Commercial Franchising: The Basics

09 February

Say the word “franchise” to most people and their minds will most likely wander to entertainment franchises like Harry Potter, Star Wars and James Bond. However, in the commercial world, a franchise is not a multi-million pound movie brand so much as a business brand which is licensed to business owners by way of a franchise agreement.

The biggest franchises in the world include the likes of McDonalds, Domino’s, KFC, Texaco and Spar but there are many smaller-scale franchisors (the owner of the brand) out there looking for people to join their business model as a franchisee. Stephen Thompson, our commercial partner, recently attended the franchise shows in Cardiff and Swansea where many such franchisors set up stands and attempt to sell themselves to potential franchisees.

If you have a great business idea and want to expand, or are looking to enter into a business venture but don’t want to start from square one, franchising may be the solution for you. Here are some of the basics to take into account when considering whether franchising is right for you:

The Franchisor

As the franchisor, you own the business concept and the brand under which the business operates. By franchising it, you will be granting other businesses the right to operate using that concept and brand. This can be a great way of expanding your business without the inherent risks of setting up new stores/branches yourself.

Your key commitment is to build up the reputation of the brand and to finesse the business concept so that others can easily begin to use it. If your business is relatively new and unknown, franchising is far less likely to be successful than if you have already generated a reasonable amount of goodwill in the name.

Your first consideration should be whether the business – primarily meaning the goods or services being provided – are susceptible to franchising. If they are, you will need to carefully consider your business plan and proposed management structure to ensure that you are able to deal with the obligations which will be placed on you.

Pilot Operation – It is generally advisable that a franchisor sets up one or more ‘pilot franchises’ to test their system before rolling it out more widely. One of the first steps in the pilot will be to agree a franchise agreement with the franchisee(s). Pilot franchisees generally have more influence over the terms of the franchise agreement than those who enter into an agreement once the franchise is fully established. This is primarily because pilot franchisees are taking a greater risk with a new business model and also because there will be an element of trial and error in the operation of the system and the performance of the franchise business.

Operations Manual – the operations manual is a fundamental component of the franchise relationship, setting out the franchise system and how it works. It also deals with the business’ operational requirements, such as the equipment needed and how it should be operated; the stock requirements; the business opening times; the accounts rules; and other operational instructions. The manual will need to be prepared and provided to franchisees and will most likely be developed by the franchisor based on its own experiences and those learnt from the pilot operation.

Key Duties – One of the benefits of the franchising system is that it gives the brand owner a much greater degree of control over the operation of the business compared with other options, such as a trade mark licence. This level of control also means that the franchisor will have greater responsibilities than in other arrangements, albeit many of them are one-off obligations which come into play at the beginning of the franchise relationship. For example, the franchisor will normally be responsible for supplying information and training to the franchisee, as well as equipment, stationery, advertising materials and possibly stock. Over the longer term, the franchisor will be responsible for reviewing the business and operational performance of the franchisee, as well as continuing to provide marketing and other support to the franchisee.

Franchisee

The key advantage of a franchise for the franchisee is the ability to tap into the franchisor’s name and reputation, which can reduce the lead time in making a business successful. Also, the provision of the operations manual, training and other support services reduces the need for the franchisee to have general business or management skills or specialised knowledge of the relevant business activity.

This pre-built model and ongoing support does, however, come at a cost. A franchisee will be subject to substantial control from the franchisor, which would obviously not exist if the franchisee was to set up a new business on its own. There will normally be an initial fee upon entering into the agreement, which covers the franchisor’s costs in establishing the franchise. Also, the business income will not belong exclusively to the franchisee. Whether via a royalty fee, or an uplift on goods or services, the franchisee will account for part of its income to the franchisor. This acts as a payment to the franchisor for it licensing the brand, the business system and for providing the support services. This is how the franchisor makes its money in the longer term.  

Except in pilot cases, the franchisee will have little scope to negotiate the terms of the franchise agreement, which will be drawn up by the franchisor and used uniformly across its franchise network. Therefore, the key issue for the franchisee is ensuring that it can meet its obligations under the agreement and that it has properly weighed up the potential benefits with the risks of business failure.

It is always advisable for a franchisee to seek legal advice on the contents of the franchise agreement and most agreements will include an undertaking that they have done so. Even so, there are a few key terms which a prospective franchisee should consider when deciding whether to proceed:

1.    Duration – how long is the initial term of the agreement? Normally, this will be at least 3-5 years. The franchisee will want the term to be as long as possible to give it time to develop the business and obtain a return on its initial investment.

2.   Fees – what fees are payable, both at the outset and on a recurring basis? The franchisee should try to negotiate that the initial fee covers everything which the franchisor is required to provide to assist with the start-up of the business. The ancillary fees which might be payable, for training, advertising and stationery supplies for example, should be carefully checked.

3.   Obligations – the franchisee should check its obligations carefully and ensure that they are fair and that it will be able to comply with them.

4.  Advertising – the franchisor will normally have advertising responsibilities but the franchisee may be required to pay a fee to contribute towards the cost of such advertising, particularly on a national basis. The franchisee may also have its own advertising duties, which it should check carefully.

5.   Operations manual – the franchisee will not generally have sight of the operations manual before entering into the agreement but should seek to do so where possible. The manual is generally incorporated into the agreement and will set out the vast majority of the practical, day-to-day obligations which the franchisee will be expected to perform.

6.   Termination/Sale – the franchisor will normally have the unilateral right to terminate the agreement if the franchisee fails to perform certain obligations or becomes subject to certain events. These should be checked carefully to ensure the franchisee does not inadvertently give the franchisor the right to terminate the agreement. Also, there will normally be restrictions on the franchisee’s ability to sell the business to a third party or transfer it to a relative, which the franchisee should be aware of and take into account.

Conclusion

Whether contemplating whether to set up a new franchise or become a franchisee, it is vital to properly scrutinise the business model and ensure it is viable before proceeding. For a franchisor, this will mean coming up with a full business and management plan and piloting the scheme before rolling it out properly. For a franchisee, this will mean reviewing the franchisor’s business, speaking with existing franchisees and considering the local market conditions.

It is equally important to deal with the legal aspects of the arrangement properly, which for the franchisor means having a suitable corporate framework in place for the franchise and a comprehensive agreement which protects its position as fully as possible. A franchisee, while having only limited negotiation power over the franchise arrangement, will need advice on the franchise agreement and the practical implications of it.  

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