Franchising works as a business model where an entrepreneur (franchisee) purchases the right to operate a proven business model and brand from an established company (franchisor). The franchisee gains access to the franchisor’s expertise, support, and established customer base in exchange for a fee and ongoing royalties.
How does this happen? What are its advantages and disadvantages? How do they make a profit? Read on to find out how franchising works.
Let’s get started!
Table of contents
- What Is a Franchise?
- Understanding How Franchising Works
- Franchise Basics and Regulations
- Advantages of Investing in a Franchise
- Disadvantages of Owning a Franchise
- How Much Profit Does a Franchise Make?
- How Do You Know If a Franchise Will Be Profitable?
- What Are the Most Profitable Franchises to Own?
- FAQs
- Conclusion
- References
- Recommendations
What Is a Franchise?
A franchise is a kind of permission that lets a franchisee use a franchisor’s exclusive business secrets, methods, and brands so that the franchisee can offer a product or service with the franchisor’s business name. To get a franchise, the franchisee normally pays the franchisor a one-time start-up fee and yearly fees.
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Understanding How Franchising Works
Franchising is a way for a business to grow its customer base and market share without spending a lot of money. It involves a partnership between a franchisor and a franchisee.
The franchisor owns the original business and gives the franchisee permission to use its name and concept. The franchisee pays for this permission and sells the franchisor’s products or services using the same business model and brand.
Many entrepreneurs choose to buy a franchise when they want to start a business, especially in the fast food industry where there is a lot of competition. A franchise gives them the benefit of using a well-known company’s name and reputation. They do not have to invest a lot of time and money to create their own brand and product.
Franchising has a long history in the United States. It started in the mid-1800s when two companies—the McCormick Harvesting Machine Company and the I.M. Singer Company—created new ways of organizing, marketing and distributing their products. They were the pioneers of franchising. They used their innovative systems to sell their reapers and sewing machines to a growing market.
The first food and hospitality franchises appeared in the 1920s and 1930s. A&W Root Beer started franchising in 1925. Howard Johnson Restaurants opened its first store in 1935 and grew quickly. They set the stage for the fast food industry and the franchises that dominate it today.
Franchises were a major part of the U.S. economy in 2022, with 790,492 establishments and an estimated 805,436 for 2023. They added more than $500 billion to the economic output. Some of the well-known franchises in the food industry were McDonald’s, Taco Bell, Dairy Queen, Denny’s, Jimmy John’s, and Dunkin’.
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Franchise Basics and Regulations
A franchise contract is complicated and different for each franchisor. Usually, a franchise agreement has three types of payment to the franchisor.
First, the franchisee has to buy the trademark or the controlled rights from the franchisor with a one-time fee. Second, the franchisor often gets paid for giving training, equipment, or business advice. Lastly, the franchisor gets regular royalties or a part of the operation’s sales.
A franchise contract is not permanent, but more like a lease or rent of a business. It does not mean that the franchisee owns the business. Depending on the contract, franchise agreements usually last from five to 30 years, with severe penalties if a franchisee breaks or ends the contract early.
In the U.S., franchises are controlled by the state level; but, the Federal Trade Commission (FTC) made one federal rule in 1979. The Franchise Rule is a legal notice that a franchisor has to give to potential buyers. The franchisor has to fully reveal any risks, benefits, or limits to a franchise investment.
This information includes fees and costs, legal history, approved business suppliers or vendors, expected financial performance, and other important details. This disclosure rule was formerly called the Uniform Franchise Offering Circular before it was changed to the Franchise Disclosure Document in 2007.
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Advantages of Investing in a Franchise
Franchising has some well-known benefits. By franchising, you become your own boss. You also get to enjoy an existing customer base and brand awareness, as well as business support from the franchisor organization.
- Be in charge of yourself! This is one of the most clear benefits of franchising. You are not completely on your own (the franchisor will provide some types of support), but the chance of being in charge of yourself can make a big difference for a franchisee with the right opportunity. By opening a franchise, you can earn a good income and shape your future.
- Enjoy already established brand recognition. Many possible franchisees like the idea of a ready-made customer base and a well-known brand. When thinking about the possible profitability of owning a franchise, not having to waste a lot of money on advertising and marketing can boost their profits a lot.
- Receive business support when you want it. When you join a franchise, you join something bigger than yourself. Besides brand recognition, the franchisor will usually offer a fair amount of support and guidance to their franchisees. With these and other benefits, franchisees can usually expect a lower level of risk—and a lower chance of failure—than starting a new business from scratch.
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Disadvantages of Owning a Franchise
Franchising has some drawbacks, even though it has many benefits. It is normal to feel nervous about buying a franchise. It is a big deal and a life-changing decision—and the stakes are high.
Some of the possible disadvantages are certain rules, expenses, and (in rare cases) the chance of conflict.
- Rules: A franchisee is their own boss, but they also have to follow some aspects set by the franchisor. These rules—and how well you can adapt to them—will differ from one franchise to another, but they might involve things like business location or hours of operation, pricing, branding and signage, and more. These rules are not about controlling everything, but about keeping a consistent brand across all franchise locations.
- Expenses: How much does a franchise cost? Franchising requires an initial and ongoing investment. First, there is the initial cost. Even relatively cheap franchises will need a starting investment to launch the business. Then, there are ongoing costs to think about, which will change among franchise opportunities. These might involve costs related to advertising costs, royalty fees, or employee training costs.
- Conflict chance: Even if you are sure you can make great profits with your franchise, there is always the possibility of conflict. This is understandable when you think that a franchisee acts as their own boss on one hand and as a part of a known brand on the other.
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How Much Profit Does a Franchise Make?
This is the big question, right? You have thought about the pros and cons of franchising, and you have maybe even looked for franchises in the industry or industries that interest you, so let’s talk about franchise profitability for a bit.
First, it’s important to differentiate between income/revenue and profit. While it may be clear to you that profit is revenue minus expenses, the specific factors that affect each franchise opportunity’s profitability can change a lot (We talked about some of the possible expenses in the “Expenses” bullet above)
In the end, you may be better off asking the question, “What franchise has the best return on investment?” This is especially important if you think of time, energy, and effort as part of your investment (as you should!).
With those factors in mind, “How much profit does a franchise owner make?” is another good question. While average numbers don’t show the whole picture, studies say the average annual income for franchise owners is around $80,000. That number, of course, does not always include the expenses that reduce gross income figures.
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How Do You Know If a Franchise Will Be Profitable?
Franchising has some ways to tell if a franchise opportunity is likely to make money. One of the simplest ways is by looking at its Franchise Disclosure Document (FDD). This document is given to a possible franchisee as part of the pre-sale research process. This document is supposed to give the kind of information needed to decide whether it is going to be a good investment or not. This legally-needed disclosure has 23 different sections covering almost every aspect of the franchisor organization and its past, as well as what the franchisee has to do. If you are not sure what some of the FDD’s contents mean, you can always ask an accountant or lawyer to help you understand the FDD and what it means. Besides looking at the FDD, an interested potential franchisee can do some of their own research.
- If you are good at numbers (or have a lawyer or accountant that is), then you can just ask for financial reports from the franchisor. This way, you can see the franchise’s usual revenue and costs.
- You can also talk to other franchisees. Ask franchisees who have bought into specific franchises you are interested in and what their experience has been like—including daily operations, how much they make, and more.
- Think about factors like the economy and where you are. Here, you should try to see how well your franchise fits in the local area. Just because a franchise is usually popular or profitable does not mean it will work well in a certain market or area.
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What Are the Most Profitable Franchises to Own?
You may think that the most money-making franchises to own are the biggest names—the McDonald’s and Starbucks level companies—but that’s not always true.
Taco Bell was at the top of Franchise 500’s 2021 list of the most money-making franchises to own, with over 7,500 locations running today. Taco Bell also has low starting franchising fees, which partly explains how it has become one of 2022’s fastest-growing franchises.
In another place, a recent study by NerdWallet said that the most money-making franchises to own also have very well-known names like McDonald’s, Dunkin’, and the UPS store. The rest of their ten most money-making franchises list have more surprising names: Dream Vacations, The Maids, Anytime Fitness, Pearle Vision, JAN-PRO, Supercuts, and Ace Hardware.
The fact that big names like McDonald’s and smaller names like JAN-PRO can both do well shows that a brand does not have to be the biggest franchise in the world to offer a good opportunity. After thinking about everything, then, which is the best franchise to buy—and how do you know?
While it may seem obvious that cheap franchises with high money-making potential are the best chances, that’s mostly a guess. As we have hopefully shown clearly by now, the question of franchising’s money-making does not have a simple or clear answer.
With that in mind, then, if we were to give one single tip for answering this question, it would be to ask the right questions of the franchisor. This is the best way to really know what kind of ROI or profit margin you can hope for, and, just as important, what you can expect from day to day as the franchisee.
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FAQs
The end game is profit. Franchise.com suggests that the expected range of return on investment of a good franchise should be at least between 25 percent and 50 percent.
The exact earning potential will depend on several factors, including the type of franchise, the location, the investment level, and the franchisee’s ability to effectively operate and manage the business. On average, franchisees can expect to earn a profit of 4-12 percent of their gross revenue.
A franchisor makes money from royalties and fees paid by the franchise owners. A franchise owner makes money through profits received from sales and service transactions. This is generally the leftover amount of money received from revenue after overhead costs are taken out.
Two to three years is the standard estimation for how long it takes a business to be profitable. That said, each startup has different initial costs and ways of measuring business profitability. A business could have enough cash to become profitable immediately or take three years or longer to make money.
Conclusion
Understanding how franchising works is the first step toward unlocking the door to the best profit margins.
By choosing the right franchise, embracing operational efficiency, and staying responsive to market trends, franchisees can pave the way for a successful and lucrative venture.
As you embark on your franchising journey, remember that strategic decisions and a commitment to excellence are key drivers of profitability in this dynamic business model.
References
- Franchiseopportunities.com – Franchise Profit Margin
- Investopedia.com – What Is a Franchise, and How Does It Work?
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