How do franchise arrangements work?
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Franchising

Latest update: Nov. 4, 2021

Franchising is a business model whereby a trademark, concept or product is used or distributed by an independent company in exchange for payment of a fee to its owner.

Franchising as a business model was developed in the USA in the mid 19th century and as a result some of the terminology used, even in Sweden, continues to be in English. While an investigation into franchising in fact recommended Swedish terminology for franchising, the word franchise was considered, similar to leasing and factoring, to be so well known and accepted that no Swedish wording for franchising was defined. The English wording therefore continues to be used in the Swedish language.

When a company grows, both nationally and internationally, a certain point in its growth can occur where demand for its products or services is greater than that its capital and staff can fulfil. Franchising is a proven method of enabling quick growth and increased revenues without the need for increased capital or a larger organisation.

When properly structured, franchising is a strong business model which creates a lasting and profitable partnership between the franchisor and the franchisee, to the benefit of both. Franchising is a commonly used business model, although few are fully knowledgeable of the details.

We will shortly explain what franchising is, the different set-ups, the importance of choosing the right set-up and some of the legal challenges.

What is franchising?

A franchisor is the owner of that which will be the subject of the franchise agreement.

A franchisee is that who is granted, and has, the right to use that owned by the franchisor.

In a franchise arrangement, the franchisor gives the franchisee the right to, in return for a fee, use the trademark, the business concept or product the franchisor owns. In addition to the fee, the franchisor often also pays an upfront fee to the franchisor in order to be a part of and use the business concept and the trademark.

Franchising gives the opportunity to grow a business without the need for the franchisor to invest itself.

Structure and strategy

Certain franchise set-ups are better suited to certain types of business. It is therefore important to consider the aspired outcome in order to determine which route to take. Within franchising and similar business models, we mainly see the following variations.

Master Franchising 

In a Master Franchise arrangement, the franchisor gives the right to a master franchisee to run the business concept himself or the he can in turn give the right to run the business concept to subcontractors. This right is often limited to a geographical area where the franchisee is the only one allowed to conduct business. This means that the master franchisee takes over roles, obligations and rights on a defined, often large, market.

Direct franchising 

In a Direct Franchise arrangement, the franchisor gives the franchisee a right to operate the business concept. Like Master Franchising, the right is often limited to a geographical area where the franchisee is the only one who conducts business, however, here the franchisee may not let a subcontractor conduct the business concept. The franchisor keeps the control over the business concept. This approach may be appropriate when the franchisor himself wants a relationship with the franchisee or when the business concept is not suitable for creating several units.

(Multi-unit) Franchise development 

In a Franchise Development approach, the franchisor gives the right to a franchise developer to penetrate a certain area by opening physical units and conducting business within the same area. It's like a Direct Franchising with a defined growth. In Direct Franchising, the franchisee usually operates one operating unit, while a Franchise Development approach operates several operating units. Here, too, the franchisor retains control of the business concept. This can be done by either entering into an agreement that specifies both the construction of premises and conditions for conducting the business or through two agreements where contract terms for premises are in one agreement and conditions for the business' achievement are in another.

Joint ventures (‘JV’) or subordinated equity

Many are familiar with the term ‘joint venture’ or ‘JV’, which refers to a business arrangement whereby 2 businesses work together to reach a common goal. JVs are commonly short lived and often used to secure presence in a particular market. A subordinated equity is however not as common and involves a franchisee giving a franchisor the right to establish the franchisor’s business model, product or trademark on a particular market with a clear understanding that the franchisor may re-purchase the business at a price that the parties have agreed to in advance, often determined through a formula.

There is much to say about these 2 business arrangements. What is important in both cases is to consider the arrangement carefully to ensure that the intended objective can be reached. This is because it can easily be incorrect and often complicated.

Keep in mind

Regardless of the chosen arrangement, additional points will also need to be considered. Take for example the case where a franchisor has significant capital and a large work force experienced in franchising – in this case, direct franchising may be a safe and cost-effective choice and arrangement. On the other hand, where the potential franchisor has limited resources, a master franchise set-up may be a better choice. In a JV, the commitment needed is greater than in a subordinate equity set-up where the commitment will be to protect the trademark and conduct quality follow-ups.

Building blocks of franchising?

A franchise set-up is simply built on some strong fundamentals.

Business concept

Central in a franchise set-up is a proven, profitable and documented business concept that is continuously updated. In a franchise set-up, should a franchisee notice a fault, the franchisor will be notified and correct the fault in the business concept. The fault will therefore not be repeated. This results in continuous improvements to the business concept.

The business concept generates profitability for both the franchisor and the franchisee. The success of the franchisee is based on its use of the franchisors business concept which generates it a profit. In order to use the business concept, the franchisee pays a fee to the franchisor. The fee is often based on the turnover of the franchisee. Given this, it is in the common interest of both parties that the business and the arrangement is successful.

Documentation – the franchise manual – describes how the business concept should be operated. This is the crown jewel of the business and what makes the business run in a similar manner regardless of the franchise holder.

Use of a common trademark

Intangible assets can be of significant value. The opportunity for a business to use an established trademark allows it to kick off and begin it’s operations in a position which would in many cases take years to establish.  This is what often makes entrepreneurs so willing to invest their capital into operating a business such as a franchise.

Training 

As previously mentioned, the business concept, product or trademark that is part of the franchise is proven. The franchisor has spent time and resources ensuring that that to which the right is given actually works. Given that the franchisee will operate the business entirely in accordance with the instructions of the franchisor, training as to how the business should be operated is an essential building block.

Follow-up

It is crucial that a franchisor follows up that the franchise manual is being followed and that the franchise manual is linked to the franchise agreement. A franchisor, as a trademark owner, must be able to respond and act should the franchisee act in a manner than could damage the trademark and the franchisor, regular follow-ups will allow it to do so. As such, follow-ups should be of a reoccurring nature.

Legal challenges

Regardless of the chosen set-up, the legal and regulatory requirements should always be identified at an early stage.

Intellectual property

If international expansion is the intention of the arrangement, rights in and protection of intellectual property such as trademarks, patents and designs should be obtained on those markets which are intended to be expanded to. In addition, domain names should be secured, and social media accounts obtained. While these are costly actions, the costs involved in handling counterfeits, copies, cyber-attacks or lawsuits can quickly surpass those for preventing their occurrence. It is strongly recommended to begin with a documented trademark strategy or intellectual property strategy.

Confidentiality, contracts, laws and rules 

Significant amounts of information will be undoubtedly shared between a franchisor and a franchisee before any form of franchise contract is entered between them. Information should, however, never be shared before a solid confidentiality agreement is signed.

The franchise manual is the core of franchising. It is a handbook to the franchise to which a right is given and to securing that the business is operated in a similar manner regardless of where it is established. The franchise manual should never be shared or shown to a potential franchisee before, at a minimum, a confidentiality agreement has been signed and at best, before a franchise contract has been signed. Given that it is the franchisors trademark(s) that generates costs until the point where the franchise contract has been signed, it should be ensured that the franchisee pays an amount to the franchisor upon signature of the franchise contract.

There are pieces of legislation that governs the content of a contract for a franchise. In some countries these can be very onerous and in others less so. It is therefore important to consider where to establish and that the applicable laws and regulatory demands are fulfilled.

For example, within the EU competition law framework there exists a number of rules which are hugely important to comply to such as those on pricing and rules concerning advertising.

Policies regarding e-commerce and the internet are also of importance. What is applicable to the particular business? Are sales between businesses or between a business and a consumer? These two forms of sales and the rules surrounding them vary hugely. In addition, there are rules on geo-blocking, online platforms and more to comply with.

Conclusion

After careful planning and consideration as to the best strategy for the business in question, a business arrangement with relatively low risk and high profitability can be rolled out. It is however of great importance to surround oneself in such a situation with experienced advisors with previous experience with franchising and even international compliance. That is us.

There is much more to say about franchising, if you are interested be sure to reach out to us.