What is a Franchise? Franchising and How it Works

By Michael Seid, Managing Director, MSA Worldwide

Put aside the legal definition of franchising and the requirements of offering a franchise. From a legal point of view, all a franchise is, is a defined type of license. At its core, though, franchising is about the relationship the franchisor has with its franchisees. The franchisor licenses its trade name and its operating methods (its system of doing business) to a franchisee; the franchisee agrees, as part of the bargain, to operate their business according to the terms of the license.

The franchisor provides the franchisee with support, and exercises some control over some elements of the franchisee’s operations necessary to protect its intellectual property and ensure that the franchisee is adhering to its brand guidelines. In exchange, the franchisee usually pays the franchisor franchise fees: a one-time initial fee (franchise fee) and a continuing fee (royalty fee) for the use of the franchisor’s trade name and operating methods.

The franchisor has little or no role in the day-to-day management of the franchisee’s business, because the franchisee is an independent operator and not joint-employers with the franchisor.
For this reason, while the franchisor may provide some guidance and information on human resources best practices, the franchisee is free to hire, compensate, schedule, set employment standards and practices, and discipline their staff without any input from the franchisor.
While uniforms and the like are part of the system’s brand standards, the rate of pay or the hours scheduled are not.

Franchising is simply a system for expanding a business and distributing goods and services, and is based on a relationship between the brand owner and the local operator to skillfully and successfully expand. It’s a contractual relationship, and while both the franchisor and franchisees share a common brand, each is in a different business in a legal and practical sense. The franchisor’s job is to expand its business and support its franchisees; the franchisee’s job is to manage and operate their business to the terms of the agreements.

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When is a license a franchise?

While every franchise is a license, not every license is a franchise under the law. In the United States a license becomes a franchise when three specific elements are in place:

The franchisee’s business is substantially associated with the franchisor’s trademark;
The franchisee pays an initial and/or continuing fee for the right to enter and remain in the business; and
The franchisor exercises control or provides assistance to the franchisee.

It is important when analyzing your business – and whether or not it is a franchise – that you don’t simply rely on the federal definition. The definition of a franchise can vary significantly under the laws in some states, and may include other definitional elements including, but not limited to, the franchisor providing a marketing plan or maintaining a community of interest with the franchisee.

Most experienced and competent franchise lawyers or consultants can help you determine whether or not you need to franchise. Interestingly, because care is not always taken in selecting the right lawyers or consultants, in our practice at MSA we have come across many business over the years that either never needed to franchise to expand, or expanded without meeting the requirements of the franchise laws. Both are costly and unnecessary mistakes to make.

The Federal Trade Commission’s definition of a franchise is provided in Section 436.1(h) of the Franchise Rule as follows:

A “Franchise means any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify, or the franchise seller promises or represents, orally or in writing, that:

(1) The franchisee will obtain the right to operate a business that is identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark;

(2) The franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and

(3) As a condition of obtaining or commencing operation of the franchise, the franchisee makes a requirement payment or commits to make a required payment to the franchisor or its affiliate.”

Under a Business Format Franchise, the type of franchising most identifiable to the average person, the franchise relationship generally includes the entire business format and not simply the franchisor’s trade name, products and services. The franchisor generally provides operating manuals, training, brand standards, quality control, a marketing strategy, etc. For instance, McDonald’s doesn’t franchise hamburgers, and Jiffy Lube doesn’t franchise oil changes: both companies license their intellectual property including their marks and business systems. As you can see from the history of both brands, their products and services have dramatically changed over the years and one of the benefits of a business format franchise is that they can.

There are many types of franchises in an ever-growing range of industries. It’s estimated that over 120 different industries use franchising. Restaurants and food offerings still make up the largest part, but today franchising is even used in home health care and for medical services.

The Power of the Franchisor’s Brand

A franchisor’s brand is its most valuable asset. Customers decide which business to shop at and how often to frequent that business based on what they know, or think that they know, about the brand. Consumers really don’t care who owns the assets of the business; they are simply looking to obtain the products and services the brand is known for. Franchising allows “formula entrepreneurs” to operate a business under identified brands and, when working with a great franchisor, franchisees receive the tools and support they need to live up to system standards and ensure customer satisfaction.

Consistent execution to brand standards is expected in each location, regardless of whether the location is company-owned or franchisee-owned. Franchisors invest a lot of time, energy, and financial resources in developing and supporting their brands: in the consumer’s mind, a franchisor’s brand equals the company’s reputation.

Great franchisors enforce system standards with franchisees because they want to ensure that that customers are satisfied each and every time they shop at a franchised location, and to protect the equity of the other franchisees sharing the brand. Franchisors provide not only the menu of established products and services, but also an operational system and brand that are already in place. In great franchise systems, franchisor and franchisee work together for mutual success.