​How Franchising Works and Why Businesses Use the Channel

Christopher Conner  |

Via Daniel Barcelona

From a business owner’s perspective, the idea of franchising a business model is many times kicked around the boardroom as an idea to scale the brand and expand the business with less capital and vested franchisees. The concept sounds appealing to many for obvious reasons, and certainly anyone can point to hundreds of successful franchise brands that have leveraged the model and scaled into markets around the world. How does the model work and why does it have the potential for growth beyond other expansion channels?

First, it is important to understand that in franchising, a franchisee is paying a royalty on sales for the right to use the name, business system and intellectual property of the franchisor. If you compare a single unit of a franchise to that of a successful company owned location, the company owned location will have a higher dollar profit and volume, which is realized by the business. Franchising is about volume and decreased risk to the franchisor, not maximizing profitability on each operating unit. With this in mind, for the franchise channel to make sense for a brand, there needs to be relatively significant growth associated with the decision.

The franchise model probably won’t make sense if we are targeting ten new unit openings, but when the target is 50, 100 or 1,000, the franchise channel carries a great deal of logic. When opening new units as a franchise, the franchisor does not bear the expense of the new locations, the cost of recruitment, management, oversight and other local market expenses associated with establishing new businesses in new markets… the franchisees are responsible for this. As a result, franchising is a much leaner, low overhead and flexible business strategy than traditional company owned growth.

The Basics of the Franchise Mode

A franchisee pays a franchisor a franchise fee for the rights to operate either an individual unit of the franchised business. This fee ranges from $15,000 up to $75,000 depending on the brand, business model and market segment and is paid strictly for intellectual property, training and initial startup costs to the franchisor to support the new unit opening. In this transaction, the franchisee owns 100% of the business and has responsibility for managing, operating and financing the new location, they are tied to the franchisor’s brand and standards through the franchise agreement. The franchisor helps the franchisee find a location, establish the business and get the location ready to open. This includes corporate training at the franchisor’s operations, training at the franchisee’s location and initial support to help get the business up and running in an efficient time period.

Once the franchisee is open and operating, a royalty fee is paid to the franchisor, generally of 5-10% of gross sales paid on a weekly or monthly basis. In addition, franchisees will usually be responsible for paying an advertising fee along with royalties of 1-3% of gross sales, which are part of a contribution to a larger pool of advertising dollars that can then be used to promote the brand and build exposure for the entire network. The franchisor’s ongoing focus as the system matures becomes finding ways to add value to the relationship, provide innovative ways to improve the business model and help franchisees increase their bottom line and build a brand that adds valuation to each franchisee’s business and assets.

The Franchise Model in Practice

There are many brands and industries that have been defined by franchising. The franchise industry is well beyond proof of concept, but there are cases where the model has been used exceptionally well and efficiently. For example, the rental car industry has franchised with amazing success. Brands like Avis (CAR), Hertz (HTZ) and Dollar all built their global networks through franchise investment and were able to leverage local market knowledge and investment from franchise operators. Certainly, the restaurant and food service market has made the headlines for franchising with global brands in Chicken, Burgers, Ice Cream and virtually anything else you eat, established brands like Kentucky Fried Chicken (YUM), Jollibee in the Philippines, Subway and others have expanded at a ferocious pace with the franchise channel.

Other market segments like Hotels, Financial Services, Tax planning and retail have all had amazing success in franchising. The big mature brands are obvious, but what about the small, startup franchisors who have recently transitioned to franchising as a way to scale. Zoup! is a soup specific franchise system that had three locations for years in the Michigan market and at one point realized they were not able to expand at the pace they desired. The business franchised in the mid-2000’s and over an almost ten-year time period has been able to expand to 115 units across the Midwest and Eastern United States. Although the brand is not nationally-known or considered a leader in the food service market, they have been able to increase their market valuation by an exponential percentage rate and with even modest unit growth will continue to build an asset value worth a great deal. The franchise concept has allowed Zoup leadership to get out of the operating business and focus on the strategic initiatives inherent in franchise expansion. Franchising has helped Zoup to transition from a “unscalable” business to one that is scalable, allowing for rapid growth.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
HTZ Hertz Global Holdings Inc 15.78 -0.66 -4.01 886,563 Trade
YUM Yum! Brands Inc. 92.40 0.35 0.38 387,416 Trade
CAR Avis Budget Group Inc. 24.63 -0.72 -2.84 463,863 Trade

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