed for expansion comes from thefranchisees.

Franchising is appropriate when a firm has a strong or potentiallystrong trademark, a well-designed business method, and a desire togrow.

Example: Franchising works very good for fast-food restaurantsbut would not work for Wal-Mart. Fast-food restaurants(McDonald’s, Burger King) have a limited menu, and policies andprocedures can be written to cover almost any contingency. Wal-Mart stores are much larger, more expensive to build, andmore complex to run. It would be nearly impossible for Wal-Martto find an adequate number of qualified people who would havethe financial capital and expertise to open a Wal-Mart store of their own.

Selecting and developing Effective Franchisees

The franchisor’s ability to select and develop effectivefranchisees strongly influences the degree to which a franchisesystem is successful. The ideal franchisee is someone who hasgood ideas and suggestions but is willing to work within thefranchise system’s rules. Franchisees must be team players.

When the franchisor selects its franchisees he must check forthe following qualities:

the ability to follow instructions the ability to operate with minimal supervision team oriented experience in the industry in which the franchise competes adequate financial resources ability to make suggestions even if they are not adopted

After selecting the franchisees, the franchisor has to develop theirpotential through the following ways:

provide mentoring/training

keep operating manuals up to date

keep product, services, and business up to date

solicit input from franchisees to reinforce their importance in the

larger system

maintain the franchise system’s integrity

Advantages and disadvantages of Franchising as a growth strategy

The advantages of franchising as a means of business expansionare:

Rapid, low-cost market expansion. Because franchisees provide most of the cost of expansion , the franchisor can expand the size of its business fairly rapidly.

Income from franchise fees and royalties.

Franchisee motivation. Because franchisees put their personal capital at risk, they are highly motivated to make their franchise outlets successful.

Access to ideas and suggestions. Franchisees represent a source of intellectual capital and often make suggestions to their franchisors.

Cost savings. Franchisees share many of the franchisor’s expenses, such as cost of regional and national advertising.

Increased buying power. Franchisees provide franchisors increased buying power by enlarging the size of their business systems, allowing them to purchase larger quantities of products and services when buying those items.

Using the franchising as a form of business growth has also itsdisadvantages:

Profit sharing. By selling franchises instead of operating company-owned stores, franchisors share the profits derived from their proprietary products or services with their franchisees.

Loss of control. It is typically more difficult for a franchisor to control its franchisees than it is for a company to control its employees.

Friction with franchisees. Friction can develop over issues such as the payment of fees, hours of operation, surprise inspections.

Managing growth. Franchisors that are in growing industries often grow quickly. Rapid growth can be sometimes difficult to manage. A franchisor provides each of its franchisees a number of services, such as a site selection and employee training. If a franchise system is growing rapidly, the franchisor will have to continually add personnel to its own stuff.

Differences in required business skills. The business skills that made a franchisor successful in his or her original business are typically not the same skills needed to manage a franchise system. (an effective owner/manager of a business is not necessarily an effective manager of a franchise system).

Buying a Franchise

Franchising can be also looked at from the franchisee’s perspective.Purchasing a franchise should be weighted against the alternative ofbuying an existing business or launching an entrepreneurial venturefrom scratch.

Answering the following questions will help determine whetherfranchising is a good fit for people thinking about starting their ownbusiness:

Are you willing to take orders?Example: Fast-food chains are very strict in terms of their restaurants’ appearance and how the units’ food is prepared. Franchising is typically not a good fit for people who like to experiment with their own ideas or are independently minded.

Are you willing to be part of a franchise “system” rather than an independent business person?Example: As a franchisee you may be required to pay into an advertising fund that covers the costs of advertising aimed at regional or national markets rather than the market for your individual outlet.

How will you react if you make a suggestion to your franchisor and your suggestion is rejected?

What are you looking for in a business? How hard do you want to work?

How willing are you to put your money at risk?

The Cost of a Franchise

The initial cost of a business format franchise varies, depending onthe franchise fee, the capital needed to start the business, and thestrength of the franchisor. Some companies like McDonald’s typicallyprovide the land and buildings for each franchisee’s unit. Otherorganizations require their franchisees to purchase the land,buildings, and equipment needed to run their franchise outlet.

Starting a business through franchising involves following costs:

Initial franchise fee, which varies depending on the franchisor’s reputation. (for example Burger King has a initial franchise fee of $ 40,000, CD Warehouse $ 20, 000, WSI Internet $ 34,700, Subway $ 34,700)

Capital requirements. These costs very, depending on the franchisor and includes the cost of buying real estate, the cost of constructing a building, the purchase of initial inventory, and the cost of obtaining a business license.

Continuing royal payment. A franchisee pays a royalty based on a percentage of weekly or monthly gross income. A franchisee may have to pay a monthly royalty even if the business is loosing money. Royalty fees are usually 5% of gross income.

Advertising fees. Franchisees are often required to pay into a national or regional advertising fund, even if the advertisements are directed at goal other than promoting the franchisor’s product or service. Advertising fees are typically less than 3% of gross income.

Other fees, including training additional staff, providing management expertise etc.

Finding a Franchise

There are thousands of franchise opportunities available toprospective franchisees, so that it is important to determine the typeof franchise that is the best fit.

Questions to ask a Franchisor:

What is the background of the company and its performance record?

What is the company’s current financial status? What other franchisees exist in my trade area? If at some point I decide to exit the franchise relationship, how

does the exit process work? Describe how you train and mentor your franchisees.

Questions to ask current Franchisees:

How much does your franchise gross per year? Are the financial projections of revenues, expenses, and profits

that the franchisor provides me accurate in your judgment? Does the franchisor give you enough assistance in operating your

business? How many hour, on average, do you work? How often do you get a vacation? If you had to do it all over again, would you purchase a franchise

in this system? Why or why not?

Buying a franchise has following advantages:

A proven product or service within an established market, which substantially reduces the risk of bankruptcy.

An established trademark or business system. The purchase of a franchise with an established trademark provides franchisees with considerable market power (for example, McDonald’s franchise has a trademark with proven market power).

Franchisor’s training, technical expertise, and managerial experience (for example the training offered by the franchisor takes place at the firms’ headquarters or at the placement of each franchisee)

Potential growth. If a franchisee is successful in its original location, the franchisee is often provided the opportunity to buy additional franchises from the same franchisor. For many franchisees, this prospect offers a powerful incentive to work hard to be as successful as possible.

The disadvantages of buying a Franchise are:

Cost of the franchise. The initial cost of purchasing and setting up and setting up a franchise operation can be quite high (franchising involves costs on short and long term).

Restriction on creativity. Many franchise systems are very rigid and leave little opportunity for individual franchisees to exercise their creativity.

Duration and nature of commitment. For a variety of reasons, many franchise agreements are difficult to exit.

Risk of fraud, misunderstanding, or lack of franchisor commitment.

Problems of termination or transfer. Often, a franchisee cannot terminate his or her franchise agreement without paying the franchisor substantial monetary damages.

Poor performance on the part of other franchisees. If some of the franchisees in a franchise system start performing poorly and make an ineffective impression on the public, that can affect the reputation and eventually the sales of a well-run franchise in the same system.