Franchising

Abstract

Franchising is a business model with a track record that spans over five hundred years. In its contemporary form, dozens of industries around the world have companies that use the franchise model. The many benefits of franchising—diminished risk, strong franchisor company support, and affordability—make it a popular option for many entrepreneurs, both new and experienced. Critics, however, claim that the franchising model hinders innovation and autonomy, and has higher rates of labor standards violations.

Overview

The term "franchise" originated from the French "franche," which referred to the privilege of being allowed to invest. Although scholars believe the earliest form of franchise to have originated in ancient China, in its modern form it began in the Middle Ages, as a privilege granted by rulers to merchants and purveyors. A franchise also authorized individuals to build roads, collect taxes, organize market fairs, and other profitable endeavors. The individual granted the franchise, or the franchisee, was awarded monopoly rights for a specific business and period of time, usually in exchange for a payment or fee. In essence, the franchise fee was a "tax" paid for the monopoly over a certain good and its endorsement by the ruler. Such businesses often had to give the monarch a portion of their profits, hence the term "royalty." Variations on these early systems survive in modern franchises (Dant & Grunhagen, 2014). With the rapid expansion of globalization and telecommunication technologies, contemporary franchise systems are increasingly varied and complex.

Franchising in its current inception refers to a legal contract that cements a business agreement between a grantor firm (franchisor) and a grantee (franchisee), in which the franchisee pays the franchisor for the rights to sell the product or service under the franchisor’s brand or trademark. The rights are usually limited to a specific geographic territory and time frame. There are many different types of franchise but most identify closely with an originating business or manufacturer. Some of these were founded between the 1880s and 1920s and have continued into the twenty-first century, such as General Motors dealerships and Hertz car rentals.

The boom in fast food franchises began in the mid-1950s, with the launch of Burger King, followed shortly after by McDonald’s, which opened in 1955. These served as the model for the homogenization and standardization typical of modern franchises. The model proved so efficient, it soon spread across industries as diverse as convenience stores, gas stations, childcare services, beauty salons, real estate, accounting services, and many other types of business (Dant & Grunhagen, 2014).

The franchise system became popular early on because it offered a business model in which both parties enjoyed higher levels of certainty than were the norm and both stood to benefit. Franchisees knew they could count on known quantities and franchisors could count on a guaranteed income flow. In most franchise agreements, both sides must contribute to the success of the franchise. Franchisees must prove successful at selling and representing the product, and the franchisor must provide a quality product and knowhow.

Franchises are very popular business models because they offer the opportunity to own a business representing a known product or service without the effort, expense, and uncertainty of starting a business from scratch. Franchisors provide logistical support, policies, technical information, and guidance, but selling the product or providing the service is up to the franchisee. In short, it may be a very rewarding arrangement for both parties if all goes well (Laughlin, 2015).

By 2015, approximately 3,700 franchises existed in the United States, representing about 20 industries and 70 categories (Laughlin, 2015). Franchises, then, run the gamut, and while some are modestly affordable, others run into the millions. Franchisees usually acquire their franchise by paying an entry fee and then royalties based on their revenue or gross income. Although a franchise agreement can be a win-win situation for the companies involved, they may often share different goals. For example, franchisors profit from the establishments they own as well as from those owned by their franchisees. Franchisees, on the other hand, need only worry about maximizing the profits of the subset of establishments they own. This often implies two different sets of incentives, priorities, risks, expectations, and costs (Ji & Weil, 2015).

The most common types of franchise businesses are in the restaurant industry. Studies show that in the United States, the eating and drinking industries account for over 20 percent of franchises. A significant portion of this segment is represented by Top 20 restaurants, which account for about 68 percent of annual sales and 48 percent of employment in the restaurant industry (Ji & Weil, 2015). Other important examples of American franchising businesses are automobile dealerships, gasoline stations, and bottled soft drinks (Dant & Grunhagen, 2014).

Further Insights

Many different types of franchise exist, such as turnkey franchise, retail franchise, distribution franchise, trademark franchise, banking franchise, cooperative franchise, and product manufacturing franchise. Each may present some variations according to geographic, economic, or social criteria. Franchises are usually temporal agreements limited to a specific territory or geographic area.

Because there are many variables involved in a franchise’s success, experts counsel that both sides do their respective due diligence in order to ensure that they are a good fit. Many successful franchisees find a niche business or one that is recession proof. Another important factor is the size of the territory that a franchisee is allocated as well as the demography and competition. In short, it requires a great deal of research and legwork.

Unsuccessful franchisees often acquire a business model that is not a good fit for his or her skills, personality and level of motivation. Therefore, critical thinking and self-evaluation are important skills. Franchisees with little capital may be attracted to an inexpensive franchise, yet not take into account that he or she must often not only sell product but also network and manage teams of people (Laughlin, 2015).

On the other hand, franchisees may not need to hire marketing, branding, quality control, or IT personnel, because the franchisor often provides those services in its package deal. In other words, they offer the expertise that a franchisee may lack.

A good franchisor can appraise a franchisee’s performance and offer advice and guidance. Having to calculate these without access to the larger picture can be burdensome, but with modern technology, franchisors can increasingly help their franchisees connect to software and telecommunications that save much time and money (Laughlin, 2015). Despite these advantages, experts warn that modern franchising contracts have changed since the 1990s, when they experienced a surge. Modern franchising contracts are often extremely long and complex documents and require many different fees. Large franchisors may be inflexible and very reliant on codes and specifications that control every aspect of the business performance and relationship. More often than not, they have become non-negotiable deals, and renewals may depend upon changing business procedures, investing in new branding, or other potentially onerous conditions. This occurs as businesses are faced with the need to ensure homogeneity and standards across national and even international territories. Moreover, franchisors may refuse to offer territorial exclusivity or any individualized provisions. Experts believe that the growing popularity of franchises and the trend towards exponential growth among businesses have created a power imbalance in favor of franchisors, a situation that will probably continue unabated (Dant & Grunhagen, 2014).

However, other experts argue that global developments may ameliorate the one-sidedness of franchising agreements. The twenty-first century experienced a growing tendency towards multi-unit franchisees, that is, those who acquire and operate multiple franchises establishments, nationally and internationally. These franchise aggregates gain power within the network hierarchy. This development has been accompanied by the rapid worldwide expansion of franchising. Experts believe that an explosive expansion of U.S. businesses toward foreign markets is underway, a phenomenon that is replicated across countries and enterprises around the world. Advanced countries such as the United States used to franchise close to its borders or in cultures with which they shared some commonalities, such as the same language.

With the emergence of rapidly industrializing economies such as Brazil, Russia, India, and China—sometime called the BRIC countries—U.S. companies have expanded their franchising efforts across very different cultures. Advanced nations increasingly offer master international franchising agreements in countries across the globe. International master franchising is a contract between a franchisor and an international franchisee, which gives the franchisee a wider span of control in a specific country and for a specified period of time. In fact, by the beginning of the twenty-first century, reports showed that close to 90 percent of quick service franchisors and 70 percent of restaurant franchisors in foreign markets acquired international master franchises. These developments have given foreign franchisees unprecedented power in their relationship with franchisors; the latter, unfamiliar in foreign markets, need to rely on and trust their franchisees abroad (Dant & Grunhagen, 2014).

Multi-unit franchising, then, is an important trend at the national and international level. For example, the average McDonald’s franchisee owns about three restaurants. Another franchisee chain, the Flynn restaurant group, own more than five hundred restaurants across the United States (Lafontaine, 2014).

Franchising has long been considered by many experts as an important system of economic development. When a country shows economic growth, it is associated with business opportunities. First, it decreases the entrepreneurial risk that usually accompanies internationalization efforts by large companies, because it uses management and operational processes that have been proven successful. Nevertheless, risk is never reduced absolutely, and social phenomena such as cultural and political factors may affect franchising performance. For example, individualistic cultures seem to prefer holding more control over their businesses than that which franchising often allows. Therefore, there are higher rates of franchising in countries with higher levels of cultural collectivism (Baena & Cervino, 2014).

Moreover, businesses prefer to invest in cultures nearby or that they are familiar with; therefore, the United States is the largest franchise operator in Latin America, with Spain running second. Since the late 1900s, many franchises have opened in Latin American countries such as Argentina, Chile, and Mexico. Studies suggest that the successful expansion of franchising across Latin America correlates with its cultures, which are traditionally low in individualism and prone to avoid uncertainty. In consequence, many Latin American entrepreneurs prefer to open businesses that minimize risk and provide the security of known factors, rather than starting a business from scratch or engaging in much innovation (Baena & Cervino, 2014).

According to an Iberoamerican Federation of Franchising Report in 2012, franchising in Latin America is growing exponentially, not only by way of business from advanced nations penetrating its markets, but also from some Latin American nations to others (Baena & Cervino, 2014). In fact, several Latin American franchises have begun to penetrate the North American markets and those of other nations abroad, such as the Guatemalan fried chicken brand Pollo Campero, which now has many franchises across the United States, Latin America, and China.

Beyond Latin America, franchising is proliferating in other emerging economies. Besides cultural elements mentioned above, experts also point to economic and financial factors. For example, the risks involved in new projects by untried entrepreneurs make it very difficult to find access to capital. In other words, few investors want to risk their capital in developing nation entrepreneurship and innovation, finding it too risky. Lack of funds prevents entrepreneurs in developing nations not only from opening new businesses from scratch, but also from networking in the national and international markets. Because they lack experience, they are not attractive to investors. These are common scenarios that make franchising a very attractive option. Franchises are often affordable for many, depending upon industry and brand, and offer growth opportunities for entrepreneurs without ample financial capital and field experience, but enough motivation and discipline to succeed (Lewandoska, 2014).

Viewpoints

Despite the advantages and popularity of franchising, the proliferation of the business model and the relatively low levels of oversight have been cause of some concern among some scholars, activists, and public officials. Critics argue, for example, that franchising is ubiquitous in the foods and beverages industry, an area that is already rife with labor violations related to minimum wage and work hours regulations. There are many complaints by workers who claim they have been pressured to do unpaid work before clocking in and after clocking out of their work shifts, as well as other abuses common to low-wage industries. In fact, government and academic studies find that franchise businesses are often guilty of noncompliance with labor standards and regulations (Ji & Weil, 2015).

Experts have examined industry practices to determine the reasons for the increase in labor standards violations overall and for franchise businesses’ decisions to comply or not with labor standards. Results suggest that the business model or organization is often related to noncompliance precisely because of the prevalence of low-wage industries in franchising, such as restaurants and hotels. Large franchisors benefit from the incoming capital from franchisees; however, they are also concerned with maintaining and enhancing the reputation of their company or brand.

Franchisees also operate their own establishments, for which they usually operate directly through managers and staff. Franchisees, however, tend to own a small number of establishments and have different concerns and costs than the franchisor. For example, Burger King owns approximately six hundred establishments, while the average franchisee owns one to three. This makes franchisees, then, less invested in the upkeep of standards and regulations than are franchisors (Ji & Weil, 2015). In addition, franchisees run a relatively low risk of investigation by labor standards inspectors, because they own fewer establishments than the franchisor. Moreover, even for larger establishments, the risk of investigation is low, given funding cuts to government agencies that are charged with inspecting businesses and investigating complaints.

Franchisors and franchisees also face differences in operational costs. Franchisees’ profits are the difference between their operating expenses (costs for overhead, labor, supplies, and such) and their revenue (sales minus royalty fees paid to the franchisor). In other words, because the franchisor receives a portion of the franchisee’s revenues, a franchisee will always profit less from its products or services than does the franchisor. As experts posit, then, the higher the fees paid by the franchisee, the less the incentive to comply with labor standards, which come at a cost. In short, this may explain why there is higher compliance with labor standards in company-owned establishments than in their franchised establishments (Ji & Weil, 2015).

Finally, both franchisors and franchisees are stakeholders in the reputation of the company brand. In fact, the brand’s reputation is likely to have been an investment incentive for the franchisee. On the other hand, the average franchisee owns a small number of franchised establishments, so that its stake is lower than that of the franchisor. In other words, a franchisee has less to lose than a franchisor if the company reputation suffers a detrimental impact and franchisors, then, are more concerned about the brand’s reputation. Moreover, the decreased profits and other costs incurred by franchisees diminish the overall importance of brand reputation. This lower concern for brand reputation, according to experts, is also a motivator for higher noncompliance with labor standards among franchise companies (Ji & Weil, 2015).

However, these issues, although serious, are not to say that franchising is not a good business model. Many franchisees do exhibit excellence in labor standards compliance, and many instances of noncompliance may be the result of error or misinformation. Franchisors could collaborate with their franchisees in order to educate them as to Fair Labor Standards Act, compensable hours, and best business practices. Contractual agreements between franchisors and franchisees may include periodic hour, wage, and workplace audits. The many benefits of franchising—risk avoidance, higher purchasing power, assistance with marketing, operations, logistics, and training—are among the many reasons franchising has maintained a track record of success.

Terms & Concepts

Brand: A product and/or its identifying name and logo, as produced by a particular company.

Fees: Amounts that the franchisee is required to pay the franchisor (usually a franchisee’s fees are around 10 percent of the franchisee’s total expenses plus royalties).

Franchise: The rights and obligations of the franchisor and franchisee as established in a franchise agreement or contract.

Franchisee: The party that receives rights and obligations as set down in a franchise agreement.

Franchisor: The party that grants rights and obligations as established in a franchise agreement.

Master Franchising: An agreement or contract in which the master franchisor or brand owner cedes control over franchising in a specific geographic area or territory.

Bibliography

Baena, V., & Cervino, J. (2014). International franchising decision-making: A model for country choice. Latin American Business Review, 15(1), 13–43. Retrieved December 27, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=94873048&site=ehost-live

Dant, R. P., & Grunhagen, M. (2014). International franchising research: Some thoughts on what, where, when, and how. Journal of Marketing Channels, 21(3), 124–132. Retrieved December 27, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=96920460&site=ehost-live

Edger, C., & Emmerson, A. (2015). Franchising: How Both Sides Can Win. Oxfordshire, UK: Libri Publishing.

Ji, M., & Weil, D. (2015). The impact of franchising on labor standards compliance. Industrial & Labor Relations Review, 58(5), 977–1006. Retrieved December 27, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=110155332&site=ehost-live

Lafontaine, F. (2014). Franchising: Directions for future research. International Journal of the Economics of Business, 21(1), 21–25. Retrieved December 27, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=94381259&site=ehost-live

Laughlin, F. (2015). How to Succeed in Franchising. Nulkaba, AU: Lioncrest Publishing.

Lewandoska, Lucyna. (2014). Franchising as a way of creating entrepreneurship and innovation. Comparative Economic Research, 17(3), 163–181. Retrieved December 27, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=99346623&site=ehost-live

Meiklejohn, A. (2014). Franchising: Cases, materials & problems. Chicago, IL: American Bar Association.

Suggested Reading

Gerhardt, S., Hazen, S., Lewis, S., & Hall, R. (2015). Entrepreneur options: "Franchising" vs. "licensing" (McDonald’s vs. Starbucks and Chick-Fil-A). ASBBBS Ejournal, 11(1), 80–88. Retrieved December 27, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=108548019&site=ehost-live

Lewandoska, Lucyna. (2014). Franchising as a way of creating entrepreneurship and innovation. Comparative Economic Research, 17(3), 163–181. Retrieved December 27, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=99346623&site=ehost-live

Merrilees, B. (2014). International franchising: Evolution of theory and practice. Journal of Marketing Channels, 2(3), 133–142. Retrieved December 27, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=96920461&site=ehost-live