What is a franchise and how does it work?

By Sarah Stowe | 29 Oct 2015 View comments

A franchise is a way of structuring a business. Generally, it involves the owner of a business (known as the franchisor) licensing to a third party (known as the franchisee) the right to operate a business or distribute goods and/or services using the franchisor’s business name and systems (which varies depending on the franchisor) for an agreed period of time, in return for a fee. 

The franchise fee may be an upfront payment by the franchisee to the franchisor, an ongoing fee (e.g. an agreed percentage of revenue or profit) or a combination of the two. Franchising is an alternative to the franchisor building a chain of stores.

Franchising has grown rapidly in Australia in recent years, particularly in the small business sector. Annual revenue from franchising exceeds $100 billion and franchises employ over 500,000 people.

Its success can be attributed to the fact that franchising provides incentives to both franchisors and franchisees, as they both share in the success of the business operated by the franchisee.

WHY WOULD YOU BUY A FRANCHSE?

There are many reasons why someone would buy a franchise. For example:

  • There are incentives to the franchisee in owning and operating its own business. Monetary rewards are directly related to the efforts of the franchisee.
  • In some respects, it is easier for the franchisee than starting up their own business. A franchise should have a brand that is well established.
  • In Australia, franchises are regulated by the Franchising Code of Conduct, which is administered by the ACCC. This provides legal protections to franchisees, in particular it requires the franchisor to make disclosures to prospective franchisees (e.g. financial information) and allows a franchisee to change its mind and walk away within seven days of signing the initial franchise agreement.
  • The franchisor generally provides assistance in identifying suitable business locations, which should minimise the risk of the franchise not operating successfully, and setting up so that it is ready to open for business.
  • The term can be flexible, it could be as short as one year or have no fixed term and last forever.
  • The franchisor generally provides ongoing support, training and knowledge (including of their past mistakes). This may be specific to their business model or general business training in areas like marketing, merchandising and accounting.
  • Buying one is generally cheaper than starting your own business.
  • If the franchise sells goods, the purchase price of the franchisee is generally cheaper than if it were a stand-alone business as the franchisor should have access to bulk discounts.
  • The franchisee indirectly benefits from advertising by other franchisees.
  • Franchisees may be protected from competition (certainly within the group), depending on the terms of their agreement. 

THINGS TO CONSIDER

When conducting due diligence, make sure you address the following: 

  • The franchisor may impose restrictions as to how their business may be operated.
  • You have to abide by your agreement, which could include onerous terms. Review it carefully, and if necessary seek legal advice.
  • The franchisee generally has to make ongoing payments to the franchisor. This is an important issue for small business, particularly during the early stages of operations.
  • You may have to make an upfront payment to the franchisor, with no guarantee of success and no refund. How do you assess the likely prospects of a franchise? If you receive information from the franchisor about past successes, how do you know it’s true? It can be difficult.
  • What happens if the franchisor goes bust? This is always a risk.