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FRANCHISING

Franchising 413

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The primary trade association for franchising issues, the International
Franchise Association, defines franchising as a “continuing
relationship in which the franchisor provides a licensed privilege to do
business, plus assistance in organizing, training, merchandising, and
management” in exchange for fees and royalties from the franchisee.
In other words, franchising is the process of expanding a business whereby
a company (franchisor) grants a license to an independent business owner
(franchisee) to sell its products or render its services. A franchise,
therefore, is a legal agreement permitting a business to furnish a
product, name, trademark, or idea to an independent business owner. Each
party of a franchise agreement gives up some legal rights to gain others.
The franchisor increases its number of outlets and gains additional
income. The franchisee opens an established business with strong potential
for success. Franchising offers people a chance to own, manage, and direct
their own business without having to take all the associated risks. This
aspect has allowed many people to open businesses of their own who might
never have done so otherwise.

Franchising plays a significant role in the U.S. economy. Franchise sales
accounted for about over 50 percent of all retail sales in the United
States in the late 1990s and U.S. franchises generated roughly $1 trillion
in sales of goods and services annually in the United States during this
period, according to the International Franchise Association (IFA).
Approximately 1 out of 12, or 600,000, businesses are franchises, which
supply jobs for over 8 million people, and there are about 3,000
franchisors in the United States.

According to the U.S. Small Business Administration, franchising is the
fastest-growing kind of small business. Furthermore, each new franchise
generates 8-14 new jobs and a new franchise opens an average of every
eight minutes per business day. Overall, franchises create over 300,000
new jobs per year.

Franchising has opened the door of opportunity for women, families, and
minorities. Women have discovered that operating franchises often allows
them to spend more time with their families. Women wholly own about 10
percent and jointly own about 30 percent of U.S. franchise outlets,
according to the Small Business Administration. In many cases, families
pool their resources and time to operate outlets—and often use the
profits to create their own mini-chain of stores. Minorities have
benefited, too. They have been able to locate establishments in urban
areas which at one time lacked minority ownership. Significantly,
some franchisors such as Burger King and the Southland Corporation, owner
of the 7-11 convenience stores, provide special financial programs for
minority owners. They also work closely with organizations like the
National Association for the Advancement of Colored People (NAACP) to
recruit more minority owners. In this respect, franchises have been a boon
for society.

No matter who owns a franchise outlet, the franchisee and the franchisor
share the risks and the responsibilities, although not always equally.
Since both parties have a financial investment at stake, the risk can be
substantial.

There are four major types of franchises: business format franchises,
product franchises, manufacturing franchises, and business opportunity
ventures, according to the

Franchise Opportunities Handbook.

Via business format franchises, the most common type, a company expands
by supplying independent business owners with an established business,
including its name and trademark. The franchisor company generally assists
the independent owners considerably in launching and running their
businesses. In return, the business owners pay fees and royalties. The
franchisee also often buys supplies from the franchisor. Fast food
restaurants are good examples of this type of franchise.

With product franchises, manufactures control how retail stores distribute
their products. Through this kind of agreement, manufacturers allow
retailers to distribute their products and to use their names and
trademarks. To obtain these rights, store owners must pay fees or buy a
minimum amount of products. Tire stores, for example, operate under this
kind of franchise agreement.

Through manufacturing franchises, a franchisor grants a manufacturer the
right to produce and sell goods using its name and trademark. This type of
franchise is common among food and beverage companies. For example, soft
drink bottlers often obtain franchise rights from soft drink companies to
produce, bottle, and distribute soft drinks. The major soft drink
companies also sell the supplies to the regional manufacturing franchises.

Finally, business opportunity ventures involve an independent business
owner buying and distributing the products from one company. The company
supplies the business owner with clients or accounts and therefore the
business owner pays the company a fee in return. Business owners obtain
vending machine routes and distributorships, for example, through this
type of franchise arrangement.

Franchise operations, as we know them, are not very old. The boom in
franchising did not take place until after World War II. Nevertheless, the
rudiments of modem franchising date back to the Middle Ages when the
Catholic Church made franchise-like agreements with tax collectors, who
retained a percentage of the money they collected and turned the rest over
to the church. The practice ended around 1562 but spread to other
endeavors. For example, in 17th century England franchisees were granted
the right to sponsor markets and fairs or operate ferries. There was
little growth in franchising, though, until the mid19th century, when it
appeared in the United States for the first time.

One of the first successful American franchising operations was started by
an enterprising druggist named John S. Pemberton. In 1886, he concocted a
beverage comprising sugar, molasses, spices, and cocaine (which is no
longer an ingredient). Pemberton licensed selected people to bottle and
sell the drink, which is now known as Coca-Cola. His was one of the
earliest—and most successful—franchising operations in the
United States.

The Singer Company implemented a franchising plan in the 1850s to
distribute its sewing machines. The operation failed, though, because the
company did not earn much money even though the machines sold well. The
dealers, who had exclusive rights to their territories, absorbed most of
the profits because of deep discounts. Some failed to push Singer
products, so competitors were able to outsell the company. Under the
existing contract, Singer could neither withdraw rights granted to
franchisees nor send in its own salaried representatives. So, the company
started repurchasing the rights it had sold. The experiment proved to be a
failure. That may have been one of the first times a franchisor failed,
but it was by no means the last. (Even Colonel Sanders did not initially
succeed in his Kentucky Fried Chicken franchising efforts.) Fortunately,
the Singer venture did not put an end to franchising.

Other companies tried franchising in one form or another after the Singer
experience. For example, several decades later, General Motors Corporation
established a somewhat successful franchising operation in order to raise
capital. Perhaps the father of modern franchising, though, is David
Liggett. In 1902, Liggett invited a group of druggists to join a
“drug cooperative.” As he explained to them, they could
increase profits by paying less for their purchases, especially if they
set up their own manufacturing company. His idea was to market private
label products. About 40 druggists pooled $4,000 of their own money and
adopted the name “Rexall.” Sales soared, and
“Rexall”
became a franchisor. The chain’s success set a pattern for other
franchisors to follow.

Although many business owners did affiliate with cooperative ventures of
one type or another, there was little growth in franchising until the
early 20th century, and what franchising there was did not take the same
form as it does today. As the United States shifted from an agricultural
to an industrial economy, manufacturers licensed individuals to sell
automobiles, trucks, gasoline, beverages, and a variety of other products.
The franchisees did little more than sell the products, though. The
sharing of responsibility associated with contemporary franchising
arrangement did not exist to any great extent. Consequently, franchising
was not a growth industry in the United States.

It was not until the 1960s and 1970s that people began to take a close
look at the attractiveness of franchising. The concept intrigued people
with entrepreneurial spirit. However, there were serious pitfalls for
investors, which almost ended the practice before it became truly popular.

Since there was no regulation of franchises to speak of, a number of
hucksters involved themselves in the field. Many of them initiated
get-rich-quick schemes which cost investors countless dollars. As a
result, franchising became a bad word to some people. In 1970 alone, over
100 franchisors went out of business. Concomitantly, thousands of
franchisees lost their businesses and their money. However, public and
private sector watchdogs helped to restore franchising’s name and
launch its way to a prominent place in the American economy.

Some franchisors formed the IFA in 1960 to police the franchising industry
and eliminate the con artists. Individual states began passing laws to
regulate franchise activities. By 1979, the

Federal Trade Commission

(FTC) initiated a franchise trade rule requiring disclosure of pertinent
information to prospective franchise owners. Franchising became a
respectable word again, and the practice flourished, aided by the efforts
of early franchisors like Ray Kroc and Dave Thomas.

Ray Kroc, the founder of the highly successful McDonald’s hamburger
chain and one of the paradigmatic franchisors, called franchising the
“updated version of the American Dream.” He established his
franchising operation in 1955, after obtaining exclusive franchise rights
from Dick and Mac McDonald, who started the chain. Kroc went on to
launched a massive franchising campaign and 15 years later the chain
included 1,500 outlets.

Wendy’s founder Dave Thomas believed that McDonald’s
hamburgers were skimpy and decided he could improve the basic hamburger.
In 1968, Thomas received $1.7 million as his share of the sale of four
chicken stores by Hobby House Restaurants, for whom he was a manager. He
invested most of it into a new chain of hamburger stands. By the end of
1972, he had nine outlets with annual sales of $1.8 million. By June 1975,
he opened the 100th Wendy’s restaurant. Less than two years later,
the number jumped to 1,000. In 1978 alone he opened 500 outlets. By 1999
there were well over 5,000 outlets worldwide. Thomas proved that there was
plenty of room in the franchising world.

Franchising grew slowly during the 1940s and 1950s. The majority of the
outlets were placed in the suburbs or along highways as people moved out
of the cities and into rural areas. The now familiar
“strips” lined with franchises started changing
Americans’ eating and shopping habits. Spurred by the success of
the early franchisors, others entered the competition for the
shoppers’ dollars.

Franchise chains in virtually every business category started operations.
Their stores were not always well received, especially in urban areas.
Individuals and community groups protested the arrival of franchises, but
their efforts were generally unsuccessful. Even today, many community
groups and individuals protest the arrival of well-known franchise
outlets—sometimes successfully.

Nonetheless, franchises are active and successful in a wide range of
categories. They exist in lawn, garden, and agricultural supplies and
services, maid and personal services, security services, tools and
hardware, weight control, and many types of food products, including baked
goods, donuts and pastry, popcorn, ice cream, yogurt, and fast foods. As
the economy and consumers’ preferences change, technology advances,
and new products are introduced, existing franchises will likely continue
to grow, change, and innovate in response.

More than 95 percent of the franchise chains in existence today started
operations in the last four decades. Most of them formed between 1965 and
1985. Their growth was phenomenal. For example, Century 21, the real
estate operation, began in 1972 and grew to include 7,400 outlets by 1980.
It took McDonald’s only 25 years to establish its 6,200th store and
the chain boasted of 25,000 outlets by 1999. There is hardly a community
anywhere that does not have at least one franchise operation.

Franchising offers a number of advantages not only to franchisors but also
to franchisees—which helps explain why franchising has been so
successful. Franchisors benefit from these agreements because
they allow companies to expand much more quickly than they could
otherwise. A lack of funds and workers can cause a company to grow slowly.
However, through franchising a company invests very little capital or
labor, because the franchisee supplies both.

A company also can ensure it has competent and highly motivated
owner/managers at each outlet through franchising. Since the owners are
largely responsible for the success of their outlets, they will put a
strong, constant effort to make sure their businesses run smoothly and
prosper. In addition, companies are able to provide franchising rights to
only qualified people. Moreover, franchisors can raise money without
selling shares of their companies through franchising.

Likewise, franchisees reap a variety of benefits from franchising. As
noted previously, the franchisee faces much less risk through franchising
a company, than through starting a business from scratch, according to
many studies. The lower risk is related to other advantages of franchising
that stem from being affiliated with a proven company. The franchisor
generally has had some experience in the field of business and has
national or regional name recognition. Franchisors also provide
franchisees with a proven and efficient method of operation through their
years in the business, with management assistance and training, and with
marketing assistance and advantages. Franchisors usually conduct national
or regional marketing campaigns developed by professional advertising
agencies and they can help franchisees run local ad campaigns, though
franchisees generally must contribute 1-5 percent of their gross profit to
advertising funds. All of these aspects of franchise agreements can
significantly increase the chances of an outlet’s success.

Furthermore, franchisors sometimes help franchisees obtain financing for
their outlets as well as prepare business plans and strategies.
What’s more, if a prospective franchisee needs to borrow money to
help with business-related costs, financial institutions may be more
willing to lend if a well-known franchisor is backing the
applicant—especially if the franchisor is well established, rather
than based on a new concept.

COSTS OF FRANCHISING.

In return for the benefits franchisees receive, they must pay fees and
royalties to the franchisors. The franchise fee may range anywhere from
$5,000 to over $1 million and hence can be a major expenditure. Besides
the franchise fee, franchisees often must pay royalties periodically
during the life of the franchise agreement. Royalty payments are either a
percentage of an outlet’s gross income—usually under 10
percent of an outlet’s gross income—or a fixed fee.

Franchise costs vary to some extent because of costs associated with
different kinds of businesses and with different locations. For example, a
person who wishes to open a franchised employment service operation, such
as Talent Force, based in Atlanta, Georgia, can get away with as little as
a $7,500 fee, plus one year’s starting capital investment of
$50,000 to $110,000. On the other hand, start-up costs for a company like
J.O.B.S., based in Clearwater, Florida, can be as little as $45,000,
including a $30,000 franchise fee.

The costs of these businesses pale in comparison to food franchises. For
example, a Popeye’s Famous Fried Chicken and Biscuits, Inc. outlet
will cost the franchisee a minimum of $200,000—with no financing
assistance available. A franchise at Perkins Restaurants, Operating Co.,
L.P. costs between $959,000 and $1,500,000. An individual’s initial
cash investment would be about $150,000. Initial costs such as these can
present serious obstacles to some people trying to purchase a franchise.

FUNDING THE FRANCHISE.

There are several sources of financial backing for potential franchisees.
Since franchisors do not always offer financial assistance, people rely
primarily on their own funds, family support, and the traditional sources
such as financial institutions, banks, and private investors. The more
money a franchise costs, the harder it is for potential operators to raise
the necessary funds. However, the search does highlight another positive
aspect of franchising: it involves a cadre of specialists (e.g., bankers,
lawyers, and accountants), who earn all or part of their salaries from
their involvement with franchise operations.

For people with limited cash or access to it, franchising may not be the
easiest career path for prospective business operators, then. However, for
many people who have made the investment, franchising has paid off
substantially from both the company and outlet owner standpoint, as
history shows.

OTHER DISADVANTAGES.

In addition to the payment of fees and royalties, franchisees give up some
control over their own businesses, as well as lose their own identity.
Most patrons do not know who owns their local McDonald’s, Burger
King, or MAACO auto body shop. So, many franchise outlet owners are
relegated to anonymity—which can be a drawback.

Franchisees are often subjected to tight supervision by the franchisor.
They cannot pick out their own business name, buy products and services
from whom they choose, or select the location at which they will do
business. In addition, franchisees usually must follow franchisor
guidelines closely and not deviate
from their approach to doing business. Some franchisors control their
outlets so tightly they even tell business operators when to empty their
trash cans, how to dress their employees, where to dispose of food, what
color to paint their fences, etc. As a result, some franchisees are
largely dependent on their franchisors. Moreover, franchisees usually
cannot implement changes without franchisor approval. Hence, if a coffee
house franchise that sells only beverages and pastries notices customer
demand for sandwiches, it cannot offer them without the consent of the
franchisor.

Another problem with franchising is that franchisees may fall victim to
the company’s problems. While a particular business owner may be
doing well, the chain itself may encounter financial problems due to
mismanagement, a failing economy, or any other reason which impacts
operations. This can result in increased fees or royalties or a switch in
suppliers which can lead to reduced quality of goods and services. In
extreme cases, the franchisor can go out of business completely.
Franchisees also enter into 10-15 year agreements with franchisors and in
most cases can get out of the agreement only by selling the business.

A final problem for potential franchisees is how to select the right
company with which to affiliate. As the number of franchisors increases,
the method of choosing which franchise is right for a particular
individual becomes more complex. Obviously, if the would-be franchisee has
certain skills or interests, these are likely to guide this choice. Even
if a potential franchisee knows which type of business to enter, the
selection of a franchisor may pose a challenge.

The person who wants to open a fast-food franchise has to decide what type
of food it will serve: pizza, hamburgers, yogurt, full meals, etc. Other
matters to consider include fees required, royalties, governmental
regulations, and whether the particular business is part of a growing
industry. Such choices are closely tied in to public policy and
governmental regulation today.

Franchising can be broken down roughly into two broad categories: retail
and service. Many of the businesses in both categories are subject to
extensive government regulations today, which can increase both the
franchisors’ and franchisees’ responsibilities and financial
investments. For example, franchisors in personal services, such as water
conditioning and pest control experts, have to be aware of

Environmental Protection Agency

(EPA) regulations governing the use of pesticides and toxic products and
the added costs associated with them. The same holds true for automotive
retail franchises. Questions must be answered regarding where and when
used batteries, replaced oil, rusted mufflers, etc., can be disposed.

These are generally matters to be resolved by the franchisor, but
franchisees must be aware of current and impending local and state laws
before opening their operations.

Governmental involvement in franchising is not new. For instance,
California enacted the first pre-sale franchise disclosure law in 1970.
The law addressed two broad areas: full and accurate pre-sale disclosure
to prospective franchisees of information about the franchisor and the
contract, and the fairness of the contract itself. Several other states
passed similar laws shortly afterward. The first federal law was passed in
1979 under the aegis of the Federal Trade Commission (FTC).

Since many companies operated in several states, it was inevitable that
the federal government would involve itself in franchise regulation. That
became the FTC’s role. The agency requires every franchisor to
provide each potential franchisee with a detailed disclosure document
which protects everyone involved in a possible agreement and this
requirement is known as the Franchise Trade Rule. The required document
contains 20 different categories of information about the franchise and
must be given to prospective franchisees at least ten days prior to
signing a franchise contract. Included is information about required fees,
basic investment, bankruptcy, and the franchisor’s litigation
history. There are also inclusions concerning how long the franchise will
be in effect, the franchisor’s financial statement, and earnings
claims (if they are available). The financial disclosure laws had a major
impact on franchising.

The laws made it clear that franchisors were in business not only to make
a profit, but to supply their clients with services and products that made
their ownership easier. The laws corrected any imbalance in franchise
agreements that were tipped in the franchisors’ favor. Under the
laws, franchisors had to reveal all the information potential franchisees
needed to make a decision on whether or not to open an outlet. The
companies had to reveal how long they had been in business, the number of
unit failures, lawsuits in which they were involved, either currently or
in the past, and supporting information to back up any claims they made
about their operations. This protection stands potential franchisees in
good stead and reduces the potential for fraud on the part of franchisors.

It is imperative to note that the financial disclosure laws do not protect
potential franchisees completely. For instance, the FTC does not certify
any information provided; instead, the individual must verify information
provided by franchisors. Since
Congress authorized the FTC to regulate franchising, franchisees can
submit complaints to the agency. Although the FTC has the ultimate
authority to regulate franchising, the states may impose their own
requirements as long as they are stricter than the federal requirements.
Consequently, some states use the Uniform Franchise Offering Circular
(UFOC) for franchisor information disclosure, which has a few more
requirements than the FTC’s disclosure policy.

The key is that laws exist to protect people interested in franchises,
which is a far cry from the early days of franchising when caveat
emptor—let the buyer beware—was the watch word for
franchisees. Because there was a great deal of risk involved in dealing
with franchisors in those days, there was considerable controversy over
the benefits of franchising. Much of that controversy remains, although it
has changed in focus somewhat.

As successful as franchising has been in the United States, there are
critics who suggest that it has been detrimental to the country’s
economy. One argument is that franchise employees receive low wages. This
is partly because the majority of the workers are part-time employees who
don’t receive any benefits. Because of the low wages and lack of
benefits, franchise owners have a hard time attracting and retaining
quality workers. One of the solutions to this problem would be union
organization. However,

labor unions

in general have lost their power in recent years, so they are more
reluctant than ever to organize franchise workers in deference to focusing
on unionizing larger and more stable employers. Without union
representation, workers may not organize and wages may remain low.

A second criticism is that chains detract from the aesthetics of a
community. They may locate in residential neighborhoods and erect huge
unsightly signs. Some communities have eliminated these problems through
strict zoning laws and other legislation. Often, these laws are
“grandfathered,” which means existing businesses are
unaffected. So, if urban blight is to be eliminated, it will not happen
for years to come.

Opponents of franchises also cite the distribution of franchise revenues.
Much of the money franchisees take in goes to the franchisor. Thus, it is
removed from the local economy. A locally owned firm’s revenues
would stay in the community. But, since chains drive out local owners,
much of a community’s revenues are lost.

Certainly, there are arguments that support the existence of franchises,
too. Regardless of the controversy, franchising has had a major impact on
the American economy, and is impacting foreign countries as well.

The growth of franchising in the United States has been phenomenal. Not
only has it encompassed virtually every aspect of American business, but
it has spread abroad. Canada in particular has proven lucrative for
American franchisors. In fact, it has the second highest number of
franchise outlets in the world. That is due primarily to the common
language and similar culture the two countries share. Canada is by no
means the only target of U.S. franchisors, though.

American companies are expanding their operations into countries as
diverse as the Dominican Republic, Saudi Arabia, and Japan. Ironically,
Japan, even thought it is culturally dissimilar from the United States,
represents a prolific market for American franchisors.

Currently, franchises account for only about 4 percent of all retail sales
in Japan. However, some American franchisors such as 7-Eleven, Inc. have
made large inroads. In fact, a Japanese company, Ito-Yokado Ltd., controls
U.S.-based 7-Eleven, Inc. (formerly Southland Corp.), which is the
franchisor and owner of the 7-Eleven trademark worldwide.
McDonald’s and Toys ‘R’ Us run a joint venture in
Japan. Certainly, not every American franchisor can function well there.
For example, Gymboree, which franchises developmental programs for
preschoolers and their parents, had to turn down Japanese investors due to
a lack of space in which to erect equipment.

Another problem American franchisors faced in Japan was the working
conditions. The concept of part-time work puzzled the Japanese. They are
accustomed to lifelong, full-time employment for which workers receive
adequate wages. So, when Kentucky Fried Chicken entered the Japanese
market, it had to change its wage policy and upgrade working conditions.
Otherwise, the company would not have survived. Other companies have faced
similar problems in Japan and elsewhere, but they have overcome them,
survived, and grown.

Occasional setbacks aside, American franchisors are moving ahead
aggressively to gain a toehold in other countries. Century 21, for
example, has established franchises in Canada, France, Japan, and the
United Kingdom. Jani-King International, Inc., a commercial janitorial
company, has operations in Canada, Japan, Australia, and the United
Kingdom. Hardee’s Food Systems has outlets in Costa Rica, the
Netherlands Antilles, Singapore, Korea, Japan, Thailand, and Hong Kong.
There is apparently no geographical limit to where franchisors
can—or will—go.

Based on the success companies have enjoyed since the franchising boom
began in the 1950s, the future of franchising is positive. The U.S.
Department of Commerce predicts that slower population growth, population
shifts to new metropolitan areas, and the introduction of new technology
will create new opportunities for franchises. Mergers and acquisitions
will increase as larger franchisors take over smaller ones. Schools and
universities are adding franchising studies to their business curricula.
These factors, combined with the low rate of franchise failure, stability
in the industry, and a considerable return on everybody’s
investment, have made franchising a major force in the American economy to
this point. Some of the emerging franchise businesses expected to drive
the growth of franchising tend to offer customers added convenience such
as to-the-door services offering everything from dry cleaning and pet care
to window coverings and furniture repair, according to

Nation’s Business.

In addition,

Nation’s Business

reported that other franchise trends of the future will include education
and training businesses, second-hand merchandise stores, office support
services, and health service providers.