In brief - Franchising presents both opportunities and risks

A franchise should provide a comprehensive and virtually foolproof business model - however, problems can arise when the financial modelling underpinning the system is flawed.

What is franchising?

There are different types of franchise structures, including (as identified by the Franchise Council of Australia) product and trade-name franchises, where franchisees distribute a manufacturer's product within a specified territory or at a specific location, usually with the use of the manufacturer's identifying name or trademark.

However, the most common form of franchising is business format franchising, in which a franchisor provides franchisees with a format or system for the conduct of a business.

Franchise business vs. standalone business

The rationale for business format franchising is that consumers are attracted to franchise businesses more than others, because they have a highly appealing brand supported by successful, centralised marketing and because consumers prefer the consistent presentation, standard and quality of the offering created by the franchise system. For example, McDonald's is a household name because of marketing and one can expect a McDonald's burger to be the same, everywhere.

There is a compelling logic to business format franchising. Ideally, the system should provide a comprehensive business model. This includes the product or service, branding, marketing, business and strategic planning, operational standards, systems and formats, training and quality control, as well as ongoing guidance and supervision. The franchisee should have clear rules to follow for the appearance, image and quality of the goods or services to be supplied, as well as the selection of the premises.

The idea is that franchisees who have such a system to support them will perform better than if they operated on a standalone basis. Anyone should be able to operate the business with little previous experience and the franchisee should benefit from the knowledge and experience of the franchisor. A good franchise should also enable the franchisee to achieve supply and procurement efficiencies it would not get on its own. At least that's the theory.

From the franchisor's perspective, the benefit is the ability to expand its business while reducing both the capital it requires and the business risk.

Legal aspects of franchising

From a legal perspective, the franchisor licenses intellectual property to franchisees, often to be used only in a specific area or place, consisting usually of a common trade mark (e.g. KFC), technology in some cases and access to confidential know-how concerning the business system. An example is the specialised equipment and process whereby franchised fast food kitchens are run to handle high volume, without compromising quality or consistency.

Intellectual property can include technical know-how, management expertise, trade marks, domain names, operations and procedures manuals, knowledge of customer and supplier networks and in some cases, patents.

On a practical level, the relationship between the franchisor and franchisee is created by a commercial contract, which is usually heavily weighted in favour of the franchisor so that it can protect the value and integrity of its intellectual property. Arguably, this protects "good" franchisees from "bad" ones who may devalue the brand.

What are the disadvantages of franchising?

Franchise relationships are unbalanced. As a result, business format franchisees don't have much discretion in how they run their business. And when things go wrong, it can be difficult for the franchisee to resist legal steps by the franchisor to terminate the relationship and recoup its losses.

Secondly, franchises usually entail an upfront cost to the franchisee and ongoing royalties, over and above the cost of running the business. Furthermore, franchises are often for fixed periods, limiting the time available for the franchisee to obtain the desired return on its investment. We have seen this problem arise even in some of the blue-chip franchises operating in Australia.

However, most problems arise either when franchisors do not have systems strong enough to deliver on their promises or the franchisees' expectations, or the financial modelling underpinning the system is flawed because revenue and cost assumptions are wrong and the fees are too high. This problem is more acute in newer franchise systems.

Should you take the plunge?

Business format franchising is a great way to run a business and should be considered an attractive way to expand an existing business as a franchisor or to enter a market as a franchisee.

However, the franchise offering must be right. Franchisors who are sensitive to the market, who continuously innovate and who actively develop and protect their intellectual property are more likely to be successful. As a potential franchisor, you have an interest in ensuring the success of your franchisees.

As a potential franchisee, the key to avoiding a costly mistake is due diligence. Generally speaking, the more mature the franchise system, the lower the risk, but due diligence is still critical to making the right decision. Mature franchises generally demand a higher entry and ongoing cost to the franchisee, which has to be balanced against the advantage of trading under a well-established brand.

If you are considering becoming a franchisee, you should read and understand the franchisor's disclosure document, test the financial model, speak to other franchisees and ensure that the franchise agreement goes no further than necessary to protect the integrity of the franchise system. In other words, professional advice is absolutely indispensable.

This is commentary published by Colin Biggers & Paisley for general information purposes only. This should not be relied on as specific advice. You should seek your own legal and other advice for any question, or for any specific situation or proposal, before making any final decision. The content also is subject to change. A person listed may not be admitted as a lawyer in all States and Territories. © Colin Biggers & Paisley, Australia 2024.

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