Franchising touches virtually every person in America.
When you pick up your morning coffee, drop off your dry cleaning, get your eyes tested, buy gas or pick up dinner, chances are it’ll be at a franchise. In a relatively short amount of time, franchising has grown into a predominant method of growing a business.
The genius of combining one party’s brand and know-how with another’s capital and work ethic has turned the retail world into a sea of opportunity for people who want to be their own boss.
Of course, while many people associate franchising with small businesses, many large businesses operate on a franchise model. Many hotels, for example, are franchises. The same with many car dealers, which may require hundreds of millions of dollars in up-front investment. Between sales, service and rentals, a franchise can be a billion-dollar stand-alone business. As one thinks of growing even very large businesses, one should not count out the possibility of franchising.
Legal Elements of a Franchise
Before we look at some of the threshold questions regarding the viability of franchising as a business model, it is important to understand how the law interprets what constitutes a franchise. There are many business operators who, in an effort to avoid being called a franchise so as to circumvent state franchising laws, have labeled their business expansion programs “licenses” or “joint ventures.”
The reality, however, is that the law does not care what you label your program. If it contains the three elements of a “franchise,” as defined by the Federal Trade Commission (as supplemented by some state’s laws), then your business is a franchise.
Focusing on the federal law definition only, the first, and perhaps most important, element of a franchise is a trademark with which the franchisees will be associated. One writer described a “brand” as a contract between the owner of the brand and the consumer, and that within the contract, there are certainties the consumer can rely on as deliverables from the brand owner.
In other words, when you deal with a business operating under the banner of a brand, you have certain expectations undefined some conscious and some unconscious. These expectations are why you look for that brand undefined or why you might try to avoid it altogether.
Of course, trademarks do not have to be a word. They can be symbols, designs or anything that creates an association with a company in the mind of the consumer.
The second element of a franchise is having significant control over or providing significant assistance to franchisees. Assistance may be systems, processes or standards that are used to produce consistency in the delivery of a product or service. These are usually compiled in system standards, process and procedures manuals, operations manuals, and similar resources that are used by the franchisor to train the franchisee in how the business is to be run. They are also used to hold the franchisee accountable under the franchise agreement for the operation of the business.
The purpose of these controls is to protect the brand by making each customer’s interaction consistent throughout the chain. They lay the foundation for the “contract” in the mind of the consumer as to what to expect when visiting a store, regardless of where it is located.
The operations manual covers everything from the physical look of the business, to how the product or service is delivered, to the precise words used to greet a customer (think of “Welcome to Moe’s”). Communication and training on the materials contained in the manuals become more significant as a system grows, usually because a franchisor sees how important it is, and realizes how hard it is to do. Herman Cain, former CEO of Godfather’s Pizza, once revealed that one of the first things he did when he took over that company was to dramatically reduce the number of pizza selections because he said it was very difficult to teach a 16-year-old how to make many different pizzas undefined and to do it right.
The third and final element of a franchise is a required payment, usually a franchise fee. This may take the form of an up-front fee, plus an ongoing royalty based on gross sales. However, there is no set structure for a franchise fee, and fees can be almost anything a franchisee pays that is required by the franchisor.
The franchising business model
In his popular business book of several years ago, The E-Myth, author Michael Gerber suggested that every business should be structured like a franchise. What he meant is that business owners should implement processes and training that allow the business to run without them, so that they can focus on more strategic initiatives.
In my practice, whenever I counsel business owners, whether large or small, I ask them to think about the functions that only they can perform. These functions usually include finding compatible and competent leadership, setting strategic goals, and determining borrowing limits. Franchising allows the business owner to pull himself or herself out of the day-to-day operation of delivering the product or service, to multiply and grow the business.
In evaluating whether a business is a good candidate for franchising, one must ask whether the business can successfully be duplicated. Restaurants are an easy example because they are essentially stand-alone operations. By contrast, a clothing manufacturer may not be as easily or as cost effectively duplicated. On the other hand, the retail storefront selling the clothing may be easy to duplicate.
Another important question to ask before franchising: what do you have that constitutes intellectual property and that is protectable? For example, are there recipes or patents that can be protected? Is there software involved that will be difficult or impossible to duplicate?
Having something proprietary, however, is not mandatory. For example, many hamburger chains are successful despite the lack of a secret recipe. What makes the difference is the difficulty of consistently duplicating the delivery, service and quality. Having something protectable simply makes it easier for a business owner to franchise when they know that a third party cannot easily duplicate their system.
And of course, there is always the issue of capital. There is much misinformation regarding franchise start-up costs. For the operation of a mature brand that has decided to franchise, capital may not be a huge issue, but for a successful small business owner who sees franchising as a way to get to the next level of growth, every penny may count.
There are also several areas of cost to consider. Legal fees, of course, will be a significant expense, but they generally are not as high as most people tend to assume. It is always wise to seek consultation to find out the realistic legal costs for putting in place a franchise program.
Usually, the legal component of that infrastructure will be the required franchise disclosure document. Much like a securities offering, this document sets forth certain required information about the franchisor and its franchise program. There will also be a form of the franchise agreement and possibly some state registrations, depending on where one intends to franchise.
Most southeastern states do not have complicated registration requirements, and I advise clients to start small and use the “hub and spoke” approach to growing the franchise business. A potential franchisor needs to consider the cost of servicing and supporting franchisees, so distance from the franchisor’s location, at least in the beginning, should be a factor in selecting target markets.
The last major piece of the franchise infrastructure will be the operations manual. While some mature businesses will already have well-defined and documented processes and can easily adapt them for the franchisee, some businesses will need to create such a manual from scratch. The key is to make sure that all of the critical areas for the operation of the business are covered.
This article is a broad overview of franchise law. anyone contemplating a franchise business model should obtain legal counsel before starting. While the challenges are many, seeing a business grow, without having to fund that growth through debt or out-of-pocket investment, can be miraculous. and seeing others become successful can be very rewarding indeed.