What Is a Franchise? And How Do They Work?

Have you dreamed of leaving the 9-5 and becoming your own boss? You’ve likely heard the term franchise thrown around quite a bit in the business world, but what exactly is a franchise, and how do they work?

In this article, I will discuss franchises in-depth, breaking down what they are, how they work, and some of the key benefits and drawbacks of purchasing a franchise.

Key Takeaways

• A franchise is a business model where an individual (franchisee) operates under an established brand’s name and system while following specific guidelines.
• The franchisor provides branding, operational procedures, training, and ongoing support to maintain consistency across locations.
• Franchisees typically pay an initial fee and ongoing royalties, which may be a percentage of revenue or a fixed amount.
• Franchising enables brands to expand quickly while allowing entrepreneurs to run businesses with an established model and brand recognition.
• Potential franchisees should thoroughly research the franchisor’s terms, support systems, and financial commitments before signing an agreement.

What Is a Franchise? The Basics

In short, a “franchise” is a business model in which an owner (franchisor) sells a license to an individual (franchisee) to operate the business. When you buy a franchise, you’ll typically earn the right to run the business in a specific location. Franchisees pay a franchise fee to gain the rights to use the business name, sell trademarked products, and gain access to internal information and knowledge. Franchises are one of the most low-risk ways to enter the business world. When you operate a business under a franchise agreement, you can potentially make fast and significant returns by capitalizing on an established brand name with a loyal customer base.

McDonald’s is a prime example. Around 93% of all McDonald’s locations are franchises, meaning that the corporation has sold franchise agreements to thousands of different franchisees.

I’m often asked why more people don’t invest in franchises given that, on the surface, it might seem like an easy way to make money – almost like a get-rich-quick scheme. Naturally, that’s not quite how it works, but a franchise can be fantastic and a safe long-term investment, provided you do your homework.

The exact legal definition of a franchise licensing agreement can slightly differ by state in the US, but the Federal Trade Commission generally views a business arrangement to be a franchise if:

• The franchisee obtains a license from the franchisor to use its trademark, business model, and services.
• The franchisor receives a fee from the franchisee.
• The franchisor provides support to and implements guidelines for the franchisee.

Role of the Franchisor

The franchisor is the parent company of the overall brand, including all trademarks. In a franchise agreement, the franchisor is responsible for providing the business model, ensuring brand consistency, marketing and advertising, training, and support. They also provide the franchisee with access to supplies and resources.

Role of the Franchisee

The franchisee is an individual or group that buys the franchise license to operate a business under the franchisor’s brand. In most cases, the franchisee is responsible for investing in and managing the business, paying royalties and fees, complying with agreed standards and guidelines, and potentially marketing at the local level.

Typically, franchisees pay a royalty fee of between 4% and 12% of their gross sales, depending on factors like industry, size of the franchisor, and market potential.

Different Types of Franchises

Let’s look at a couple of different types of franchise licenses and how they differ.

Business Format Franchising

While there are a few types of franchising relationships, the one that applies to most entrepreneurs is Business Format Franchising. This is the standard franchise model that major companies like McDonald’s, Dunkin Donuts, and Subway use. This type of franchise is all about uniformity. When you purchase the franchise, you buy the rights to run the business, but you won’t get much flexibility when it comes to operations or products.

Product and Trademark Franchises

This type of franchise is less common. It allows the franchisee to sell a franchisor’s products under their trademark, but it doesn’t provide a complete business model or set operational guidelines like a business format franchise. Instead, franchisees in a Product and Trademark Franchise are typically manufacturers or distributors who gain the right to sell branded products—examples include car dealerships or gas stations that use the brand name and products but operate more independently. Unlike business format franchising, which requires franchisees to follow a specific system, a product and trademark franchise offers more flexibility in business operations.

How Are Franchises Different From Other Business Models?

Still a bit confused about how franchises differ from other types of businesses? I don’t blame you; the concept can definitely be difficult to grasp. Let’s take a closer look at how franchises differ from other business models.

Franchise vs. Chain

A chain is a business with multiple locations. The parent company generally owns, operates, and manages each location. Famous chains include IKEA, the Apple Store, Walmart, and H&M.

Franchise vs. Licensing Agreement

A franchise uses the brand of a parent company as its entire business model, whereas a licensing agreement grants you permission to use certain intellectual property for specific purposes. For example, clothing companies may have licensing agreements that allow them to make a line of Disney-branded clothing.

Franchise vs. Startup

A franchise takes advantage of an established business model, while a startup refers to an independent business started from the ground up. Startups are much more risky as they face the challenge of building brand recognition and developing their own business strategies.

Read more in our comparisons of franchises vs. startups and independent businesses vs. franchises.

Benefits of Starting a Franchise

Starting a franchise can be beneficial for all sorts of reasons. For starters, you’ll likely be able to generate revenue almost immediately, but there are many more behind-the-scenes advantages to this type of business model.

Capitalize on an Established Brand Name

As consumers, we often choose to shop at stores with the most recognizable brands, particularly if we believe they have a good reputation and consistently meet our needs. In fact, we pay very little regard to who actually owns any business in most cases. Would you buy a meal at McDonald’s based on the local franchise owner’s reputation or the brand’s reputation?

By starting a franchise, you can gain immediate access to an already loyal customer base. If you maintain the high standards your customers expect, a franchise can potentially provide you with immediate returns as an investor.

Access to Industry-Leading Business Support

Many franchisors have invested heavily in support systems and tools to help their franchisees stay at the top of their game. You’ll have the freedom to manage a business independently while having access to well-established distribution networks, quality products and services, business plans, training support, and development support. That’s all on top of being able to use a leading brand’s trademark and benefit from all your franchisor’s mass marketing and advertising campaigns.

Skip Many Hurdles Typically Associated With Entrepreneurship

For numerous reasons, setting up a franchise can be more straightforward than establishing a business from the ground up. You’ll generally be able to get a team of employees up to speed with effective training and support from your franchisor. In some cases, you also won’t even need to spend a cent on marketing or advertising. 

You’ll still need to conduct local market research to operate a franchise successfully, but you can start selling market-tested services and products without building brand recognition.

High Chance of Success

The failure rate for franchises is far lower than for startups with no brand recognition. While data varies from different sources, some studies show that more than 8 out of 10 franchisees are still in business after 10 years. On the other hand, the failure rate for startups is much higher, with only 10% being successful in the long run.

Long-Term Competitive Edge

When you run a franchise, you can financially benefit from negotiated supplier agreements by your franchisor and bulk purchasing. Franchises don’t just start off with a better chance for success than startups with no brand recognition – they retain their competitive edge over the long term.

Risks and Drawbacks of Franchises

Franchises are a great way to dip your toes into entrepreneurship without taking on the same risks associated with startups. That said, the business model is not for everyone. Here are some downsides of franchising.

Significant Start-up Fees

With careful forward planning, starting a franchise can generate a lot of revenue almost immediately. But starting a franchise in the first place is no cheap endeavor. For example, it costs between – on average – $1.47 million and $2.64 million to start a McDonald’s franchise, and that’s assuming you have at least $500,000 in liquid capital.

Royalty Fees Can Be High

When you purchase a franchise, you’ll have to pay an ongoing royalty fee to the franchisor. Royalty fees are typically based on either revenue or sales. That means that you might have to give a significant portion of your income away in royalty fees. The amount can range from as low as 4% to as high as 12.5%, which is a relatively high ongoing expense. Of course, this royalty fee is more than worth paying if you carefully research areas with a high demand for your franchisor’s products or services.

Starting a Franchise Requires a Lot of Research

Brand recognition and free advertising might help, but that doesn’t guarantee a worthwhile profit automatically. Given the significant initial start-up expense, your franchise will likely take at least a year, maybe even a few, to become profitable.

Still, as long as you do your research, you have a high chance of long-term success with a franchise.

Expectations Are High

Running a franchise isn’t as straightforward as “everything’s already done for you.” Franchisors expect their franchisees to meet extremely high standards. After all, the franchisor’s very survival depends on its franchisees. You will have to maintain a consistently high level of professionalism to comply with rigorous tests and checks. These standards and checks are in place to ensure you maintain the standards your customers demand.

Your Franchisor’s Reputation Is Crucial to Your Survival

When you start your own company, you are in complete control of your brand reputation, but with franchises, your reputation is directly linked to that of the franchisor. This can be a blessing or a curse, depending on the state of the company’s reputation. Do your due diligence, check the brand’s reputation, and read reviews to further understand the experiences of other franchisees.

Get Started On Your Franchise Journey With Franzy

Franchises are a rewarding business model that can make entering the business world much easier. That said, it is beyond important to properly research franchises before making a purchase. In the past, researching franchises was a challenge, but with Franzy, you can easily do your due diligence on a single platform. Franzy is the platform I wish I had access to when I bought my first franchise. It is the ultimate platform for gaining insights into different franchises and making data-driven decisions.