The primary trade association for franchising issues, the International Franchise Association, defines franchising as a "continuing relationship in which the franchisor provides a licensed privilege to do business, plus assistance in organizing, training, merchandising, and management" in exchange for fees and royalties from the franchisee. In other words, franchising is the process of expanding a business whereby a company (franchisor) grants a license to an independent business owner (franchisee) to sell its products or render its services. A franchise, therefore, is a legal agreement permitting a business to furnish a product, name, trademark, or idea to an independent business owner. Each party of a franchise agreement gives up some legal rights to gain others. The franchisor increases its number of outlets and gains additional income. The franchisee opens an established business with strong potential for success. Franchising offers people a chance to own, manage, and direct their own business without having to take all the associated risks. This aspect has allowed many people to open businesses of their own who might never have done so otherwise.
Franchising plays a significant role in the U.S. economy. Franchise sales accounted for about over 50 percent of all retail sales in the United States in the late 1990s and U.S. franchises generated roughly $1 trillion in sales of goods and services annually in the United States during this period, according to the International Franchise Association (IFA). Approximately 1 out of 12, or 600,000, businesses are franchises, which supply jobs for over 8 million people, and there are about 3,000 franchisors in the United States.
According to the U.S. Small Business Administration, franchising is the fastest-growing kind of small business. Furthermore, each new franchise generates 8-14 new jobs and a new franchise opens an average of every eight minutes per business day. Overall, franchises create over 300,000 new jobs per year.
Franchising has opened the door of opportunity for women, families, and minorities. Women have discovered that operating franchises often allows them to spend more time with their families. Women wholly own about 10 percent and jointly own about 30 percent of U.S. franchise outlets, according to the Small Business Administration. In many cases, families pool their resources and time to operate outlets—and often use the profits to create their own mini-chain of stores. Minorities have benefited, too. They have been able to locate establishments in urban areas which at one time lacked minority ownership. Significantly, some franchisors such as Burger King and the Southland Corporation, owner of the 7-11 convenience stores, provide special financial programs for minority owners. They also work closely with organizations like the National Association for the Advancement of Colored People (NAACP) to recruit more minority owners. In this respect, franchises have been a boon for society.
No matter who owns a franchise outlet, the franchisee and the franchisor share the risks and the responsibilities, although not always equally. Since both parties have a financial investment at stake, the risk can be substantial.
There are four major types of franchises: business format franchises, product franchises, manufacturing franchises, and business opportunity ventures, according to the Franchise Opportunities Handbook. Via business format franchises, the most common type, a company expands by supplying independent business owners with an established business, including its name and trademark. The franchisor company generally assists the independent owners considerably in launching and running their businesses. In return, the business owners pay fees and royalties. The franchisee also often buys supplies from the franchisor. Fast food restaurants are good examples of this type of franchise.
With product franchises, manufactures control how retail stores distribute their products. Through this kind of agreement, manufacturers allow retailers to distribute their products and to use their names and trademarks. To obtain these rights, store owners must pay fees or buy a minimum amount of products. Tire stores, for example, operate under this kind of franchise agreement.
Through manufacturing franchises, a franchisor grants a manufacturer the right to produce and sell goods using its name and trademark. This type of franchise is common among food and beverage companies. For example, soft drink bottlers often obtain franchise rights from soft drink companies to produce, bottle, and distribute soft drinks. The major soft drink companies also sell the supplies to the regional manufacturing franchises.
Finally, business opportunity ventures involve an independent business owner buying and distributing the products from one company. The company supplies the business owner with clients or accounts and therefore the business owner pays the company a fee in return. Business owners obtain vending machine routes and distributorships, for example, through this type of franchise arrangement.
Franchise operations, as we know them, are not very old. The boom in franchising did not take place until after World War II. Nevertheless, the rudiments of modem franchising date back to the Middle Ages when the Catholic Church made franchise-like agreements with tax collectors, who retained a percentage of the money they collected and turned the rest over to the church. The practice ended around 1562 but spread to other endeavors. For example, in 17th century England franchisees were granted the right to sponsor markets and fairs or operate ferries. There was little growth in franchising, though, until the mid19th century, when it appeared in the United States for the first time.
One of the first successful American franchising operations was started by an enterprising druggist named John S. Pemberton. In 1886, he concocted a beverage comprising sugar, molasses, spices, and cocaine (which is no longer an ingredient). Pemberton licensed selected people to bottle and sell the drink, which is now known as Coca-Cola. His was one of the earliest—and most successful—franchising operations in the United States.
The Singer Company implemented a franchising plan in the 1850s to distribute its sewing machines. The operation failed, though, because the company did not earn much money even though the machines sold well. The dealers, who had exclusive rights to their territories, absorbed most of the profits because of deep discounts. Some failed to push Singer products, so competitors were able to outsell the company. Under the existing contract, Singer could neither withdraw rights granted to franchisees nor send in its own salaried representatives. So, the company started repurchasing the rights it had sold. The experiment proved to be a failure. That may have been one of the first times a franchisor failed, but it was by no means the last. (Even Colonel Sanders did not initially succeed in his Kentucky Fried Chicken franchising efforts.) Fortunately, the Singer venture did not put an end to franchising.
Other companies tried franchising in one form or another after the Singer experience. For example, several decades later, General Motors Corporation established a somewhat successful franchising operation in order to raise capital. Perhaps the father of modern franchising, though, is David Liggett. In 1902, Liggett invited a group of druggists to join a "drug cooperative." As he explained to them, they could increase profits by paying less for their purchases, especially if they set up their own manufacturing company. His idea was to market private label products. About 40 druggists pooled $4,000 of their own money and adopted the name "Rexall." Sales soared, and "Rexall" became a franchisor. The chain's success set a pattern for other franchisors to follow.
Although many business owners did affiliate with cooperative ventures of one type or another, there was little growth in franchising until the early 20th century, and what franchising there was did not take the same form as it does today. As the United States shifted from an agricultural to an industrial economy, manufacturers licensed individuals to sell automobiles, trucks, gasoline, beverages, and a variety of other products. The franchisees did little more than sell the products, though. The sharing of responsibility associated with contemporary franchising arrangement did not exist to any great extent. Consequently, franchising was not a growth industry in the United States.
It was not until the 1960s and 1970s that people began to take a close look at the attractiveness of franchising. The concept intrigued people with entrepreneurial spirit. However, there were serious pitfalls for investors, which almost ended the practice before it became truly popular.
Since there was no regulation of franchises to speak of, a number of hucksters involved themselves in the field. Many of them initiated get-rich-quick schemes which cost investors countless dollars. As a result, franchising became a bad word to some people. In 1970 alone, over 100 franchisors went out of business. Concomitantly, thousands of franchisees lost their businesses and their money. However, public and private sector watchdogs helped to restore franchising's name and launch its way to a prominent place in the American economy.
Some franchisors formed the IFA in 1960 to police the franchising industry and eliminate the con artists. Individual states began passing laws to regulate franchise activities. By 1979, the Federal Trade Commission (FTC) initiated a franchise trade rule requiring disclosure of pertinent information to prospective franchise owners. Franchising became a respectable word again, and the practice flourished, aided by the efforts of early franchisors like Ray Kroc and Dave Thomas.
Ray Kroc, the founder of the highly successful McDonald's hamburger chain and one of the paradigmatic franchisors, called franchising the "updated version of the American Dream." He established his franchising operation in 1955, after obtaining exclusive franchise rights from Dick and Mac McDonald, who started the chain. Kroc went on to launched a massive franchising campaign and 15 years later the chain included 1,500 outlets.
Wendy's founder Dave Thomas believed that McDonald's hamburgers were skimpy and decided he could improve the basic hamburger. In 1968, Thomas received $1.7 million as his share of the sale of four chicken stores by Hobby House Restaurants, for whom he was a manager. He invested most of it into a new chain of hamburger stands. By the end of 1972, he had nine outlets with annual sales of $1.8 million. By June 1975, he opened the 100th Wendy's restaurant. Less than two years later, the number jumped to 1,000. In 1978 alone he opened 500 outlets. By 1999 there were well over 5,000 outlets worldwide. Thomas proved that there was plenty of room in the franchising world.
Franchising grew slowly during the 1940s and 1950s. The majority of the outlets were placed in the suburbs or along highways as people moved out of the cities and into rural areas. The now familiar "strips" lined with franchises started changing Americans' eating and shopping habits. Spurred by the success of the early franchisors, others entered the competition for the shoppers' dollars.
Franchise chains in virtually every business category started operations. Their stores were not always well received, especially in urban areas. Individuals and community groups protested the arrival of franchises, but their efforts were generally unsuccessful. Even today, many community groups and individuals protest the arrival of well-known franchise outlets—sometimes successfully.
Nonetheless, franchises are active and successful in a wide range of categories. They exist in lawn, garden, and agricultural supplies and services, maid and personal services, security services, tools and hardware, weight control, and many types of food products, including baked goods, donuts and pastry, popcorn, ice cream, yogurt, and fast foods. As the economy and consumers' preferences change, technology advances, and new products are introduced, existing franchises will likely continue to grow, change, and innovate in response.
More than 95 percent of the franchise chains in existence today started operations in the last four decades. Most of them formed between 1965 and 1985. Their growth was phenomenal. For example, Century 21, the real estate operation, began in 1972 and grew to include 7,400 outlets by 1980. It took McDonald's only 25 years to establish its 6,200th store and the chain boasted of 25,000 outlets by 1999. There is hardly a community anywhere that does not have at least one franchise operation.
Franchising offers a number of advantages not only to franchisors but also to franchisees—which helps explain why franchising has been so successful. Franchisors benefit from these agreements because they allow companies to expand much more quickly than they could otherwise. A lack of funds and workers can cause a company to grow slowly. However, through franchising a company invests very little capital or labor, because the franchisee supplies both.
A company also can ensure it has competent and highly motivated owner/managers at each outlet through franchising. Since the owners are largely responsible for the success of their outlets, they will put a strong, constant effort to make sure their businesses run smoothly and prosper. In addition, companies are able to provide franchising rights to only qualified people. Moreover, franchisors can raise money without selling shares of their companies through franchising.
Likewise, franchisees reap a variety of benefits from franchising. As noted previously, the franchisee faces much less risk through franchising a company, than through starting a business from scratch, according to many studies. The lower risk is related to other advantages of franchising that stem from being affiliated with a proven company. The franchisor generally has had some experience in the field of business and has national or regional name recognition. Franchisors also provide franchisees with a proven and efficient method of operation through their years in the business, with management assistance and training, and with marketing assistance and advantages. Franchisors usually conduct national or regional marketing campaigns developed by professional advertising agencies and they can help franchisees run local ad campaigns, though franchisees generally must contribute 1-5 percent of their gross profit to advertising funds. All of these aspects of franchise agreements can significantly increase the chances of an outlet's success.
Furthermore, franchisors sometimes help franchisees obtain financing for their outlets as well as prepare business plans and strategies. What's more, if a prospective franchisee needs to borrow money to help with business-related costs, financial institutions may be more willing to lend if a well-known franchisor is backing the applicant—especially if the franchisor is well established, rather than based on a new concept.
In return for the benefits franchisees receive, they must pay fees and royalties to the franchisors. The franchise fee may range anywhere from $5,000 to over $1 million and hence can be a major expenditure. Besides the franchise fee, franchisees often must pay royalties periodically during the life of the franchise agreement. Royalty payments are either a percentage of an outlet's gross income—usually under 10 percent of an outlet's gross income—or a fixed fee.
Franchise costs vary to some extent because of costs associated with different kinds of businesses and with different locations. For example, a person who wishes to open a franchised employment service operation, such as Talent Force, based in Atlanta, Georgia, can get away with as little as a $7,500 fee, plus one year's starting capital investment of $50,000 to $110,000. On the other hand, start-up costs for a company like J.O.B.S., based in Clearwater, Florida, can be as little as $45,000, including a $30,000 franchise fee.
The costs of these businesses pale in comparison to food franchises. For example, a Popeye's Famous Fried Chicken and Biscuits, Inc. outlet will cost the franchisee a minimum of $200,000—with no financing assistance available. A franchise at Perkins Restaurants, Operating Co., L.P. costs between $959,000 and $1,500,000. An individual's initial cash investment would be about $150,000. Initial costs such as these can present serious obstacles to some people trying to purchase a franchise.
There are several sources of financial backing for potential franchisees. Since franchisors do not always offer financial assistance, people rely primarily on their own funds, family support, and the traditional sources such as financial institutions, banks, and private investors. The more money a franchise costs, the harder it is for potential operators to raise the necessary funds. However, the search does highlight another positive aspect of franchising: it involves a cadre of specialists (e.g., bankers, lawyers, and accountants), who earn all or part of their salaries from their involvement with franchise operations.
For people with limited cash or access to it, franchising may not be the easiest career path for prospective business operators, then. However, for many people who have made the investment, franchising has paid off substantially from both the company and outlet owner standpoint, as history shows.
In addition to the payment of fees and royalties, franchisees give up some control over their own businesses, as well as lose their own identity. Most patrons do not know who owns their local McDonald's, Burger King, or MAACO auto body shop. So, many franchise outlet owners are relegated to anonymity—which can be a drawback.
Franchisees are often subjected to tight supervision by the franchisor. They cannot pick out their own business name, buy products and services from whom they choose, or select the location at which they will do business. In addition, franchisees usually must follow franchisor guidelines closely and not deviate from their approach to doing business. Some franchisors control their outlets so tightly they even tell business operators when to empty their trash cans, how to dress their employees, where to dispose of food, what color to paint their fences, etc. As a result, some franchisees are largely dependent on their franchisors. Moreover, franchisees usually cannot implement changes without franchisor approval. Hence, if a coffee house franchise that sells only beverages and pastries notices customer demand for sandwiches, it cannot offer them without the consent of the franchisor.
Another problem with franchising is that franchisees may fall victim to the company's problems. While a particular business owner may be doing well, the chain itself may encounter financial problems due to mismanagement, a failing economy, or any other reason which impacts operations. This can result in increased fees or royalties or a switch in suppliers which can lead to reduced quality of goods and services. In extreme cases, the franchisor can go out of business completely. Franchisees also enter into 10-15 year agreements with franchisors and in most cases can get out of the agreement only by selling the business.
A final problem for potential franchisees is how to select the right company with which to affiliate. As the number of franchisors increases, the method of choosing which franchise is right for a particular individual becomes more complex. Obviously, if the would-be franchisee has certain skills or interests, these are likely to guide this choice. Even if a potential franchisee knows which type of business to enter, the selection of a franchisor may pose a challenge.
The person who wants to open a fast-food franchise has to decide what type of food it will serve: pizza, hamburgers, yogurt, full meals, etc. Other matters to consider include fees required, royalties, governmental regulations, and whether the particular business is part of a growing industry. Such choices are closely tied in to public policy and governmental regulation today.
Franchising can be broken down roughly into two broad categories: retail and service. Many of the businesses in both categories are subject to extensive government regulations today, which can increase both the franchisors' and franchisees' responsibilities and financial investments. For example, franchisors in personal services, such as water conditioning and pest control experts, have to be aware of Environmental Protection Agency (EPA) regulations governing the use of pesticides and toxic products and the added costs associated with them. The same holds true for automotive retail franchises. Questions must be answered regarding where and when used batteries, replaced oil, rusted mufflers, etc., can be disposed.
These are generally matters to be resolved by the franchisor, but franchisees must be aware of current and impending local and state laws before opening their operations.
Governmental involvement in franchising is not new. For instance, California enacted the first pre-sale franchise disclosure law in 1970. The law addressed two broad areas: full and accurate pre-sale disclosure to prospective franchisees of information about the franchisor and the contract, and the fairness of the contract itself. Several other states passed similar laws shortly afterward. The first federal law was passed in 1979 under the aegis of the Federal Trade Commission (FTC).
Since many companies operated in several states, it was inevitable that the federal government would involve itself in franchise regulation. That became the FTC's role. The agency requires every franchisor to provide each potential franchisee with a detailed disclosure document which protects everyone involved in a possible agreement and this requirement is known as the Franchise Trade Rule. The required document contains 20 different categories of information about the franchise and must be given to prospective franchisees at least ten days prior to signing a franchise contract. Included is information about required fees, basic investment, bankruptcy, and the franchisor's litigation history. There are also inclusions concerning how long the franchise will be in effect, the franchisor's financial statement, and earnings claims (if they are available). The financial disclosure laws had a major impact on franchising.
The laws made it clear that franchisors were in business not only to make a profit, but to supply their clients with services and products that made their ownership easier. The laws corrected any imbalance in franchise agreements that were tipped in the franchisors' favor. Under the laws, franchisors had to reveal all the information potential franchisees needed to make a decision on whether or not to open an outlet. The companies had to reveal how long they had been in business, the number of unit failures, lawsuits in which they were involved, either currently or in the past, and supporting information to back up any claims they made about their operations. This protection stands potential franchisees in good stead and reduces the potential for fraud on the part of franchisors.
It is imperative to note that the financial disclosure laws do not protect potential franchisees completely. For instance, the FTC does not certify any information provided; instead, the individual must verify information provided by franchisors. Since Congress authorized the FTC to regulate franchising, franchisees can submit complaints to the agency. Although the FTC has the ultimate authority to regulate franchising, the states may impose their own requirements as long as they are stricter than the federal requirements. Consequently, some states use the Uniform Franchise Offering Circular (UFOC) for franchisor information disclosure, which has a few more requirements than the FTC's disclosure policy.
The key is that laws exist to protect people interested in franchises, which is a far cry from the early days of franchising when caveat emptor—let the buyer beware—was the watch word for franchisees. Because there was a great deal of risk involved in dealing with franchisors in those days, there was considerable controversy over the benefits of franchising. Much of that controversy remains, although it has changed in focus somewhat.
As successful as franchising has been in the United States, there are critics who suggest that it has been detrimental to the country's economy. One argument is that franchise employees receive low wages. This is partly because the majority of the workers are part-time employees who don't receive any benefits. Because of the low wages and lack of benefits, franchise owners have a hard time attracting and retaining quality workers. One of the solutions to this problem would be union organization. However, labor unions in general have lost their power in recent years, so they are more reluctant than ever to organize franchise workers in deference to focusing on unionizing larger and more stable employers. Without union representation, workers may not organize and wages may remain low.
A second criticism is that chains detract from the aesthetics of a community. They may locate in residential neighborhoods and erect huge unsightly signs. Some communities have eliminated these problems through strict zoning laws and other legislation. Often, these laws are "grandfathered," which means existing businesses are unaffected. So, if urban blight is to be eliminated, it will not happen for years to come.
Opponents of franchises also cite the distribution of franchise revenues. Much of the money franchisees take in goes to the franchisor. Thus, it is removed from the local economy. A locally owned firm's revenues would stay in the community. But, since chains drive out local owners, much of a community's revenues are lost.
Certainly, there are arguments that support the existence of franchises, too. Regardless of the controversy, franchising has had a major impact on the American economy, and is impacting foreign countries as well.
The growth of franchising in the United States has been phenomenal. Not only has it encompassed virtually every aspect of American business, but it has spread abroad. Canada in particular has proven lucrative for American franchisors. In fact, it has the second highest number of franchise outlets in the world. That is due primarily to the common language and similar culture the two countries share. Canada is by no means the only target of U.S. franchisors, though.
American companies are expanding their operations into countries as diverse as the Dominican Republic, Saudi Arabia, and Japan. Ironically, Japan, even thought it is culturally dissimilar from the United States, represents a prolific market for American franchisors.
Currently, franchises account for only about 4 percent of all retail sales in Japan. However, some American franchisors such as 7-Eleven, Inc. have made large inroads. In fact, a Japanese company, Ito-Yokado Ltd., controls U.S.-based 7-Eleven, Inc. (formerly Southland Corp.), which is the franchisor and owner of the 7-Eleven trademark worldwide. McDonald's and Toys 'R' Us run a joint venture in Japan. Certainly, not every American franchisor can function well there. For example, Gymboree, which franchises developmental programs for preschoolers and their parents, had to turn down Japanese investors due to a lack of space in which to erect equipment.
Another problem American franchisors faced in Japan was the working conditions. The concept of part-time work puzzled the Japanese. They are accustomed to lifelong, full-time employment for which workers receive adequate wages. So, when Kentucky Fried Chicken entered the Japanese market, it had to change its wage policy and upgrade working conditions. Otherwise, the company would not have survived. Other companies have faced similar problems in Japan and elsewhere, but they have overcome them, survived, and grown.
Occasional setbacks aside, American franchisors are moving ahead aggressively to gain a toehold in other countries. Century 21, for example, has established franchises in Canada, France, Japan, and the United Kingdom. Jani-King International, Inc., a commercial janitorial company, has operations in Canada, Japan, Australia, and the United Kingdom. Hardee's Food Systems has outlets in Costa Rica, the Netherlands Antilles, Singapore, Korea, Japan, Thailand, and Hong Kong. There is apparently no geographical limit to where franchisors can—or will—go.
Based on the success companies have enjoyed since the franchising boom began in the 1950s, the future of franchising is positive. The U.S. Department of Commerce predicts that slower population growth, population shifts to new metropolitan areas, and the introduction of new technology will create new opportunities for franchises. Mergers and acquisitions will increase as larger franchisors take over smaller ones. Schools and universities are adding franchising studies to their business curricula. These factors, combined with the low rate of franchise failure, stability in the industry, and a considerable return on everybody's investment, have made franchising a major force in the American economy to this point. Some of the emerging franchise businesses expected to drive the growth of franchising tend to offer customers added convenience such as to-the-door services offering everything from dry cleaning and pet care to window coverings and furniture repair, according to Nation's Business. In addition, Nation's Business reported that other franchise trends of the future will include education and training businesses, second-hand merchandise stores, office support services, and health service providers.
[ Arthur G. Sharp ]
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