What Is a Franchise? The Definition and History of Franchising
In short, a franchise is a legal and business relationship. When someone franchises their business, they legally authorize another individual to open up new locations of their business to sell a product or provide services according to the terms of an agreement. That relationship is regulated by state and federal laws.
In this article, we dive into what franchising is and how it’s regulated, as well as explore the past and present of franchises.
What is franchising and how does it work?
In franchising, a business owner — known as the franchisor — authorizes another individual — known as the franchisee — to open new locations of their business using their trademarks and following their requirements, training and systems. The franchisee then oversees the day-to-day operations of that location independently according to the franchisor’s model.
In exchange for getting to use a franchisor’s brand and resources, the franchisee pays fees, including an initial franchise fee and ongoing royalties. Aside from this income, a franchisor benefits by expanding the reach of their brand and the markets they serve.
Charles Internicola, Franchise Counsel for Growing Brands at Internicola Law Firm, explains that opportunities for franchising typically arise organically when someone is successful in their business. “The way franchising comes about is when a business owner like yourself sets up a successful business, you’re achieving good results and people come to you [asking], ‘Hey, how have you done it? Can I open up a location like yours?’ So it’s that relationship. What follows next is, sure I’ll train you, I’ll let you use my name and you pay me some fees.”
How franchises are regulated
In order to franchise your business, you must comply with state and federal franchise laws. The federal franchise law that governs all franchising in the U.S. is the Federal Franchise Rule, which is enforced by the Federal Trade Commission (FTC). There are also state franchise laws, rules and regulations that each state may enact; if a state opts not to enact these laws, then only the federal franchise rules will apply in that state.
The main requirement of franchise law is issuing a franchise disclosure document, or an FDD. Before you can sell a franchise, you must issue an FDD, disclose it to potential franchisees and register or file the FDD in the states that require FDD registration, known as the Franchise Registration States.
In general, a franchise relationship is based on a written or verbal agreement. This agreement typically involves the following parts:
- The license of a trademark: This gives the franchisee the permission to use the franchisor’s brand or name.
- The payment of a fee: This payment, made to the franchisor, can be for training, the right to use the franchisor’s name or the right to open up a new location.
- A degree of control: This stipulates certain standards, such as which products can be sold or the quality of services and products provided.
If you meet all of the above requirements, it’s likely you have established a franchise relationship, triggering franchise law.
The history of franchises
Franchising dates back as early as the 1500s and 1600s in Europe. In the United States, the first modern franchisor is considered to be Martha Matilda Harper, who started to franchise her hair salon business, the Harper Method Shops, in 1891. However, elements of the franchise have been noted as early as 1731, when Benjamin Franklin and Thomas Whitmarsh entered into an agreement for printing businesses.
Franchising really began to take off around the start of the 20th century, as the Industrial Revolution created opportunities for growth. In particular, franchising took hold in the automotive, manufacturing and beverage businesses, as shown in the timeline below that highlights some key dates in the growth of franchising in the U.S.:
- 1898: General Motors issued its first franchise to William Metzger of Detroit.
- 1901: Coca-Cola sold its first franchise to the Georgia Coca-Cola Bottling Company.
- 1909: The Western Auto franchise was established, marking one of the first times business-related services like training and marketing help were offered in addition to brand and the supply of product.
- 1924: A&W Root Beer entered into franchising.
- 1925: Hertz started to franchise.
- 1946: The federal Lanham (Trademark) Act was enacted by Congressing, offering a national system of trademark protection and allowing property owners to enter into licenses with third parties in a safe manner.
- 1960: The trade organization International Franchise Association was founded to serve the franchising community.
Over the next few decades, many notable brands began to franchise, including Kentucky Fried Chicken, Carvel, Dunkin Donuts, Burger King and McDonald’s. As branded goods and service chains grew throughout the 1950s and 1960s, so did franchising.
Examples of franchises today
Today, there are more than 770,000 franchises in the U.S., and over 8.4 million people employed by franchise establishments, per Statista, a provider of market and consumer data.
Franchises span a wide range of industries, with some of the largest being limited and full-service restaurants, gas stations, hotels and motels and new car dealers, per Census Bureau data. According to Franchise Direct’s rankings, which are based on factors like sales revenue, number of locations, years franchising and others, the top 15 global franchises in 2021 are:
- Burger King
- Ace Hardware Corporation
- Century 21
- Papa John’s
- Taco Bell
- Pizza Hut
- Tim Hortons
What are the advantages of franchising?
Franchising can offer a number of benefits, both to franchisors and franchisees. “The goal of franchising — if it’s done correctly — is a win-win relationship,” Internicola says. “A win for you as franchisor — you’re expanding the reach of your brand and you’re monetizing all the good things you created with your business — and for the franchisee, who can successfully set up and establish their new locations.”
Benefits for franchisors
- Grow your market share and geographical reach: With franchising, business owners have the chance to expand the reach of their brand as franchisors invest their own capital and time to open new locations, potentially in new service territories.
- Achieve economies of scale: Through franchising, business owners can achieve economies of scale, securing better purchasing power, vendor relationships and revenue.
- Receive regular royalty payments: In addition to the initial franchise license fees, franchisors will also earn regular royalty payments from their franchisees in exchange for allowing them to use their brand and systems.
Benefits for franchisees
- Market-tested brands and products: Franchisees are opening a business with a known brand and an existing customer base, which means they don’t have to build that up from scratch themselves.
- Model to follow for running a successful business: The franchisee will receive knowledge and guidance from the franchisor, who has already determined the systems and practices of running a successful business.
- Support and training from franchisor: Some franchisees may benefit from ongoing support from the franchisor, such as training, marketing or financial planning.
How does a franchisor earn money?
As a franchisor, you grow new revenue streams consisting of initial franchise fees, ongoing royalties, and other system generated revenues.
Are there any risks to franchising?
Though there is the potential for franchising to be a win-win relationship, few business propositions are without any risk. Potential disadvantages for franchisors include ensuring you comply with franchise laws, reduced control of their business locations, the sharing of profits and the time and cost of franchising your business. Franchisees, meanwhile, face the risk of financial losses if their franchise location doesn’t pan out.
What’s the difference between licensing versus franchising?
The main difference between licensing and franchising comes down to the scope of the legal relationship. Licensing is a limited relationship in which only the use of the trademark or technology is licensed. With franchising, the relationship is far more extensive, allowing for the use of a business’ entire system and brand in order to expand the business.
Are there different types of franchising?
Yes, there are two different types of franchising. The most common type – and what we refer to throughout this article – is known as Business Format Franchising. In this type of franchising, the franchisor provides a full system for operating the business alongside the brands, products and services.
The other, less popular type of franchising is traditional or product distribution franchising, where the franchisee can distribute the product under the brand but typically does not get a system under which to run the business.