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Section 2: The Entrepreneurial Journey Begins

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Essentials of Entrepreneurship and Small Business Management

Ninth Edition

Chapter 8

Franchising and the Entrepreneur

Learning Objectives (1 of 2)

1. Describe the three types of franchising: trade name, product distribution, and pure.

2-A. Explain the benefits of buying a franchise.

2-B. Explain the drawbacks of buying a franchise.

In this chapter, you will:

1. Describe the three types of franchising: trade name, product distribution, and pure.

2.A. Explain the benefits of buying a franchise.

2.B. Explain the drawbacks of buying a franchise.

Learning Objectives (2 of 2)

3. Understand the laws covering franchise purchases.

4. Discuss the right way to buy a franchise.

5. Describe the major trends shaping franchising.

In addition, you will:

3. Understand the laws covering franchise purchases.

4. Discuss the right way to buy a franchise.

5. Describe the major trends shaping franchising.

The Franchising Boom

About 3,800 franchisors operate more than 750,000 outlets in the United States.

Franchises generate more than $710 billion in annual sales and account for 2.3% of the U.S. GDP.

Franchises employ 7.8 million workers in the United States in more than 300 major industries.

Most franchised outlets are small, but as a whole, they have a significant impact on both the U.S. and global economies.

Number of Franchised Outlets in the United States

Figure 8.1 Number of Franchised Outlets in the United States

Source: Based on data from Franchise Business Economic Outlook for 2017, IHS Economics and the International Franchise Association Educational Foundation, January 2017, p. 2.

In the United States alone, about 3,800 franchisors operate nearly 750,000 franchise outlets, and more are opening constantly.

Franchised Outlets by Industry

Figure 8.2 Franchised Outlets by Industry

Source: Based on data from Franchise Business Economic Outlook for 2017, IHS Economics and the International Franchise Association Educational Foundation, January 2017, p. 2.

Figure 8.2 provides a breakdown of the franchise market by industry.

Franchising

Franchising:

A system in which semi-independent business owners (franchisees) pay fees and royalties to a parent company (franchiser) in return for the right to become identified with its trademark, to sell its products or services, and often to use its business format and system.

Franchising also has a significant impact on the global economy. Because the United States franchise market is the most mature in the world, U.S. franchisors are expanding globally to reach their growth targets.

Franchising Basics

Franchisee gets the right to use all of the elements of a fully integrated business operation.

Essence of what franchisees purchase from the franchisors: Experience.

Key Question: “What can a franchise do for me that I cannot do for myself?”

Franchisees do not establish their own autonomous businesses; instead, they buy a “success package” from the franchisor, who shows them how to use it.

The Franchising Relationship

Figure 8.3 The Franchising Relationship

Source: Adapted from Economic Impact of Franchised Businesses: A Study for the International Franchise Association Educational Foundation, Copyright 2004 by the International Franchise Association. eprinted with permission.

Franchising is built on an ongoing relationship between a franchisor and a franchisee. The franchisor provides valuable services, such as a proven business system, training and support, name recognition, and many other forms of assistance; in return, the franchisee pays an initial franchise fee as well as an ongoing percentage of his or her outlet’s sales to the franchisor as a royalty and agrees to operate the outlet according to the franchisor’s terms.

Types of Franchising

Trade-Name:

A franchisee purchases the right to use the franchisor’s trade name without distributing particular products exclusively under the franchisor’s name.

Product Distribution:

A franchisor licenses a franchisee to sell its products under the franchisor’s brand name and trademark through a selective, limited distribution network.

Pure:

A franchisor sells a franchisee a complete business format and system.

Three basic types of franchises operate in almost every industry: trade-name franchising, product distribution franchising, and pure franchising.

Franchise Business Index

Figure 8.4 Franchise Business Index

Source: Franchise Business Economic Outlook for 2017, IHS Economics and International Franchise Association Educational Foundation, January 2017, p. 4.

Figure 8.4 shows the International Franchise Association’s Franchise Business Index, a composite measure of the economic health of the franchise industry that includes six different indicators.

Benefits of Franchising (1 of 3)

A business system

Management training and support

Start-up

Ongoing

Brand name appeal

“Cloning”

Standardized quality of goods and services

For many first-time entrepreneurs, access to a business model with a proven track record is the safest way to own a business.

Benefits of Franchising (2 of 3)

National advertising programs

Franchisees contribute 1% to 5% of sales.

Financial assistance

About 20% of franchisors offer direct financial assistance to franchisees.

SBA – Franchise Registry

An effective advertising program is essential to the success of every franchise operation.

A basic principle of franchising is to use franchisees’ money to grow their businesses, but some franchisors realize that because start-up costs have reached breathtakingly high levels, they must provide financial help for franchisees.

Benefits of Franchising (3 of 3)

Proven products and business formats

Centralized buying power

Site selection and territorial protection

Important issue: Territorial encroachment

Greater chance for success

A franchise owner does not have to build the business from scratch.

Drawbacks of Franchising (1 of 3)

Franchise fees and ongoing royalties

Average upfront franchise fee = $25,147

Royalties range from 1% to 11% of franchisees’ sales

Average royalty = 6.7% of sales

Prospective franchisees must understand the disadvantages of franchising before choosing this method of doing business. Perhaps the biggest drawback of franchising is that a franchisee must sacrifice some freedom to the franchisor.

Planned Sources of Financing for Prospective Franchisees

Figure 8.5 Planned Sources of Financing for Prospective Franchisees

Source: Prospective Franchisee Survey Results, FranchiseDirect, 2016, www.franchisedirect.com/information/prospectivefranchiseesurveyresults2016/?r=5380.

Franchisees use many of the same sources to finance franchises that independent entrepreneurs use to finance start-up companies.

Franchise Royalty Fees

Figure 8.6 Franchise Royalty Fees

Source: Based on 2015 Franchise Sales Trends Report, FranConnect, 2015, p. 6.

This figure shows a breakdown of franchise royalty fees.

Drawbacks of Franchising (2 of 3)

Strict adherence to standardized operations

Restrictions on purchasing

Approved suppliers only

Limited product line

Contract terms and renewal

Average term = 10.5 years

Although franchisees own their businesses, they do not have the autonomy that independent owners have. To protect its image, a franchisor requires that franchisees maintain certain operating standards.

Drawbacks of Franchising (3 of 3)

Unsatisfactory training programs

Market saturation

Less freedom

“No independence”

“Happy prisoners”

Before signing on with a franchise, it is wise to find out the details of the training program the franchisor provides to avoid unpleasant surprises.

Franchise Breakdown by Number of Outlets

Figure 8.7 Franchise Breakdown by Number of Outlets

Source: Based on 2015 Franchise Sales Trend Report, FranConnect, 2015, p. 3.

Figure 8.7 shows a breakdown of the number of outlets operated by U.S.-based franchises.

Ten Myths of Franchising (1 of 2)

Franchising is the safest way to go into business because franchises never fail.

I’ll be able to open my franchise for less money than the franchiser estimates.

The bigger the franchise organization, the more successful I’ll be.

I’ll use 80 percent of the franchiser’s business system, but I’ll improve upon by substituting my experience and know-how.

All franchises are the same.

Many myths surround franchising.

Ten Myths of Franchising (2 of 2)

I don’t have to be a hands-on manager. I can be an absentee owner and still be very successful.

Anyone can be a satisfied, successful franchise owner.

Franchising is the cheapest way to get into business for yourself.

The franchiser will solve my business problems for me; after all, that’s why I pay an ongoing royalty fee.

Once I open my franchise, I’ll be able to run things the way I want to.

Franchising and the Law

Franchise Disclosure Document (FDD)

Established in 2008 to replace the Uniform Franchise Offering Circular (UFOC)

Requires franchisors to disclose to potential franchisees information on 23 important topics

Objective: To give franchisees the information they need to protect themselves from dishonest franchisees and to make good investment decisions.

Joint Employer Liability

Browning-Ferris Industries (BFI) decision

The FDD applies to all franchisors, even those in the 35 states that lack franchise disclosure laws. The purpose of the regulation is to assist potential franchisees’ investigations of a franchise deal and to introduce consistency into the franchisor’s disclosure statements.

In a recent decision known as Browning-Ferris Industries (BFI), the National Labor Relations Board (NLRB) overturned more than 30 years of regulatory practice and franchise law by declaring that franchisors are considered “joint employers” with their franchisees. Even though franchisees make decisions about hiring, paying, scheduling, and firing their employees, the ruling holds franchisors jointly responsible for those decisions.

The Right Way to Buy a Franchise (1 of 3)

Evaluate yourself: What do you like and dislike?

By asking the right questions and resisting the urge to rush into an investment decision, potential franchisees can avoid being taken by unscrupulous operators.

Are You Franchise Material?

Successful franchise owners have:

Commitment

A willingness to work with others

A positive attitude

Leadership ability

Solid people skills

Adequate capital

Compatible values

A learning attitude

Patience

General business skills

Coachability

Adequate capital

A willingness to follow the system

Do you have what it takes to be a successful franchise owner?

The Right Way to Buy a Franchise (2 of 3)

Evaluate yourself: What do you like and dislike?

Research your market.

Consider your franchise options.

Get a copy of the Franchisor’s FDD – and read it!

Factors that Make a Franchise Appealing

Unique concept or marketing approach

Profitability

Registered trademark

Business system that works

Solid training program

Affordability

Positive relationship with franchisees

The Right Way to Buy a Franchise (3 of 3)

Evaluate yourself: What do you like and dislike?

Research your market.

Consider your franchise options.

Get a copy of the Franchisor’s FDD – and read it!

Talk to existing franchisees.

Ask the franchiser some tough questions.

Make your choice.

Trends Shaping Franchising (1 of 6)

Changing face of franchisees

Minorities own 31.2% of all franchises compared to 14.6% of independent businesses.

Modern franchisees are also better educated, more sophisticated, more financially secure, and have more business acumen compared to just 20 years ago.

Franchising has experienced three major growth waves since its beginning. The first wave occurred in the early 1970s, when fast-food restaurants used the concept to grow rapidly.

The second wave took place in the mid-1980s, as the U.S. economy shifted heavily toward the service sector.

A third wave began in the early 1990s and continues today. It is characterized by new low-cost franchises that focus on specific market niches. In the wake of major corporate downsizing and the burgeoning costs of traditional franchises, these new franchises allow would-be entrepreneurs to get into proven businesses faster and at reasonable costs.

Franchisees today are a more diverse group than in the past.

Age Distribution of Franchisees

Figure 8.8 Age Distribution of Franchisees

Source: Based on “Prospective Franchisees Survey 2016,” FranchiseDirect, July 5, 2016, www.franchisedirect.com/information/prospectivefranchiseesurvey2016/?r=5380.

People of all ages and backgrounds are choosing franchising as a way to get into business for themselves.

Trends Shaping Franchising (2 of 6)

International opportunities

Many franchises are focusing on international markets as a source of growth.

McDonald’s earns 67% of its sales internationally.

Yum! Brands has more than 14,000 restaurants outside the United States.

One of the major trends in franchising is the internationalization of American franchise systems. Franchising has become a major export industry for the United States, with franchises focusing on international markets to boost sales and profits as the domestic market has become saturated.

Top 10 Franchise Markets

Table 8.4 Top 10 Franchise Markets

Rank	Country
1	Canada
2	Australia
3	China
4	Indonesia
5	South Africa
6	Mexico
7	India
8	Vietnam
9	Colombia
10	Brazil

Source: 2016 Top Markets Report: Franchising, U.S. Department of Commerce, International Trade Administration, 2016, pp. 2–3.

This table shows the top 10 countries that present the greatest potential for franchisors, according to a cross-country analysis of five factors, including the availability of business infrastructure and a suitable labor force, sufficient market size, and the government regulatory environment.

Trends Shaping Franchising (3 of 6)

Mobile Franchises

Putting businesses on wheels.

Smaller, nontraditional locations

Intercept Marketing: putting a franchise’s products or services directly in the paths of potential consumers, wherever they may be.

Conversion Franchising

Owners of independent businesses become franchisees to gain the advantage of name recognition.

Mobile franchising is one of the fastest-growing segments in the franchise market because mobile franchises typically have lower capital requirements than brick-and-mortar businesses, and they offer a marketing advantage: the ultimate in convenience for customers because the product or service comes to them.

As the high cost of building full-scale locations continues to climb, more franchisors are searching out nontraditional locations in which to build smaller, less expensive outlets.

It is not unusual for entrepreneurs who convert their independent stores into franchises to experience an increase of 20% or more in sales because of the instant name recognition the franchise offers.

Trends Shaping Franchising (4 of 6)

Refranchising

Franchisors sell their company-owned outlets to franchisees.

Multi-unit franchising

IFA: 20% of franchise owners are multiple-unit owners.

Typical multiple-unit franchises own five outlets.

Refranchising not only increases franchisors’ profitability because it generates more royalty income for franchisors but also provides capital to finance international expansion.

Franchisors are finding that multi-unit franchising is an efficient way to do business. For a franchisor, the time and cost of managing 10 franchisees each owning 10 outlets are much less than managing 100 franchisees each owning 1 outlet. A multi-unit strategy also accelerates a franchise’s growth rate. Not only is multiple-unit franchising an efficient way to expand quickly, it also is effective for franchisors who are targeting foreign markets, where having a local representative who knows the territory is essential.

Trends Shaping Franchising (5 of 6)

Area development and master franchising

Area Development: the franchisee earns the exclusive right to open multiple units in a specific territory in a specific time.

Master Franchise: franchisee has the right to create a semi-independent organization in a particular territory to recruit, sell, and support other franchisees.

Driving the trend toward multiple-unit franchising are area development and master franchising.

Trends Shaping Franchising (6 of 6)

Co-Branding

Aka piggyback or combination franchising:

Two or more franchises team up to sell complementary products or services under one roof.

This “buddy-system” approach works best when the two franchise ideas are compatible and appeal to similar customers.

Conclusion

Franchising:

Is a key part of the small business sector

Increases the chance of business success for the entrepreneur

Growth continues