If you’re thinking about going into business, there's a good chance you've thought about franchising as an option. After all, there are currently over 700,000 franchises open in the U.S. Still, you may be wondering, “How does a franchise work?”
In this guide, we’ll outline everything you need to know about the franchise business model so you can decide if becoming a franchise business owner is the right career move for you.
How Does a Franchise Work? Understanding the Franchise Structure...
When you buy a franchise, you pay a franchise fee and become a franchisee. As the franchisee, you lock yourself into an agreement with the franchisor, the company allowing you to open a branch of its business. A franchisor also provides the materials you need to run your business.
Once you’ve paid, you receive a license to own, operate, and profit from the franchise. You must also sign a contract called a franchise agreement that dictates the terms of your relationship with the franchisor. You agree to contractual obligations and franchisor controls, which define your responsibilities and expectations as the franchise business owner.
Here’s a breakdown of the franchise business model.
Franchise Fees and Expenses
Opening a franchise isn’t cheap. There are a number of costs, which include the following:
- Franchise fee: A one-time initial fee that typically ranges between $20,000-$50,000, depending on the franchise.
- Royalty payments: Depending on the terms in your franchise agreement, you’ll typically pay either monthly or quarterly royalty fees based on your gross sales. The industry average is between 4%-5% of your gross sales, but it varies by franchise industry.
- Advertising fees: Not all franchises charge advertising fees, but if they do, these expenses usually hover around 1%-4% of your monthly gross sales.
As the franchisee, you sign an agreement that dictates how, where, and when you conduct business. Here are a few contractual controls typically granted to the franchisor:
- Franchise location: Many franchises conduct extensive site research to ensure a specific location is good for business.
- Design and logo: Your franchise’s appearance and design must be consistent with other locations. As the business owner, you must also pay for design renovations when needed.
- Goods and services sold: The goods or services sold at your franchise are determined by the franchisor. For example, if you run a food franchise, such as Subway, the menu items are determined by the franchisor.
- Method of operation: Everything from your business hours to where you source your goods are dictated by the franchise.
Your franchise agreement concludes at the time specified in your contract. However, the franchisor may terminate your agreement early in special cases. Here’s what you need to know:
Your franchisor can terminate your agreement for a number of reasons. For example, if you fail to meet certain performance standards or miss too many royalty payments, they have the right to end your contract. In some cases, you can “cure” your mishaps by demonstrating good behavior going forward, but the matter will vary case by case.
When your contract comes to a close, you may (or may not) have the opportunity to renew. It’s the franchisor’s call. If they decide to renew, there’s also no guarantee you’ll have the same terms as your last agreement. They have the right to restructure your agreement as they see fit.
Potential for Earnings for Franchise Owners
When considering a franchise, you want to know how much money you can make. However, franchisors aren’t required by law to share exact sales or income figures.
Some franchisors only share the earning averages of their establishments before expenses are deducted. According to some reports, the average franchise owner rakes in $60,000 a year.
To know exactly what payments you’re liable for and how much you can potentially make, be sure to get a Franchise Disclosure Document (FDD) from your franchisor.
Specifically, there are four items in the FDD that you’ll want to carefully review:
Item 5 discusses the “Initial Fee” you pay to the franchisor. This includes all upfront fees you must pay before opening your location for business.
Item 6 explains other fees you must pay, such as royalties, advertising fees, training charges, bookkeeping costs, late fees, and more.
Item 7 is the “Estimate Initial Investment,” and details what expenditures you incur within the first few months of opening and operating your business. These fees usually include rent, costs for furniture, equipment, utility charges, and more.
Item 19 contains the franchise’s earnings claims, also known as financial performance representations (FPR). Financial disclosures aren’t required by law, and are often omitted due to the legal liability of a claim. However, more franchises are starting to include financial disclosures in their FDD.
According to Franchise Direct, here’s what you may find in the FPR:
- Average gross sales for a combined number of units
- Adjusted gross sales for individual units
- Store sales breakdowns by square footage
- Cost breakdowns of goods, labor, leases, etc.
The figures found in item 19 can give you an accurate idea of your profitability potential as a franchise. From there, consider the startup costs mentioned in items five, six, and seven to get the full financial picture of running a franchise. Doing so will also give you an idea of your take-home pay after royalties and other business costs (like payroll) are factored in.
Is a Franchise Right for You?
Now that you know how a franchise works and what goes into running one, it’s time to answer the question: Is owning a franchise right for you?
Calculate Your Investment
Purchasing a franchise is no small endeavor. It requires a large upfront investment. Should things go poorly, you could potentially lose your investment and be back at square one.
Your franchise might also not take off as you had hoped, which means you’ll be stuck with it unless you decide to sell it back to the franchisor. The risk factor comes with the territory, which is part of the excitement for some entrepreneurs.
Determine the Growth Potential
You’ll want to make sure you’re investing in a growing, successful franchise. International chains, for instance, have proven systems and business plans that work time and again. A fledgling local franchise, though, may experience success for a limited time before declining. Be sure to assess the franchise by its profitability and record of growth.
Evaluate Your Abilities and Interests
Some franchise opportunities require a high level of technical expertise or education. Are you there yet, or will it require a large time commitment on your end before opening your business? At the same time, is the business a good fit for you?
For instance, if you have a background in the restaurant industry and love hospitality, opening an automotive franchise probably wouldn’t be the best fit. It’s essential to choose a business that aligns with your personal interests and experience.
Be Clear about Your Goals
Think about your long-term career goals and job satisfaction. Do you genuinely like the franchise and look forward to devoting a significant amount of your time and energy to it? Or are you someone who’d rather start something from scratch without having to report to a superior?
While franchises can offer a sense of stability, they don’t give you the freedom of being your own boss.
Consider the Risks Before Moving Forward
Opening a franchise can be risky. That’s why it’s essential to understand how they operate and what’s expected of you as a franchisee. If you have an entrepreneurial spirit but want to minimize the risk and uncertainty associated with becoming a business owner, then a franchise isn’t the only option.
With Main Street, you can start your own business with less upfront costs and better systems and technology than a franchise. Plus, Main Street provides a clearer and more proven path than going it alone. If running your own small business is your dream, then consider starting one with Main Street.