Franchising is a business model where the owner (franchisor) of a product, service, or method utilizes the distribution services of an affiliated dealer (franchisee). Usually, the franchisee pays a royalty to the franchisor to be using the brand, process, and product. And the franchisor instead supports the franchisee in starting up the activity and providing a set of services as part of the franchising agreement. Franchising models can be heavy-franchised, heavy-chained, or hybrid (franchained).
A business model or a growth strategy?
As the story goes McDonald’s started to use a franchising model to grow its restaurant business, and it became over the 1960s a giant in the restaurant business (or real estate depending on the perspective).
McDonald’s leveraged the existing “Speedy Service System” developed by the McDonald’s brothers (what we would later call “fast food”) which was an incredible process development able to provide an improved product at a faster pace.
The speedy system itself represented the application of the manufacturing process to the restaurant business. Later another important building block was added.
The franchising model really became widely applied during the 1920s and 1930s in the restaurant business.
As new physical communication networks (in the US, the Interstate Highway System) enabled people to move long distances with their cars.
Later on, Ray Kroc would apply, in its most aggressive form, the franchising model (different formats already existed centuries before) to McDonald’s existing operation to create one of the most scalable restaurant businesses in the world.
But is franchising a business model, a revenue model, or a growth (expansion) strategy?
Yet, franchising combined with a product delivered differently (the “speedy system”) made up a whole new experience that made it a new business model: the heavily franchised McDonald’s business model.
Therefore, as we’ll see throughout this research, franchising here is considered a business model, as it embraces product, distribution, and growth as a whole.
Understanding franchising
Modern franchising, as conceived in today’s business world, came as a bio-product of the incredible expansion of the restaurant chains business across the US, like the automobile and the infrastructure of highways built around it, also enabling people to travel distances to go to their favorite restaurants.
From there, especially after the 1950s, franchising was used as a great way for restaurants to expand their operations across the country.
This model today, while it has become a standard, it’s all but a unified model.
In fact, as we’ll see, several companies mastered it and tweaked it to make it in line with their business philosophy, growth model, and strategy.
When a business is looking for a cost-effective means of increasing market share or geographical reach, it may opt to franchise its product and brand name.
Franchising is essentially a joint venture between a franchisor and a franchisee.
The franchisor is the original business that sells the rights to its name, idea, brand, or systems.
The franchisee then buys these rights, which allows it to sell the franchisor’s goods and services under an existing trademark and business model.
The franchise business model itself is an attractive proposition for franchisees, particularly those wanting to leverage the brand equity of a franchisor in a highly competitive market.
Franchising is thought to have originated in the United States, with the model first implemented by the Singer sewing machine company in the mid-19th century.
Today, some of the world’s leading fast-food restaurant companies utilize the franchise model.
These include McDonald’s, Dairy Queen, Taco Bell, Dunkin’ Donuts, and Jimmy John’s Gourmet Sandwiches.
Some of the key points to take into account when it comes to franchising:
Growth
Franchising can work for sure as a growth propeller as you can easily increment the speed of opening up new locations by also reducing initial capital requirements, operational costs, and time to market.
Control
While franchising is a great model to speed up operations and test new markets. It also comes with the loss of control over products, brands and standards when executed too fast.
As we’ll see throughout this research, different franchising models have come up over the years to make up for the loss of control over speed (like McDonald’s land operations trying in franchisees and making them accountable for the company’s best practices).
Speed
The speed of execution is definitely one of the key advantages of the franchising model.
And as the market widens up or shrinks, a franchising model can help the company adapt fast, as locations can be open or closed according to market trends.
Product development
While franchising is a great model for increasing the growth of the business. It might also come at the expense of product development.
Imagine the case of a company only running franchised stores that loses the understanding of the customer.
Instead, as we’ll see, franchising models have adapted also to leave a small percentage of owned stores, where the franchising company can experiment and test new product lines.
Branding
Also, here, franchising can make or break a whole brand.
And this all depends on whether the company has been able to balance out the speed and ability of the franchisees to stick with the company’s standards and be true to the company’s mission.
How franchising agreements work
Like any agreement between two parties, successful franchising depends on both companies demonstrating professional competence and acting in good faith.
To some extent, this can be facilitated by:
A code of conduct
Which sets out how each party must act toward the other.
Most codes outline disclosure requirements, a good faith obligation, a predetermined cooling-off period, dispute resolution mechanisms, and procedures for ending the agreement.
Legislation
In addition to the code of conduct, franchise parties are also required to act in accordance with laws and regulations.
In general terms, franchising agreements must operate within the bounds of fair work legislation, relevant tax laws, state licensing schemes, and anti-competitive conduct guidelines.
As we’ll see, franchising agreements will take different shapes according to the company’s franchising model.
The three main types of franchising
Within the franchising model itself are three different types:
1 – Traditional franchising
In traditional franchising, the franchisee sells products manufactured by the franchisor.
This arrangement appears at first glance to be rather similar to a supplier-dealer relationship. However, this is not the case.
The traditional franchise is more closely associated with the franchisor’s brand and generally receives more services than a dealer would from its supplier.
For example, The Coca-Cola Company manufactures and bottles soft drinks before selling them to franchisees.
The Ford Motor Company offers regular maintenance and servicing for Ford vehicles bought at franchise dealerships.
2 – Business-format franchising
The franchisee under this second model receives a complete system for delivering the product or service of the franchisor.
The role of the franchisor is to define the business system and establish the brand standards, while the role of the franchisee is to manage its day-to-day activities within those systems and standards.
Domino’s doesn’t franchise pizza any more than McDonald’s franchises hamburgers.
Both companies use business-format franchising to streamline the systems for delivering their branded products and services amongst franchisees.
3 – Social franchising
Social franchising is the newest franchising type and is the application of business-format franchising techniques in the delivery of products and services to disadvantaged people.
Companies that engage in social franchising provide basic items such as drinking water, pharmaceutical drugs, and other items related to healthcare, education, sanitation, and energy.
The franchising arrangement itself is often with a not-for-profit organization, religious institution, or government body.
Other types of franchising based on the FourWeekMBA research
Beyond the classic configuration and categorization of franchising business models, the FourWeekMBA research identified three main types of franchising models, mainly swinging between a model where most restaurants are owned (skewed toward a chain model) or a model where most restaurants are franchised or a hybrid model.
McDonald’s is a heavy-franchised business model. In 2021, over 56% of the total revenues came from franchised restaurants. The long-term goal of the company is to transition toward 95% of franchised restaurants (in 2020 franchised restaurants were 93% of the total). The company generated over $23 billion in revenues in 2021, of which $9.78 billion from owned restaurants and $13 billion from franchised restaurants.
Many have argued over the years that McDonald’s is more of a real estate company than a restaurant company.
Why is it the case?
While McDonald’s does use a heavy-franchise model, where most restaurants are franchised (McDonald’s keeps a low ratio of chain restaurants where it can also do product development and discovery, which then gets extended to its franchised restaurants), there is a twist.
McDonald’s secures the land or the rental contract of the land; therefore, the franchisee, even if an “independent restaurateur,” is locked into McDonald’s growth plan.
Indeed, one of the risks of a franchising strategy is the loss of standards, especially related to product quality.
To prevent that, McDonald’s controls the land, thus making sure that the franchisee is aligned with the product’s standards.
In addition, starting a McDonald’s franchising operation might be quite expensive, and it might require substantial experience.
Therefore, this works as friction at the onset, which should motivate to open McDonald’s restaurants only those who really have solid growth plans.
In fact, as McDonald’s highlights, an initial investment to open up a restaurant might range from $1,008,000 to $2,214,080 (including a $45,000 franchise fee), and at least half a million of liquidity available to be invested into the business.
Franchisee can’t go on and open a McDonald’s on its own, instead, the land lease agreement has to go always thourhg the company.
In fact, McDonald’s keeps them separated.
On the one side, the land development process; on the other side, the franchisee selection and operations.
On the one hand, the company has a real estate arm dedicated to the selection of lands for developing new restaurants. As the company highlights:
McDonald’s looks for the best locations within the marketplace to provide our customers with convenience. We build quality restaurants in neighborhoods as well as airports, malls, tollways and colleges at a value to our customers.
Some of the key criteria for restaurant development are:
50,000+/- sq. ft.
Corner or corner wrap with signage on two major streets.
Signalized intersection.
Ability to build up to 4,000 sq. ft.
Parking to meet all applicable codes.
Ability to build to a minimum height of 23′ 4″.
Source: McDonald’s
When it comes instead to the franchisees, McDonald’s offers a proven playbook and process to create a money-making restaurant machine.
To recap:
McDonald’s does use a heavy-franchised model. However, the company has tweaked the model to quickly expand its operations through franchising, while at the same time keeping control over standards followed by the franchisees, as McDonald’s operates as the landowner/operator.
This tweak is extremely important as it helps balance out the otherwise too-aggressive franchising strategy, which is great for growth, but it might result in a loss of control over process and product quality standards.
For that, McDonald’s has created two separate operations arms: one is a real estate development unit to develop the restaurant land; the other is the franchising operations to select franchisees and help them kick off operations.
That might also explain the high EV/Revenue Multiple of McDonald’s in the last years, as it rolled out a heavy franchised strategy.
In 2022, McDonald’s EV/Revenue Multiples was 8.33 in 2022, compared to 8.53 in 2021.
Heavy-chained business model
McDonald’s has found a balance between quick expansion and opening of new franchising by owning the land where franchisees operate and locking them in through contractual agreements, thus making sure they respect the group’s best practices.
Other restaurant chains, like Chick-fil-A, use the opposite model.
While growth in opening new locations is much slower compared to the fast pace players like McDonald’s, the focus is on ensuring the store is successful.
In fact, the initial fee requested from franchisees is way lower compared to McDonald’s ($10,000 vs. $45,000):
While the entry fee is lower, operating Chick-fil-A franchisees will have to pay a 15% royalty fee.
As the company explains in the franchise disclosure document as 15% of franchised restaurant sales, fewer amounts charged to franchisees for equipment rentals and business services fees, and 50% of net profits.
In short, the Chick-fil-A franchising model has the following features:
It doesn’t require a net worth, compared to other franchising operations such as McDonald’s, as it’s the company that undertakes the expenses to open up a new restaurant.
The franchising fee (entry fee) is just $10,000, compared to, for instance, McDonald’s $45,000 fee.
However, the franchisee has to pay 15% of the net sales and 50% of the net sales.
This makes sense as the franchisor and not the franchisee is the owner of the business, where the franchisee primarily operates the business.
Therefore, the Chick-fil-A franchising operations look more like a chain model, while it skews its playbook in finding the right people to operate the business. In fact, of the applicants, only a tiny percentage of those make it up to become franchisees.
In a franchained business model (a short-term chain, long-term franchise) model, the company deliberately launched its operations by keeping tight ownership on the main assets, while those are established, thus choosing a chain model. Once operations are running and established, the company divests its ownership and opts instead for a franchising model.
Coca-Cola follows a business strategy (implemented since 2006) where through its operating arm – the Bottling Investment Group – it invests initially in bottling partners’ operations. As they take off, Coca-Cola divests its equity stakes, and it establishes a franchising model, as long-term growth and distributionstrategy.
More precisely:
The Coca-Cola distribution system (source: Coca-Cola Company)
While in the directly owned bottling facilities, Coca-Cola sells directly, in the concentrate operations, independent bottling partners manage distribution.
Therefore, Coca-Cola makes money by selling its concentrate to bottling partners (they must place a full order for the concentrate available in that territory as part of the bottling agreement).
As exemplified below, this is how the whole system works:
Coca-Cola follows a business strategy (implemented since 2006) where through its operating arm – the Bottling Investment Group – it invests initially in bottling partners’ operations. As they take off, Coca-Cola divests its equity stakes, and it establishes a franchising model as long-term growth and distributionstrategy.
An opposite scenario might be that of using the franchising model in the short-term to test whether new markets are profitable by reducing the operational costs required to open new units and by speeding up the growth while internalizing them in the long run, if they turn out to be successful and strategic for the company.
This will work as a reverse franchained model.
In a reverse franchained business model, the franchising company can leverage franchising to test whether new markets are profitable, by reducing the operational costs required to open new units, and by speeding up the growth while internalizing them in the long run, if they turn out to be successful and strategic for the company by making it easy and convenient for franchisees to sell back the operations.
The key differences between franchising and licensing
Franchising and licensing are similar in that they are both types of business agreements where one party pays another for the use of brands, trademarks, technology, and other business systems.
Most of the differences between the two approaches relate to the level of control and underlying intent of the transaction itself.
These differences can be summarised in the following points:
Level of control
In a franchise agreement, the franchisor has broader control over how the franchisee uses its brand and operates.
In a license agreement, the licensee has access to the licensor’s intellectual property and has more control over how that property may be used.
Business objectives
Franchise agreements exist primarily for the franchisor to grow its brand in a relatively passive way using established systems.
License agreements, on the other hand, are favored by independently run businesses that simply want to monetize certain technology or trademarks.
Regulation
In the United States, franchise agreements are governed by state and franchise law.
However, it is general contract law that governs license agreements.
Key takeaways
Franchising is a business model where the owner (franchisor) of a product, service, or method utilizes the distribution services of an affiliated dealer (franchisee). While most associate franchising with fast-food chains, the model can be traced back to the Singer sewing machine company.
Franchising as a business model can be split into three types: traditional, business-format, and social. Most franchising agreements in place today are business-format agreements.
Franchising is only successful if both parties act professionally and behave appropriately. This means following guidelines set out in a formal code of conduct or any applicable legislation.
Franchising models recap
Heavy-franchising modelslike McDonald’s
In a heavy-franchising modellike McDonald’s, the initial fee, the investment to open up a restaurant, and the net worth required to operate the business is quite high.
To keep the standards high, McDonald’s has a dedicated arm that is in charge of land development and controls the rental agreement with the franchisees.
The franchisees, in turn, own the business and they will pay royalties to the company.
In a heavy-chained model, like Chick-fil-A
The initial fee to open up a restaurant, the net worth required to operate, and the overall investment required are much smaller.
Indeed, the company owns the whole operation, and it accepts applications from thousands of potential franchisees each year.
In this franchising model, therefore, the growth of opening new restaurants is much slower compared to the heavy-franchised model.
However, the company makes much more money from the franchising operations, as it gets high royalties as a percentage of sales, and it also splits profits with franchisees.
De facto, in this model, the franchisee is more like a high-profile manager than the business owner.
And in part, this is justified by the fact that Chick-fil-A bears the costs of opening these restaurants.
In a hybrid model
Or what we define franchained, a company can leverage a chain model in the short term and unleash the franchising model, once the operations have been established.
An opposite scenario might be that of using the franchising model in the short term to test whether new markets are profitable by reducing the operational costs required to open new units and by speeding up the growth while internalizing them in the long run, if they turn out to be successful and strategic for the company.
One of the major risks of a franchising strategy is the loss of standards, especially related to product quality. For instance, McDonald’s has figured out how to keep standards higher for its franchisees by controlling the land, thus making sure that the franchisee is aligned with the product’s standards.
What makes a good franchise model?
A good franchise model combines amplified distribution and growth by outsourcing expansion to franchisees while making sure these franchisees follow the core standards that the franchisor sets. Not everyone can run a franchising business model at scale. One of the companies that managed to run such a model is McDonald’s.
McDonald’s is a heavy-franchised business model. In 2022, over 60% of the total revenues came from franchised restaurants. The company’s long-term goal is to transition toward 95% of franchised restaurants (by 2022, franchised restaurants were 94.7% of the total). The company generated over $23 billion in revenues in 2022, of which $8.75 billion was from owned restaurants and $14.1 billion from franchised restaurants.
Starbucks is a retail company that sells beverages (primarily consisting of coffee-related drinks) and food. In 2022, Starbucks had 51% of company-operated stores vs. 49% of licensed stores. In 2022, company-operated stores accounted for more than 80% of total revenues, thus making Starbucks a chain business model.
IKEA, as a brand comprising two separate owners. INGKA Holding B.V. owns IKEA Group, the holding of the group. At the same time, that is held by the Stichting INGKA Foundation, which is the owner of the whole Group. Thus, IKEA Group is a franchisee that pays 3% royalties to Inter IKEA Systems.
An effective business model has to focus on two dimensions: the people dimension and the financial dimension. The people dimension will allow you to build a product or service that is 10X better than existing ones and a solid brand. The financial dimension will help you develop proper distribution channels by identifying the people that are willing to pay for your product or service and make it financially sustainable in the long run.
Business model innovation is about increasing the success of an organization with existing products and technologies by crafting a compelling value proposition able to propel a new business model to scale up customers and create a lasting competitive advantage. And it all starts by mastering the key customers.
Digital and tech business models can be classified according to four levels of transformation into digitally-enabled, digitally-enhanced, tech or platform business models, and business platforms/ecosystems.
A digital business model might be defined as a model that leverages digital technologies to improve several aspects of an organization. From how the company acquires customers, to what product/service it provides. A digital business model is such when digital technology helps enhance its value proposition.
A tech business model is made of four main components: value model (value propositions, mission, vision), technological model (R&D management), distribution model (sales and marketing organizational structure), and financial model (revenue modeling, cost structure, profitability and cash generation/management). Those elements coming together can serve as the basis to build a solid tech business model.
A platform business model generates value by enabling interactions between people, groups, and users by leveraging network effects. Platform business models usually comprise two sides: supply and demand. Kicking off the interactions between those two sides is one of the crucial elements for a platform business model success.
A Blockchain Business Model is made of four main components: Value Model (Core Philosophy, Core Value and Value Propositions for the key stakeholders), Blockchain Model (Protocol Rules, Network Shape and Applications Layer/Ecosystem), Distribution Model (the key channels amplifying the protocol and its communities), and the Economic Model (the dynamics through which protocol players make money). Those elements coming together can serve as the basis to build and analyze a solid Blockchain Business Model.
In an asymmetric businessmodel, the organization doesn’t monetize the user directly, but it leverages the data users provide coupled with technology, thus have a key customer pay to sustain the core asset. For example, Google makes money by leveraging users’ data, combined with its algorithms sold to advertisers for visibility.
In an asymmetric businessmodel, the organization doesn’t monetize the user directly, but it leverages the data users provide coupled with technology, thus having a key customer pay to sustain the core asset. For example, Google makes money by leveraging users’ data, combined with its algorithms sold to advertisers for visibility. This is how attention merchants make monetize their business models.
While the term has been coined by Andrew Lampitt, open-core is an evolution of open-source. Where a core part of the software/platform is offered for free, while on top of it are built premium features or add-ons, which get monetized by the corporation who developed the software/platform. An example of the GitLab open core model, where the hosted service is free and open, while the software is closed.
Cloud business models are all built on top of cloud computing, a concept that took over around 2006 when former Google’s CEO Eric Schmit mentioned it. Most cloud-based business models can be classified as IaaS (Infrastructure as a Service), PaaS (Platform as a Service), or SaaS (Software as a Service). While those models are primarily monetized via subscriptions, they are monetized via pay-as-you-go revenue models and hybrid models (subscriptions + pay-as-you-go).
Open source is licensed and usually developed and maintained by a community of independent developers. While the freemium is developed in-house. Thus the freemium give the company that developed it, full control over its distribution. In an open-source model, the for-profit company has to distribute its premium version per its open-source licensing model.
The freemium – unless the whole organization is aligned around it – is a growth strategy rather than a business model. A free service is provided to a majority of users, while a small percentage of those users convert into paying customers through the sales funnel. Free users will help spread the brand through word of mouth.
A freeterprise is a combination of free and enterprise where free professional accounts are driven into the funnel through the free product. As the opportunity is identified the company assigns the free account to a salesperson within the organization (inside sales or fields sales) to convert that into a B2B/enterprise account.
A marketplace is a platform where buyers and sellers interact and transact. The platform acts as a marketplace that will generate revenues in fees from one or all the parties involved in the transaction. Usually, marketplaces can be classified in several ways, like those selling services vs. products or those connecting buyers and sellers at B2B, B2C, or C2C level. And those marketplaces connecting two core players, or more.
B2B, which stands for business-to-business, is a process for selling products or services to other businesses. On the other hand, a B2C sells directly to its consumers.
A B2B2C is a particular kind of business model where a company, rather than accessing the consumer market directly, it does that via another business. Yet the final consumers will recognize the brand or the service provided by the B2B2C. The company offering the service might gain direct access to consumers over time.
Direct-to-consumer (D2C) is a business model where companies sell their products directly to the consumer without the assistance of a third-party wholesaler or retailer. In this way, the company can cut through intermediaries and increase its margins. However, to be successful the direct-to-consumers company needs to build its own distribution, which in the short term can be more expensive. Yet in the long-term creates a competitive advantage.
The C2C business model describes a market environment where one customer purchases from another on a third-party platform that may also handle the transaction. Under the C2C model, both the seller and the buyer are considered consumers. Customer to customer (C2C) is, therefore, a business model where consumers buy and sell directly between themselves. Consumer-to-consumer has become a prevalent business model especially as the web helped disintermediate various industries.
A retail business model follows a direct-to-consumer approach, also called B2C, where the company sells directly to final customers a processed/finished product. This implies a business model that is mostly local-based, it carries higher margins, but also higher costs and distribution risks.
The wholesale model is a selling model where wholesalers sell their products in bulk to a retailer at a discounted price. The retailer then on-sells the products to consumers at a higher price. In the wholesale model, a wholesaler sells products in bulk to retail outlets for onward sale. Occasionally, the wholesaler sells direct to the consumer, with supermarket giant Costco the most obvious example.
The term “crowdsourcing” was first coined by Wired Magazine editor Jeff Howe in a 2006 article titled Rise of Crowdsourcing. Though the practice has existed in some form or another for centuries, it rose to prominence when eCommerce, social media, and smartphone culture began to emerge. Crowdsourcing is the act of obtaining knowledge, goods, services, or opinions from a group of people. These people submit information via social media, smartphone apps, or dedicated crowdsourcing platforms.
In a franchained business model (a short-term chain, long-term franchise) model, the company deliberately launched its operations by keeping tight ownership on the main assets, while those are established, thus choosing a chain model. Once operations are running and established, the company divests its ownership and opts instead for a franchising model.
Businesses employing the brokerage business model make money via brokerage services. This means they are involved with the facilitation, negotiation, or arbitration of a transaction between a buyer and a seller. The brokerage business model involves a business connecting buyers with sellers to collect a commission on the resultant transaction. Therefore, acting as a middleman within a transaction.
Dropshipping is a retail business model where the dropshipper externalizes the manufacturing and logistics and focuses only on distribution and customer acquisition. Therefore, the dropshipper collects final customers’ sales orders, sending them over to third-party suppliers, who ship directly to those customers. In this way, through dropshipping, it is possible to run a business without operational costs and logistics management.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
