Franchise: What It Is and How It Works

Definition

A franchise is a business arrangement where a franchisor grants a franchisee the right to operate using the franchisor’s brand, systems, and proprietary knowledge in exchange for fees. The franchisee runs a business under the franchisor’s trademark and established operating model rather than creating a brand from scratch.

Key Takeaways

• Franchising lets businesses expand by licensing their brand and systems to independent owners, increasing market reach without direct management.
• Franchisees gain access to established processes, brand recognition, training, and supplier networks, which reduces startup uncertainty.
• Franchises involve upfront fees, ongoing royalties, and contractual limits on operations and creativity.
• Prospective franchisees must carefully review the Franchise Disclosure Document (FDD) and understand fees, obligations, territory rights, and performance expectations before committing.

How the Franchise Model Works

• Franchisor: Owns the brand, trademarks, and operating system. Provides training, marketing, and operational guidance.
• Franchisee: Purchases the rights to operate one or more locations using the franchisor’s name and methods.
• Typical payments to the franchisor:
• Upfront franchise fee (for the trademark and territory rights).
• One-time or periodic fees for training, equipment, or advisory services.
• Ongoing royalties (a percentage of sales) and sometimes advertising fees.
• Agreements are contractual and temporary—often lasting 5–30 years—with conditions, renewal rules, and penalties for breach.

Regulation and Required Disclosures

• In the U.S., franchising is regulated primarily at the state level, with a federal requirement known as the Franchise Rule. The Rule mandates that franchisors provide a Franchise Disclosure Document (FDD) to prospective buyers.
• The FDD must include fees, estimated financial performance, litigation history, approved vendors, and other material facts to help candidates evaluate the opportunity.

Brief History

The franchise concept in the U.S. dates to the mid-19th century with manufacturers licensing distribution systems. Food and hospitality franchising expanded in the 1920s–1930s and became central to the fast-food and lodging industries thereafter.

Pros and Cons

Pros
* Ready-made business formula and operating system
* Market-tested products and established brand recognition
* Training, operational support, and approved supplier lists
* Faster market entry and often easier customer acquisition

Cons
* High startup costs and required liquid capital
* Ongoing royalties and advertising fees (industry examples range widely; royalties can be roughly 4–12% of sales)
* Limited control over product, layout, branding, and territory
* Variable franchise value — not all franchises deliver the promised returns
* Financing and site success still depend on location and management

Financing and Costs

Start-up costs vary greatly by brand and industry. Large national brands can require substantial initial investment and liquidity. In addition to the franchise fee, expect build-out costs, equipment, inventory, working capital, and recurring royalty and marketing contributions.

Franchises vs. Startups

• Franchises are suited for entrepreneurs who prefer an established model, training, and brand recognition in exchange for fees and operational constraints.
• Startups suit founders who want full creative control and ownership, but they carry higher uncertainty and require creating systems, brand, and market demand from scratch.
• Choosing depends on risk tolerance, available capital, experience, and desire for independence versus support.

How Franchisors Make Money

Revenue streams for franchisors typically include:
* Initial franchise fees
* Payments for training, equipment, or proprietary systems
* Ongoing royalties (percentage of franchisee revenue)
* National or local advertising fund contributions and sales of approved supplies or services

What to Review Before Buying

• The Franchise Disclosure Document (FDD) in full—fees, obligations, territory rules, and historical performance claims
• Franchise agreement terms: length, renewal, transferability, termination clauses
• Support offered: training, marketing, supply chain, and field assistance
• Financial requirements: total initial investment and required liquid capital
• Litigation history and franchisor financial health
• Independent performance data and conversations with existing franchisees

Bottom Line

Franchising offers a pathway to entrepreneurship by leveraging established brands and systems, reducing some startup risks while imposing contractual limits and ongoing costs. Success depends on careful due diligence, realistic financial planning, effective site selection, and strong local management. Review the FDD and seek professional advice before committing to any franchise opportunity.