How Does a Franchise Work?

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Buying into a franchise gives you a way to own and manage a business that already has a brand name and a solid reputation. You don’t have to learn everything by trial and error, and instead can run the business using the franchisor’s experience and guidance to help you succeed. Understanding how a franchise works is key to deciding if opening one is a solid decision for your business goals.

Expanding into Franchises

A company that wants to expand may choose to sell clones, or franchises, of its business to people willing to buy into and operate the business themselves. Franchises run the gamut from cleaning companies and tax services to sit sit-down restaurants, fast food establishments and stores that sell auto parts. The franchisor makes money from the initial investment fees a new franchisee pays to open his store, and the franchise owner's ongoing payments thereafter based on the resources he is obligated to buy and the money he makes.

Investment Fees and Other Costs

The franchisor requires you to pay an initial investment fee once you decide you want to open one of their franchises. The franchisor sets the fee based on factors such as the potential return on investment and the costs associated with setting up the franchise. For example, opening a Snap-On store requires an initial investment of $135,390 while a Panera Bread franchise costs about $1.5 million as of this publication.

You also need money to cover costs associated with leasing or renting a building, remodeling it to the franchisor’s specifications and operating the business. You'll have to cover utilities, legal fees, insurance, payroll, benefits and supplies until your store starts making money.

Making Money

As the owner of the franchise, you get to keep any money leftover after paying the franchisor royalties based on the income your store makes in a specified time period. You also need to pay expenses, such as rent, utilities, products, marketing costs and payroll. Whatever is left over is profit for you, as the owner, to spend however you see fit.

Documents and Agreements

Before you buy in, the franchisor will send you a disclosure document, known as the Uniform Franchise Offering Circular. This lengthy document outlines the franchisor’s offering and the financial investment required. It also explains how responsibilities are divided between you and the franchisor. You’ll learn about the background of the founders, review financial information about the franchisor and see how territories are determined.

Once you agree to buy into the franchise, you sign a contract, referred to as a Franchise Agreement. The agreement outlines what the franchisor provides, what fees and royalties are paid and what happens if you terminate the contract early.

The Blueprint

After you pay the fees and sign the required documents, the franchisor gives you a highly detailed plan for starting and operating the business. The plan provides information about setting up shop, hiring employees, using the franchisor’s systems, following procedures and how to market to get customers through your door. The franchisor also provides site and appearance standards for your storefront so the brand name stays consistent.