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Buying a Franchise: Overview

Many of us may refer to a store with multiple locations as part of a "chain" or franchise. But many of us don't understand the structure or business model of these businesses. What is a franchise business? How are they formed, and how do they operate?

If you're considering becoming a franchise owner, this FindLaw article is for you. Learn about the aspects of franchises that make them distinct from other kinds of businesses. You'll also learn why it may be more beneficial to you than starting an independent business from scratch.

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Deciding to Franchise

An important step in the small business start-up process is deciding whether to go into business at all. Each year, thousands of potential entrepreneurs face this difficult decision. Because of the risk and work involved in starting a new business, many new entrepreneurs choose franchising as an alternative to starting a new, independent business from scratch.

One of the biggest mistakes a potential business owner can make is to hurry. This can be glossing over the franchise disclosure document (FDD) or franchise success rates. It's important to understand your reasons for going into business. You should determine if opening your own business is worth it.

If the risk involved in a new, independent business venture worries you, franchising may be the best business option for you. You start with instant brand recognition, a customer base, and a business plan. But remember that hard work, dedication, and sacrifice are essential to the success of any business venture, including franchising.

What Is Franchising?

Franchising in the United States dates back to the early part of the 20th century when it first gained popularity among fast-food restaurants. A business may have multiple locations without being a franchise. If the locations all have the same owner, then the business doesn't meet the franchise definition. Ownership structure defines a business franchise.

Franchising occurs when a business owner grants a license to one or more parties to conduct business using the same trademarks, trade names, trade dress, and other identifying aspects of the business. The party granting the license is the "franchisor," while those purchasing licenses are the "franchisee."

The franchisor buys the products and services offered by the franchisees. They may also provide a system of operation, marketing tools, raw materials, training, and other forms of support.

McDonald's is a franchise that owns fast food products and recipes. Still, it leases those things to a local person or group to sell the products using the recipes.

How Much Does a Franchise Cost?

You still need a stream of cash flow and upfront funds to buy a franchise. You can get financing for the initial startup cash from typical lenders like financial institutions. If you don't have the money already, you must seek cash from a small business loan at a bank or other financial institution. The Small Business Administration (SBA) is another option.

You must pay royalty fees and a franchise fee directly to the franchisor. The amount and schedule of payments differ from franchise to franchise. Royalty fees are often paid every quarter based on an amount from a percentage of sales. The franchise fee is due at the initial franchise application and yearly after that.

Typically, the franchise leases you the land or building of your new franchise. This keeps real estate costs down at startup because you don't have to purchase land.

What Is a Franchise Disclosure Document?

Before signing a contract to buy the franchise, the franchisor has to deliver a franchise disclosure document (FDD) to the franchisee. This must be delivered at least 14 days before signing an agreement to buy.

Things included in the FDD:

  • Franchisor's background information
  • Franchise fees and costs of entering into the business
  • Legal obligations of the franchisor and franchisee
  • Statistics on franchised and company-owned outlets
  • Audited financial information, including financial statements

Each state has its own additional disclosure laws. Review the FDD with an experienced franchise lawyer.

Who Owns the Franchise Business?

A franchise is a legal and commercial relationship between the trademark owner, service mark, trade name, or advertising symbol and an individual or group wishing to use that identification in a business.

The franchise governs the method of conducting business between the two parties. The franchisor provides the business expertise (marketing plans, management guidance, financing assistance, site location, training, etc.) that otherwise wouldn't be available to the franchisee.

The franchisee sells the goods or services supplied by the franchisor. Franchising operates on mutual trust between the franchisor and the franchisee. The franchisee operates the day-to-day business necessary to make the franchise a success.

What Are the Types of Franchises?

There are two forms of franchising:

  • Product or trade name franchising is when the owner holds the right to a name or trademark, which is then sold or licensed to franchisees.
  • Business format franchising is when the franchisor and franchisee have an ongoing relationship in which the franchisor provides services such as site selection, training, product supply, marketing plans, and even assistance obtaining financing.

Individual states may have different business franchise definitions. Some states require a marketing plan or "community of interest" provision in their definition. The Federal Trade Commission (FTC) has its business franchise definition that will generally apply when:

  • The franchisor licenses the right to use its trade or service marks to the franchisee.
  • These marks identify the franchisee's business in marketing a product or service using the franchisor's operating method.
  • The franchisor supports the franchisee and maintains some degree of control over the franchisee's activities.
  • The franchisee pays the franchisor a fee.

Indeed, every franchise involves a license, though not all licenses are franchises. Whether a business meets the federal or local business franchise definition may affect the required disclosures. But these definitions don't greatly impact your rights when a disagreement arises since, in either case, a contract is involved.

What Are Franchise Agreements?

Franchises are governed by contracts between the franchisor and franchisees. This means there are two places a franchisee can look to determine their rights and responsibilities within the relationship: the contract's language and the relevant state's contract laws.

The franchise agreement creates many of the most important rights and obligations between the franchisor and franchisee. These obligations and rights include the following:

  • Degree of control the franchisor may exercise over the franchisee
  • Terms of operation
  • Training requirements
  • Trademark and copyright obligations
  • Renewal and termination options
  • Other important details

The franchise agreement should reference the FDD, but make sure to carefully read the agreement before signing. The jurisdiction's laws indicate how contracts are interpreted and enforced when the parties disagree.

Using a Lawyer To Help You Buy a Franchise

While it may seem like a dream to open your own coffee shop, small business owners should take franchise ownership seriously. Look at the franchise's track record of success and consider the franchise fees, brand recognition, and franchise system. You'll want a business law attorney to review your franchise agreement before signing it.

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