franchising

What Is A Franchising Business Model?

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?

Well, franchising alone is just a distribution/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 heavy franchised McDonald’s business model.

Therefore, as we’ll see throughout this research, franchising here is considered as 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 restaurants’ chains business across the US, like the automobile, and the infrastructure of highways built around it also enabled 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 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, and 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. In the United States alone, the franchising industry employs approximately 8.67 million people across more than 785,000 establishments.

Some of the key points to take into account when it comes to franchising:

  • Growth: franchisning 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 loss of control over product, brand 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 defenitely one of the key advantage 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 the product development. Imagine the case of a company only running franchised stores, who 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 francihising 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 speed and ability of the franchisees to stick with the company’s standards and be true to the company’s mission.

How a 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 anticompetitive conduct guidelines.

As we’ll see franchising agreements will take different shapes, according to the franchising model the company operates.

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.

Dominoes 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.

Heavy-franchised business model

McDonald’s follows what can be defined as a heavy-franchised business model.

mcdonald's-business-model
McDonald’s is a heavy-franchised business model. In 2018, of McDonald’s total restaurants, 93% were franchised. The long-term goal of the company is to transition toward 95% of franchised restaurants. The company’s operating income in 2018 was $8.8 billion compared to $9.55 in operating income for 2017.

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 for 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″.
mcdonald's-land-development
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 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 land for the restaurants; the other is the franchising operations to select franchisees and help them kick off operations.

Heavy-chained business model

Where McDonald’s has found a balance to quick expansion and opening of new franchising by owning the land where franchisees operate and by locking them in through contractual agreements, thus making sure they respect the best practices of the group. Other restaurant chains, like Chick-fil-A use the opposite model.

While growth in opening new locations is much slower in comparison to the fast pace. ofplayers like McDonald’s the focus is on making sure the store would be successful. In fact, the initial fee requested to franchisees is way lower compared to McDonald’s ($10,000 vs. $45,000):

chick-fil-a-franchising

While the entry fee is lower, operating a Chick-fil-A franchisees will have to pay a 15% royalty fee. As the company explains it the franchise disclosure document as 15% of franchised restaurant sales, less 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 franchisng operations as McDonald’s, as its the company who undertakes the expenses to open up a new restaurant.
  • The franchising fee (entry fee) is just $10,000, compared to for instance, the McDonald’s $45,000 fee.
  • However, the franchisee has to pay 15% on the net sales, and 50% on 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, looks more like a chain-model, while it skewes 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.

Hybrid or franchained business model

The Coca-Cola Company, has mastered a franchising model, which also works as a go-to-market strategy, which we defined franchained:

franchained-business-model
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.

As we highlighted in the Coca-Cola business model analysis:

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 distribution strategy.

More precisely:

https://author-prod-go-aem6-4.coke.com/assetdetails.html/content/dam/journey/us/en/testimages/sustainability-story-desktop-703x450.jpg
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-business-strategy
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 distribution strategy.

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.

reverse-franchained
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.

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

  • In a heavy-franchising model like McDonald’s the initial fee, the investment to open up a restaurant and the net worth required to operate the business are quite high. To keep the standards high, McDonald’s has a dedicated arm, which is in charge of land development, and that 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 is 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 owner of the business. And in part, this is justified by the fact, that Chick-fil-A bears the costs of opening up these restaurants.
  • In a hybrid model, or what we defined franchained, a company can leverage on a chain model in the short-term and unleash the franchising model, once the operations have been established. The Coca-Cola Company leverages this model to establish new operations. 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.

Connected Case Studies

mcdonald's-business-model
McDonald’s is a heavy-franchised business model. In 2018, of McDonald’s total restaurants, 93% were franchised. The long-term goal of the company is to transition toward 95% of franchised restaurants. The company’s operating income in 2018 was $8.8 billion compared to $9.55 in operating income for 2017.
starbucks-business-model
Starbucks is a retail company that sells beverages (primarily consisting of coffee-related drinks) and food. In 2018, Starbucks had 52% of company-operated stores vs. 48% of licensed stores. The revenues for company-operated stores accounted for 80% of total revenues, thus making Starbucks a chain business model. 
who-owns-ikea
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. 

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