An

Introduction to
Franchising

Sponsored by:
IFA EDUCATIONAL
FOUNDATION
© 2010 The IFA Educational Foundation. All Rights Reserved. No part of this book may be reproduced or transmitted
in any form, by any means (electronic, photocopying, recording or otherwise), without the written permission of the
publisher. IFA Educational Foundation, 1501 K Street, NW, Washington, DC 20005, (202) 628-8000, www.franchise.org.
An
Introduction to
Franchising

IFA EDUCATIONAL FOUNDATION

Sponsored by:

By Barbara Beshel
 CHAPTER
1 1.
2.
3.
4.

What is a franchise?
What are common franchise terms?
What are the alternatives to franchising?
What are the advantages and disadvantages of
owning a franchise?
An Introduction to Franchising 5. What are the legal issues in franchising?

WHAT IS A FRANCHISE?
A franchise is the agreement or license between two legally
independent parties which gives:

• a person or group of people (franchisee)

the right to market a product or service using
the trademark or trade name of another business
(franchisor)

• the franchisee the right to market a product or service

using the operating methods of the franchisor

• the franchisee the obligation to pay the franchisor fees

for these rights

• the franchisor the obligation to provide rights and

support to franchisees

FRANCHISE AGREEMENT

FRANCHISOR FRANCHISEE

Owns trademark or trade name Uses trademark or trade name

Provides support: Expands business with
• (sometimes) financing franchisors support
• advertising and marketing
• training
Receives Fees Pays Fees

THE IFA EDUCATIONAL FOUNDATION AN INTRODUCTION TO FRANCHISING 5

 TYPES OF FRANCHISES

PRODUCT DISTRIBUTION
Product distribution franchises simply sell the franchisor’s products and are supplier-dealer
relationships. In product distribution franchising, the franchisor licenses its trademark and
logo to the franchisees but typically does not provide them with an entire system for running
their business. The industries where you most often find this type of franchising are soft drinks,
automobiles and gasoline.

Some familiar product distribution franchises include:

• Coca-Cola
• Goodyear Tires
• Ford Motor Company

Although product distribution franchising represents the largest percentage of total retail
sales, most franchises available today are business format opportunities.

BUSINESS FORMAT FRANCHISE

Business format franchises, on the other hand, not only use a franchisor’s product, service and
trademark, but also the complete method to conduct the business itself, such as the marketing
plan and operations manuals. Business format franchises are the most common type of franchise.

USA Today reported that the 10 most popular franchising opportunities are in these industries:
• fast food • retail
• service • automotive
• restaurants • maintenance
• building and construction • retail—food
• business services • lodging

Some popular business format franchises include:

Fast Food Health & Beauty Auto
Wendy’s Jenny Craig Weight Loss AAMCO
McDonald’s Great Clips Midas
Hardee’s Pearle Vision, Inc. Budget Rent-A-Car

Retail Business Services Education

Athlete’s Foot H & R Block Sylvan Learning
Blockbuster Video Signs By Tomorrow Huntington
Play It Again Sports UPS Store New Horizons

Lodging Maintenance Restaurants

Comfort Inn Roto-Rooter Blimpie
Embassy Suites Stanley Steemer Dairy Queen
Quality Inn ServiceMaster Outback Steakhouse

6 AN INTRODUCTION TO FRANCHISING THE IFA EDUCATIONAL FOUNDATION

 TYPES OF FRANCHISE
ARRANGEMENTS
Because so many franchisors, industries and range of investments are possible, there are
different types of franchise arrangements available to a business owner.

SINGLE-UNIT (DIRECT-UNIT) FRANCHISE

A single-unit (direct-unit) franchise is an agreement where the franchisor grants a franchisee

the rights to open and operate ONE franchise unit. This is the simplest and most common
type of franchise. It is possible, however, for a franchisee to purchase additional single-unit
franchises once the original franchise unit begins to prosper. This is then considered a multiple,
single-unit relationship.

MULTI-UNIT FRANCHISE
• area development
• master franchise (sub-franchising)

A multi-unit franchise is an agreement where the franchisor grants a franchisee the rights to
open and operate more than one unit.

AREA DEVELOPMENT FRANCHISE MASTER FRANCHISE

Under an area development franchise, a A master franchise agreement gives

franchisee has the right to open more than the franchisee more rights than an area
one unit during a specific time, within a development agreement. In addition to
specified area. For example, a franchisee having the right and obligation to open and
may agree to open 5 units over a five year operate a certain number of units in a defined
period in a specified territory. The franchisor area, the master franchisee also has the right
grants the franchisee exclusive rights for the to sell franchises to other people within the
development of that territory. territory, known as sub-franchises. Therefore,
the master franchisee takes over many of the
tasks, duties and benefits of the franchisor,
such as providing support and training, as
well as receiving fees and royalties.

Another hybrid-type of multi-unit franchise is an area representative franchise. In this

model, the area representative buys a territorial franchise to sell and service unit franchisees
in the territory. The area representative does not contract with the unit franchisees (who sign
agreements directly with the franchisor), but does receive a portion of the initial fees and ongoing
fees paid by the unit franchisee to the franchisor.

THE IFA EDUCATIONAL FOUNDATION AN INTRODUCTION TO FRANCHISING 7

 COMMON FRANCHISE TERMS

se nt
n chi e
fra a tem
t t

D
a

es

FD
m

sur
for

this type of franchise also known as the FDD, the Franchise Disclosure

disclo
includes not only a product,
business

or Franchise Disclosure Document, FDD, is the

service and trademark, but Document, the disclosure format for the disclosure
also the complete method to document provides document which provides
conduct the business itself, information about the information about the
such as the marketing plan franchisor and franchise franchisor and franchise
and operations manuals system system to the franchisee

nt
eme se
e
ise re hi

nc
ag
h
nc

fra
i se
fra

the person or company

franch

a license that describes the the legal, written contract

relationship between the between the franchisor and that gets the right from the
franchisor and franchisee franchisee which tells each franchisor to do business
including use of trademarks, party what each is supposed under the franchisor’s
fees, support and control to do trademark or trade name

chisee
fran
r n
ng iso tio
bu
i si

h
nc
ch

ri
fra

dist
fran

a franchise where the

a method of business the person or company
product

franchisee simply sells the

expansion characterized by a that grants the franchisee
franchisor’s products without
trademark license, payment of the right to do business
using the franchisor’s method
fees, and significant assistance under their trademark or
of conducting business
and/or control trade name

k
y ar
m
alt

de
roy

tra

the regular payment made the marks, brand name and

by the franchisee to the logo that identify a franchisor
franchisor, usually based which is licensed to the
on a percentage of the franchisee
franchisee’s gross sales

8 AN INTRODUCTION TO FRANCHISING THE IFA EDUCATIONAL FOUNDATION

 WHAT ARE THE ALTERNATIVES
TO FRANCHISING?

In addition to franchising, there are two other popular methods by which businesses
expand their market and distribution channels:

DISTRIBUTORSHIP

In a distributorship, the distributor usually:

• has a contractual relationship with the supplier
• buys from the supplier in bulk and sells in smaller quantities
• is familiar with local markets and customers
• may do business with many companies, more than just the supplier/producer
• may not receive contractual support and training from the supplier/producer like a
franchisee

Some distribution arrangements are similar to franchises, and vice versa. A franchisee with
a great deal of leeway in how to run the business may look like an independent distributor. A
distributor may be subject to many controls by the supplier/producer and begin to resemble a
franchise.

Some popular distributorships include:

• Amway
• Color Me Beautiful Cosmetics
• Mountain Life Spring Water
• Knorr Soup Vendor
• Campbell’s Soup Vending Machines

LICENSING

Licensing, on the other hand, allows a licensee to pay for the rights to use a particular
trademark. Unlike franchises, in which the franchisor exerts significant control over the
franchisee’s operations, licensors are mainly interested in collecting royalties and supervising
the use of the license rather than influencing the operations of the business. Check out www.
licensing.org.

Some popular licensors include:

• Netscape Communications
• Apple Computer
• Canon Inc.
• Woolmark

THE IFA EDUCATIONAL FOUNDATION AN INTRODUCTION TO FRANCHISING 9

 WHAT ARE THE ADVANTAGES
AND DISADVANTAGES OF
OWNING A FRANCHISE?

ADVANTAGES
 “Owning a franchise allows you to go into
business for yourself, but not by yourself.”

 A franchise provides franchisees with a certain

level of independence where they can operate DISADVANTAGES
their business.  The franchisee is not completely
independent. Franchisees are required to
 A franchise provides an established product or operate their businesses according to the
service which may already enjoy widespread procedures and restrictions set forth by the
brand-name recognition. This gives the franchisee franchisor in the franchisee agreement. These
the benefits of a pre-sold customer base which restrictions usually include the products or
would ordinarily takes years to establish. services which can be offered, pricing and
geographic territory. For some people, this is
 A franchise increases your chances of business the most serious disadvantage to becoming a
success because you are associating with franchisee.
proven products and methods.
 In addition to the initial franchise fee,
Franchises may offer consumers the attraction franchisees must pay ongoing royalties and
of a certain level of quality and consistency advertising fees.
because it is mandated by the franchise
agreement.  Franchisees must be careful to balance
restrictions and support provided by the
 Franchises offer important pre-opening support: franchisor with their own ability to manage
• site selection their business.
• design and construction
• financing  A damaged, system-wide image can result if
• training other franchisees are performing poorly or the
• grand-opening program franchisor runs into an unforeseen problem.

 Franchises offer ongoing support:  The term (duration) of a franchise agreement

• training is usually limited and the franchisee may
• national and regional advertising have little or no say about the terms of a
• operating procedures and operational termination.
assistance
• ongoing supervision and management
support
• increased spending power and access to
bulk purchasing

10 AN INTRODUCTION TO FRANCHISING THE IFA EDUCATIONAL FOUNDATION

 WHAT ARE THE LEGAL ISSUES
OF FRANCHISING?

A good relationship between the franchisor and franchisee is critical for the success of both
parties. Since franchising establishes a business relationship for years, the foundation must
be carefully built by having a clear understanding of the franchise program. Unfortunately,
understanding the legal language of franchising can be daunting. The advice of an experienced
franchise attorney should be sought to help a prospective franchisee understand the legal issues
and to protect them from making costly mistakes.

Franchising is governed by federal and state laws that require franchisors to provide
prospective franchisees with information that describes the franchisor-franchisee relationship.

The two main franchising legal documents are:

THE DISCLOSURE DOCUMENT (also known as the FDD)

The purpose of the FDD is to provide prospective franchisees with information about the
franchisor, the franchise system and the agreements they will need to sign so that they can
make an informed decision.

In addition to the disclosure part of the document, the FDD includes the actual franchise
agreement as well as other agreements the franchisee will be required to sign, along with the
franchisor’s financial statements.

The FDD is designed to give you some of the information you need in order to make an
informed decision about investing in a particular franchise.

By law, a franchisor cannot sell a franchise until the franchisor has presented the prospective
franchisee with a Disclosure Document. In fact, 14 states require franchisors to register
their FDDs with the state or to notify them that they will offer franchises before they begin to
conduct any franchising activity in the state.

The FDD includes information about:

• the franchisor
• the company’s key staff
• management’s experience in franchise management
• franchisor’s bankruptcy and litigation history
• initial and ongoing fees involved in opening and running the franchise
• required investment and purchases
• territory rights
• responsibilities of the franchisor and franchisee
• other franchisees in the system with contact information

THE IFA EDUCATIONAL FOUNDATION AN INTRODUCTION TO FRANCHISING 11

 WHAT ARE THE LEGAL ISSUES
OF FRANCHISING? (continued)

Receipt of the FDD is governed by the “14-day rule.” This is a cooling-off period in which
franchisors must give prospective franchisees 14 days to think about their decision before they
are allowed to sign the franchise agreement.

THE FRANCHISE AGREEMENT

The franchise agreement is more specific than the FDD about the terms of the relationship
between the franchisor and franchisee.

The franchise agreement includes information about:

• the franchise system, such as use of trademarks and products

• territory
• rights and obligations of the parties: standards, procedures, training, assistance,
advertising, etc.
• term (duration) of the franchise
• payments made by the franchisee to the franchisor
• termination and/or the right to transfer the franchise

The franchise agreement is the legal, written document that governs the relationship and
specifies the terms of the franchise purchase. A prospective franchisee should closely review
the franchise agreement and consult with a professional advisor, like an attorney or an
accountant, before making a final decision.

12 AN INTRODUCTION TO FRANCHISING THE IFA EDUCATIONAL FOUNDATION

 CHAPTER
3
1. What are the key subjects in the franchise
agreement?
2. What information is found in the Disclosure
Document (FDD)?
3. What are the key items in the Disclosure
Document (FDD)?
4. What do you have to know about financial
statements?
5. Where can I get help? Navigating the Paper Trail

WHAT ARE THE KEY SUBJECTS IN

THE FRANCHISE AGREEMENT?

The franchise agreement is more specific than the

FDD about the terms of the relationship between the
franchisor and franchisee.

USE OF TRADEMARKS
One of the main benefits you receive when purchasing a franchise is the use of
well-known trademarks. This section lists the trademarks, service marks or logos the
franchisee is entitled to use.
• Has the trademark been in operation for a significant amount of time and is it
well known?
• Are there any restrictions on its use by the franchisor or franchisee?

LOCATION OF THE FRANCHISE

This section describes the exclusive area or territory granted to the franchisee.
• Do you have exclusive rights in a certain territory?

22 AN INTRODUCTION TO FRANCHISING THE IFA EDUCATIONAL FOUNDATION

 TERM OF THE FRANCHISE
. In this section, the duration of the agreement is specified.
• How long does the agreement last?
• Can the franchisor purchase the franchise before the agreement expires?
• Do you have the right to renew the agreement?

FRANCHISEE’S FEES AND OTHER PAYMENTS

In this section, all the mandatory fees are described:
• initial fee and what the franchisee receives for that fee
• royalty payment, what it is based on and when it is due

OBLIGATIONS AND DUTIES OF THE FRANCHISOR

This section describes the franchisee’s responsibilities:

• requirements for training
• requirements for participation in the business
• requirements for keeping and submitting adequate records

ire RESTRICTION ON GOODS AND SERVICES OFFERED

uh
e yo
r
su nced y
ke ie e This section describes any restrictions placed on the goods or services offered,
Ma xper orn
e e att
an chis the including:
n
fra v iew t. • required quality standards
re n
ro me
g ree • approved suppliers
a
• approved advertising
• hours of operation
• pricing

RENEWAL, TERMINATION AND TRANSFER

OF FRANCHISE AGREEMENT
This section includes:
• the rights and obligations of a franchisee upon termination
• descriptions about the transfer of the franchise agreement
• descriptions about the renewal of the franchise agreement

THE IFA EDUCATIONAL FOUNDATION AN INTRODUCTION TO FRANCHISING 23

 WHAT INFORMATION IS
FOUND IN THE FDD?

The purpose of the FDD is to provide prospective franchisees with information

about the franchisor, the franchise system and the agreements they will need to sign so
that they can make an informed decision. (Refer to pages 83 to 91 in Franchising for
Dummies.)

THE DISCLOSURE DOCUMENT (FDD)

Item 1: The franchisor and any parents, predecessors and affiliates. This section
provides a description of the company and its history.

Item 2: Business experience. This section provides biographical and professional

information about the franchisors and its officers, directors and executives.

Item 3: Litigation. This section provides relevant current and past criminal and civil
litigation for the franchisor and its management.

Item 4: Bankruptcy. This section provides information about the franchisor and any
management who have gone through a bankruptcy.

Item 5: Initial fees. This section provides information about the initial fees and the
range and factors that determine the amount of the fees.

Item 6: Other fees. This item provides a description of all other recurring fees or
payments that must be made.

Item 7: Initial investment. This item is presented in table format and includes all the
expenditures required by the franchisee to make to establish the franchise.

Item 8: Restriction on sources of products and services. This section includes the
restrictions that franchisor has established regarding the source of products or
services.

Item 9: Franchisee’s obligations. This item provides a reference table that indicates
where in the franchise agreement franchisees can find the obligations they
have agreed to.

Item 10: Financing. This item describes the terms and conditions of any financing
arrangements offered by the franchisor.

Item 11: Franchisor’s Assistance, Advertising, Computer Systems and Training.

This section describes the services that the franchisor will provide to the
franchisee.

24 AN INTRODUCTION TO FRANCHISING THE IFA EDUCATIONAL FOUNDATION

 Item 12: Territory. This section provides the description of any exclusive territory and
whether territories will be modified.

Item 13: Trademarks. This section provides information about the franchisor’s
trademarks, service marks and trade names.

Item 14: Patents, copyrights and proprietary information. This section gives
information about how the patents and copyrights can be used by the
franchisee.

Item 15: Obligation to participate in the actual operation of the franchise business.
This section describes the obligation of the franchisee to participate in the
actual operation of the business.

Item 16: Restrictions on what the franchisee may sell. This sections deals with
any restrictions on the goods and services that the franchisee may offer its
customers.

Item 17: Renewal, termination, transfer and dispute resolution. This section tells
you when and whether your franchise can be renewed or terminated and
what your rights and restrictions are when you have disagreements with your
franchisor.

Item 18: Public Figures. If the franchisor uses public figures (celebrities or public
persons), the amount the person is paid is revealed in this section.

Item 19: Financial Performance Representations. Here the franchisor is allowed, but
not required, to provide information on unit financial performance.

Item 20: Outlets and Franchisee Information. This section provides locations and
contact information of existing franchises.

Item 21: Financial statements. Audited financial statements for the past three years
are included in this section.

Item 22: Contracts. This item provides of all the agreements that the franchisee will
be required to sign.

Item 23: Receipts. Prospective franchisees are required to sign a receipt that they
received the FDD.

THE IFA EDUCATIONAL FOUNDATION AN INTRODUCTION TO FRANCHISING 25

 WHAT ARE THE KEY
ITEMS IN THE FDD?

Item 7: Initial investment. Some of these costs are averages or estimates and may vary
in your area.

Talk to other franchisees who have been in the system for a year or more to see:
• how much money they needed in the beginning until they became
profitable
• how much they were able to draw from the business to support
themselves

Item 11: Franchisor’s obligations.

Be sure you understand the services you will get before you open:
• site selection
• training
• development assistance

Be sure you know what services you will receive for your grand opening:
• marketing
• advertising
• field support

Be sure you know what services you will receive after you begin operating your
business:
• training
• advertising
• operations

Pay particular attention to those services the franchisor is obligated to provide

and the services they may provide.

Item 17: Renewal, termination, transfer and dispute resolution.

Take your time to understand what rights you will have and what rights you are
giving up.

Pay particular attention to any non-compete provisions and your obligations

when the franchise relationship ends.

26 AN INTRODUCTION TO FRANCHISING THE IFA EDUCATIONAL FOUNDATION

 Item 19: Financial performance representations.

Only 30 to 40 percent of all franchisors provide prospective franchisees with

information about financial performance. The next best thing to do is to talk to
existing franchisees about sales and earnings potential.

Another good source of information is How Much Can I Make? by Robert Bond.
(800-841-0873 or www.worldfranchising.com).

Item 20: Outlets and franchisee information.

Examine how many units the franchisor has taken back and resold. If this
number is high, this could indicate churning (when the franchisor takes back failed
locations and remarkets them over and over.)

Pay attention to the contact information of the franchisees who have left the
system. These are people you definitely want to talk to.

Item 21: Financial statements.

Financial statements are the track record of the franchisor. You should be given
copies of the franchisor’s last three years financial statements. Take them to an
accountant who specializes in franchising to evaluate.

Remember that the financial condition of the franchisor not only affects its
ability to run a financially successful operation in the future, but it also determines
whether it may go under and you will be left “holding the bag.”

The two key financial statements to focus on are the balance sheet and the
income statement. Make sure they are audited.

Item 22: Contracts.

Make sure that all the agreements listed are attached to the FDD—and read
every one of them.

THE IFA EDUCATIONAL FOUNDATION AN INTRODUCTION TO FRANCHISING 27

 WHAT DO YOU HAVE TO KNOW
ABOUT FINANCIAL STATEMENTS?
Financial statements are the track record of the franchise. They are provided for
you in the FDD and contain important information about the franchisor’s financial
status and strength.

The two most important financial statements you need to review:

balance sheet income statement

THE BALANCE SHEET

A balance sheet is a snapshot summary of how much a company is worth on any

given day. It reports the financial condition (solvency) of the franchisor.

Balance sheet categories include:

• assets – what a company owns: current, fixed and intangible assets
• liabilities – what a company owes: current and long-term debt
• stockholders’ equity – the company’s net worth; it is the money the company
has taken in from the sale of stock plus any accumulated profits:

Stockholder’s Equity = Assets – Liabilities = Net Worth

Things you want to see on a franchisor’s balance sheet:

• increasing assets
• increasing stockholders’ equity
• more cash than debt
• amount of current debt < (less than) 1/2 of the total assets
• amount of current debt < 1/3 of the stockholders’ equity

28 AN INTRODUCTION TO FRANCHISING THE IFA EDUCATIONAL FOUNDATION

 Sample Balance Sheet

ar
ABC Sleepwe
t
Balance Shee
January, 2010

ASSETS $6,900
Current Assets
Cash $4,900
eivable $8,000
Accounts Rec
$200
Inventory
nses
Prepaid Expe
$20,000
Assets
Total Current

$8,500
Fixed Assets
Machinery $1,000
nter $4,500
Computer/Pri

Furniture
$14,000
ssets
Total Fixed A
$34,000


Total Assets

ND EQUITY
LIABILITIES A $6,500
ities
Current Liabil ble
Accounts Paya $1,200
-Term Due $1,800
Current Long
nses
Accrued Expe
$9,500
Liabilites
Total Current
$12,500
te
Long-Term L iabilities – No
$12,000
Equity
Stockholder’s
$34,000
y
a n d E q u it
Total Liabilities

THE IFA EDUCATIONAL FOUNDATION AN INTRODUCTION TO FRANCHISING 29

 THE INCOME STATEMENT

An income statement reports a company’s profit or loss. It shows a company’s

income, expense and net income—also known as the “bottom line” or earnings.

Other names for an income statement include:

• Profit and Loss Statement
• Statement of Income
• Statement of Operation
• Statement of Earnings
• Results of Operations
• Statement of Consolidated Income

Income statement categories include:

• revenues
• costs and expenses: cost of sales, selling, general administrative, interest
expenses
• income before taxes
• provision for income taxes
• net income (earnings)
• net income (earnings) per share

Things you want to see on a franchisor’s income statement:

• increasing profit
• more revenue derived from royalties and system income than from selling
franchises
• increasing revenue trends, usually > 15%
• increasing net income trends, usually > 15%
• increasing net income per share trend, usually > 15%
• a profitable franchisor!

What you should know about these financial statements:

• The financial statements should be audited financial statements.
• The statements should contain three years of financial data (unless the
franchisor has less than 3 years of operating history).

You should take these to an accountant experienced in franchising for evaluation.

30 AN INTRODUCTION TO FRANCHISING THE IFA EDUCATIONAL FOUNDATION

 Sample Income Statement

r
ABC Sleepwea
ent
Income Statem
January, 2010

$2,600
E
SALES/REVENU
$1,776

ODS $1,155
COST OF GO
$610
Merchandise
$11
Purchases
Freight
$824
T
GROSS PROFI
$544
SES
O STS AND EXPEN
OPERATING C
$26
Fixed
Insurance $100

Rent $310

Salaries $42

Utilities
$24
Variable
Advertising $4
Dues $24

Telephone $14

Office Supplies
$280
XES
ME) BEFORE TA
PROFIT (INCO
$84

TAXES (30%)
$196

IN C O M E)
NET
NET PROFIT (
ne”)
(“The Bottom Li

THE IFA EDUCATIONAL FOUNDATION AN INTRODUCTION TO FRANCHISING 31

 WHERE CAN I GET HELP?

• International Franchise Association (IFA), 202-628-8000, www.franchise.org

• American Bar Association’s Forum on Franchising, www.abanet.org
• Directory of Franchise Attorneys, www.franchise-update.com
• IFA’s Council of Franchise Suppliers (CFS) publishes a list of firms that
specialize in franchising law, www.franchising.org
• recommendations from other franchisees

32 AN INTRODUCTION TO FRANCHISING THE IFA EDUCATIONAL FOUNDATION