Under a franchising arrangement, a franchisor allows a third party, the franchisee, to utilise the franchisor's brand name and operational methodology. As a result a franchise agreement would normally have the following elements:
- The franchisor allows the franchisee to use a name which is associated with the franchisor.
- The franchisee operates his business under the franchisor's trade name or trade mark so that to the outside world the franchisee is the franchisor.
- The franchisor exercises continuing control over the franchisee. Indeed the franchisor must be able to exert substantial influence and control on the way that the franchisee operates its business.
- The franchisor provides assistance to the franchisee.
- The franchisee periodically has to make payments to the franchisor.
Franchise agreements have advantages and disadvantages for both the franchisor and the franchisee
Advantages of franchising for the franchisor
Franchising offers the opportunity to secure distribution for products or services faster than would be the case if the franchisor had to train up its own employees and develop its own internal marketing, sales and distribution organisation. The use of a franchisee's capital will facilitate the expansion of a network more quickly than would be the case if the franchisor had to find the funds itself. A franchisor, with its increased purchasing power and possibly also reduced overheads, may be able to increase the profitability of small units.
Disadvantages of franchising for the franchisor
The major disadvantage for franchisors is loss of control. While the franchise agreement will impose substantial restrictions on franchisees, it is important to remember that franchisees will be independent third parties who will be seeking to maximise their profits, sometimes at the expense of the franchisor. Part of the franchisor's profit element is used in supporting an additional entity, the franchisee, in the distribution chain. By involving third parties in their business, franchisors will, inevitably, have to divulge substantial know-how and information concerning their business. The franchise agreement will contain restrictions on the franchisee's ability to make use of this information for his own purposes, but such provisions are often difficult to monitor and enforce. The skills required to control franchisees and provide the back-up are different from those involved in operating a business through employees.
Advantages of franchising for the franchisee
Franchisees do not have to have general business or management skills, or specialised knowledge in the proposed business activity. By taking advantage of the franchisor's name and reputation the lead time in making a business successful may be reduced. This reduces the franchisee's working capital requirements. Finance may be more readily available to franchisees than those setting up in business on their own account. All the clearing banks have their own franchise departments. Gearing of 1:1 between a business's own financial resources and bank borrowings may be relaxed in a franchising context so that banks may be prepared to accept a gearing of 1:2 or even 1:3 for well established franchises. The risks of business failure are substantially reduced. The franchisee is able to make use of the franchisor's purchasing power and there may be other benefits relating to the size of the franchisor's operation. National advertising is undertaken by the franchisor for the benefit of the franchisee. Assistance and training is given throughout the term of the franchise.
Disadvantages of franchising for the franchisee
A franchisee is subject to substantial control from the franchisor. (No restrictions would, in theory at least, be placed on the franchisee were he to set up in business independently.) A franchisee will have to pay royalties and/or a mark up on the goods or services which he receives from the franchisor or his nominated supplier. There may be restrictions on the franchisee's ability to sell the franchised business or to pass it on to a relative. The franchisee's operation will be directly affected by the actions or insolvency of the franchisor.