In this lesson. you’ll learn about franchising, a common entrepreneurial strategy in which an individual manages his or her own location of a larger company – with strings attached. After the lesson, you can test your understanding with a short quiz.

What Is Franchising?

Some entrepreneurs are ready to take an idea, build a business, find their own financing, and take the risk of starting with very little and hopefully building a successful venture. Others want the opportunity to be their own boss, but aren’t excited about blazing their own trail. For these more risk-adverse entrepreneurs, franchising may be just what they are looking for.

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Franchising is a business model wherein an individual operates their own location of a larger, more established company. For example, when you go to your local McDonald’s, Subway, Dunkin’ Donuts, or nearly any hotel in the United States, you are most likely at a franchise location.

Franchising Relationships

A franchise is an agreement between two business partners: the franchisee and the franchisor. The franchisee is the entrepreneur that is going to buy the franchise from the larger company, also known as the franchisor. When a franchisee buys a franchise, they are essentially paying the franchisor for their name, general business plan, and help in starting and operating the business.

The relationship between the franchisee and franchisor is extremely important. Obviously, the franchisee needs the support and assistance of the franchisor to succeed, and the franchisor will be paid a percentage of the franchisee’s sales, so the franchisor wants to help the franchisee succeed. But, the franchisor must also protect their most valuable assets: their name and reputation.

An entrepreneur running their own business has free reign over every operational decision. They can market how they want to, sell at the price they want to, develop the products they want to, and really, make their own rules. Because a franchisor needs to maintain a consistent reputation throughout their market and among a number of different franchisees, part of buying a franchise is agreeing to a number of conditions set by the franchisor.

McDonald’s is a great example. When a customer goes to a McDonald’s in New York, California, Hawaii, and any state in between, they expect to see the same menu, taste the same food, and generally pay the same price. All of those are decisions made by the franchisor, not the franchisee. Without that control, you may go to McDonald’s in Seattle and order a Big Mac expecting the same sandwich you get at your local McDonald’s but be served something different. That wouldn’t only confuse customers, it would also tarnish McDonald’s image.

Financial Agreements

Buying a franchise is not cheap. The cost obviously depends on the franchise you are purchasing. A McDonald’s franchise costs much more than a Dippin’ Dots stand (Dippin’ Dots is a unique ice cream product typically sold at theme parks and/or mall kiosks).

The typical financial agreement for a franchise includes a franchise fee and royalties, and some franchisors charge an advertising fee. The franchise fee is the cost the franchisee pays the franchisor just for the opportunity to use their name. If you want to start your own McDonald’s, you’ll pay corporate McDonald’s $45,000 as a one-time start-up cost. Royalties are regular payments made to the franchisor, usually based on sales. For example, McDonald’s usually collects about 4% of gross sales as a royalty.

While the franchise fee and royalty are pretty standard when purchasing a franchise, the advertising fee varies. Some franchisors will collect an advertising fee from each franchise that will be used for nationwide advertising. When you see a McDonald’s commercial on television, that isn’t paid directly by your local McDonald’s, but they may have contributed by paying an advertising fee.

Lesson Summary

Owning a franchise can be a profitable and enjoyable way for an entrepreneur to be their own boss. But, by limiting their own risk by relying on a more established company, they also give up some freedom to make management decisions. Whether a franchise is the right fit for the entrepreneur, only they can decide; but, many wealthy small business owners have made their money by owning a franchise.