What is a franchise and how does it work?

By Sarah Stowe | 05 Apr 2019 View comments

What is a franchise? Every franchise model may be different, but each operates on similar principles. It’s important to understand the foundations of franchising before setting out to buy a franchise.

Franchising is a well-established practice. An existing business allows other individuals to profit from the success of the original concept. It’s doubtful that the man credited with setting up the first franchise, sewing machine distributor Isaac Singer, would have imagined his idea would achieve such a global presence nearly 100 years later.

Franchising is a method of doing business that incorporates diverse business models across almost every conceivable industry, from the traditional to the up-and-coming, from the high-profile food retail chains to studio gyms, from lawn mowing to drones, from commercial cleaning to business advisory boards, from early learning to aged care, from IT to robotic dessert dispensers.

McDonald’s is probably the most famous business format franchise – a perfect example of a business that grew exponentially once Ray Krock introduced the systems and consistency that mark a solid franchise.

What is a franchise?

A franchise has to have two main ingredients: the franchisor who owns the rights to the brand and the systems employed to run the business; and the franchisee, who buys the rights to operate under the brand and use the systems.

The franchisee usually signs up to run the business for a set period of time.

Both the franchisor and franchisee can be an individual or group of individuals.

6 vital points you need to know

1. A franchise is not a licence

While the franchisor is effectively licensing the rights to a third party, franchising is more stringent than a licence or distribution model.

2. Why businesses franchise

Franchisors are looking for franchisees to replicate the business they have established, and are likely to use the capital injection from new franchisees to help support the existing businesses and expand the network of franchisees.

3. What a franchisee buys

A franchisee is purchasing the rights to operate a business, and the details of compliance will be outlined in a franchise agreement. While the franchisee runs the business according to the particular rules set out, this is likely to be for a term – often five years. There may then be the opportunity to renew the contract, or to exit from the business. On exiting, the franchisee has no further rights over the branded business and will be expected to vacate any premises it occupies under the franchise name.

4. How a franchisee makes money

There are two ways a franchisee can get a return on their investment: firstly, by making enough money to put aside profits as the business is operating; secondly, by selling the business and getting a big capital gain at the end.

Of course a good ROI is dependent on the purchase price of the business, ongoing costs and the final sale. Franchising offers no guarantees for profitability.

5. What are the fees?

The franchisor has taken the risk to trial a business concept so will charge an initial fee and ongoing royalty fees and marketing levies for the rights to operate and for head office support.

Regular fees are likely to be paid monthly. There are rules around marketing fees, which dictate the funds must be used to advertise and promote the brand. Franchisees can expect to pay for their own local area marketing.

6. The rules around franchising

Every franchise in Australia, whether it is headquartered here or is an overseas brand, comes under the jurisdiction of the Franchising Code of Conduct.

This code outlines important rights for the franchisee, and sets out processes to deal with disputes, and renewing and ending a franchise agreement.

 

Do you want to read more about franchising basics? Read 5 pros and cons of franchising and 6 things to do before buying a franchise.