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The Franchise Business Model: Everything You Need to Know
You may be wondering what to make of franchising and whether it's something you should pursue. But if you don't have a solid indication of what franchising is, even the basic concept can be overwhelming. Here's a guide to everything you need to know about franchising.
What Is Franchising?
Franchising, or a business franchise model, is a contractual business model or relationship whereby an established brand, known as the 'franchisor,' allows an independent business owner, or franchisee, to use its branding, business model, and other intellectual property. In return, the franchisee agrees to pay an upfront franchise fee, plus ongoing royalties to the franchisor.
There are dozens of different types of franchise arrangements, but three of them are the most common. They include:
- Business format franchise : This is the most common type of franchise arrangement. In this model, the franchisor allows a third party to do business using their trademarks and business model in exchange for fees and a recurring percentage of sales revenue. Franchisees under this model are run according to the parent company's guidelines and rules.
- Product franchise : This is the oldest form of a franchise arrangement. Under this model, the franchisees exclusively distribute or sell franchisor's products.
- Manufacturing franchise : Within this model, third-party manufacturers obtain exclusive rights to produce and distribute products using the franchisor's trade name and trademark.
Advantages of Franchising For Entrepreneurs
Ongoing support from the franchisor is not the only benefit of franchising. Here are a few benefits associated with franchise businesses:
- You'll work with an already established brand name: A strong brand will inspire customer loyalty, lead to more sales opportunities, and lend a competitive edge to your business.
- Reduced risk: If you work with a top franchisor, the risk of your business failing is very low compared to starting a business of your own.
- Simplified procurement processes: Another added advantage of franchising is you'll get access to quality suppliers and better deals.
- You don't have to worry about advertising or marketing: Your business will benefit from ad campaigns and promotions managed by the franchisor. The franchisor will also conduct market research on the best potential locations and share the findings with you.
- Quality leadership and lower operating costs: The franchisor will train you and help you identify the best strategies to manage your business operations effectively while keeping your costs low.
What Does the Franchisor Get Out of This Arrangement?
On the opposite end, there are a variety of incentives for businesses to adopt the franchise model. Here are some benefits of franchising for the franchisor:
- New locations and desirable market: Franchising is a source of capitalized expansion to new and desirable locations. Rather than franchisors putting their own money into market research, franchisees invest their funds to establish a business in a desirable location.
- Additional revenue: Franchisors benefit from ongoing royalties.
- Additional advertising: Franchisors also benefit from expanded advertising power through franchisees.
How Does the Franchising Process Work?
The franchising process varies depending on the type of franchise arrangement, state, and franchisor guidelines. That said, a typical franchising process will look something like this:
Step 1: Gather background information
First things first, conduct research to identify the type of franchise you would like to venture into. Make sure you have a clear idea of what you expect to gain from starting a franchise. Next, come up with a list of franchisors you'd be interested in investing in. Prioritize selecting businesses that match your goals, budget, and business acumen. Also, make sure you research the legal considerations involved with a particular industry or jurisdiction for starting a franchise in your state.
Step 2: Reach out to the franchisor
Contact the franchisor's representative and schedule a meeting. A face-to-face meeting is an opportunity for you to know more about the business and help you make an informed decision. Key questions to consider include inquiring about how long the business has been in operation, its growth plan, and risk factors. After the interview, the franchisor should offer you their franchising brochures, guidelines, and other relevant initial documentation for potential franchisees.
Step 3: Negotiations
Assuming initial conversations go well and the franchisor meets your key criteria, it's time to negotiate the terms of the partnership. This stage is often quite complicated, so you need to equip yourself with the best negotiation skills and strategies. Tulane SoPA can help sharpen your negotiation skills and understand business fundamentals via our Applied Business Studies program .
Step 4: Agreement Signing
Once the terms on the table are accepted, the next step forward is signing a formal agreement. At this stage, consider hiring a legal expert to guide you. Also, take some time to review the agreement to ensure that it's as clear and detailed as possible to avoid confusion and potential disputes down the road.
The franchise disclosure document, or FDD, forms the legal foundation to sell a franchise. It is a fundamental requirement for both the federal and state franchising laws. The FDD requires a franchisor to provide all franchise disclosure documents with their respective state regulators. Also, under the FDD, franchisors can renew their agreement with their franchisees at the end of an agreement in accordance with (Sec. 8) Small Business Franchise Act.
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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 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.
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-19 th 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:
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.
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).
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.
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.
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.
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.
- Heavy-franchised business model
McDonald’s follows what can be defined as a heavy-franchised business model .
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″.
When it comes instead to the franchisees, McDonald’s offers a proven playbook and process to create a money-making restaurant machine.
- 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.
- 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.
- 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 :
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 .
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:
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.
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.
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.
In the United States, franchise agreements are governed by state and franchise law.
However, it is general contract law that governs license agreements.
- 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 models like mcdonald’s.
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 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.
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.
What are the 3 types of franchises?
The three main types of franchising comprise:
According to the FourWeekMBA’s research, three other types of franchising models were identified:
What are the risks of franchising?
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 .
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The Franchise Business Model 101 – Introduction and How Does It Work
The franchise business model is not new. In fact, franchising is an ancient distribution model that dates back to the middle ages and ancient China. “In the middle ages, the local titled landowner would grant rights to the peasants or serfs, probably for a consideration, to hunt, hold markets or fairs or otherwise conduct business on his domain. With the rights came rules and these rules became part of European Common Law, explained FranChoice .
Modern-day franchising is believed to have started with Benjamin Franklin, who in 1731 entered into the first franchise agreement with Thomas Whitmarsh to provide printing services in Charlestown, South Carolina. In the early 1850s, Isaac M. Singer again looked to the franchising model to distribute the Singer sewing machines. But, it would be another century after Singer before franchising would become truly popular, thanks to Ray Kroc and his discovery of the McDonalds hamburger stand.
Today, there are thousands of franchises across hundreds of industries and sectors. As of 2018, the franchise industry employed 21 million people and generated $2.3 trillion of economic activity, according to a U.S. government report.
Franchising has contributed greatly to the overall US economy and has proven to be a lucrative avenue for those who seek both freedom and financial stability. But what exactly is a franchise? Are there different types of franchise models? How does it all work? And is owning a franchise right for you?
What is a Franchise? Understanding the Franchise Business Model and How Does It Work
A franchise is a type of business that is operated by an individual(s) known as a franchisee using the trademark, branding and business model of a franchisor. In this business model, there is a legal and commercial relationship between the owner of the company (the franchisor) and the individual (the franchisee). In other words, the franchisee is licensed to use the franchisor’s trade name and operating systems.
In exchange for the rights to use the franchisor’s business model — to sell the product or service and be provided with training, support and operational instructions — the franchisee pays a franchisee fee (known as a royalty) to the franchisor. The franchisee must also sign a contract (franchise agreement) agreeing to operate in accordance with the terms specified in the contract.
A franchise essentially acts as an individual branch of the franchise company.
Should You Buy a Franchise or Start a Business From Scratch?
The Franchisor and Franchisee Relationship
The Franchisor is the parent company that sells the rights to franchise their brand to prospective franchisees. The franchisor is the one who has developed the company, brand and operating systems. Upon the decision to franchise their business, the franchisor offers franchisees the rights to their proven business model, recognizable trademark, established business systems, and their training and support.
The Franchisee is the individual who buys the rights to sell the products or services and utilize the proven and established business systems mentioned above. Although the franchisee is, in essence, buying a pre-established business, franchisees must work hard in order to gain loyalty in their market, attract talent and grow their franchise business. After all, it is the franchisee that runs the day to day business.
The franchisor/franchisee relationship should be one built upon mutual respect, understanding, and support. Of course, as with all relationships, no two are the same. Although relationships between franchisee and franchisor will differ from brand to brand, one thing always remains the same: the franchisee/franchisor relationship matters.
What Franchisees Can Expect from Their Franchisor
When a franchisee is serious about a franchise opportunity, the franchisor will share their Franchise Disclosure Document (FDD) , which holds imperative information about bankruptcies, various fees, franchisee obligations, and more.
For interested and serious buyers, some franchisors offer financing programs that can assist franchisees in finding a loan servicer or alternative methods of payment.
If the franchise requires a physical location, usually, the franchisor will assist in site selection as well as finding a local contractor to construct the approved architecture.
Training and Operational Guidance
Franchisors also provide franchisees with an operating manual and in-person or online training to understand how the business runs. The operating manual includes all of the roles of employees, performance standards, management operations, and other specifications. The training tends to take place either at the franchisor’s corporate headquarters or a combination of online training and in-person training.
Marketing and Advertising
Franchisors also supply their franchisees with marketing and advertising. This could be through television and radio ads or through social media and email campaigns. Franchisees are usually charged a marketing fee to cover this cost. Some franchisors also lend administrative services for their franchisees, like human resources and accounting services.
As a franchisee gets their business up and running there are bound to be questions and concerns that arise. The franchisor will provide varying levels of support throughout the life of the franchise agreement. Not to mention, franchisee also have access to an entire network of fellow franchisees, who may be able to offer advice or offer you a solution to a common problem.
The Pros and Cons of Franchising: Is it Right for You?
Types of Franchising – Two Primary Franchise Business Models
There are two primary franchise business models that exist today: The Product Distribution Franchise Model and The Business Format Franchise Model.
Product Distribution Franchise – In the product distribution franchise model the franchisor manufacturers the product and the franchisee sells the product. This relationship is similar to the supplier-dealer relationship with a few differences. One major difference is that in the franchise relationship the franchisee may distribute the products on an exclusive or semi-exclusive basis whereas a supplier-dealer relationship may allow the dealer to sell several different brands at once. Examples of product distribution franchises include Coca-Cola, John Deere, and Ford Motor Company.
Business Format Franchise – The Business Format Franchise is the most common franchise model. In this model, the franchise is allowed to use the brand and trade name of the franchisor, like in the product distribution model, but they are also granted access to the product distribution model. Most of the franchises that immediately comet o mind, like Wendy’s, Dunkin Donuts, or McDonald’s are business format franchises.
Different Types of Franchise Ownership
Single Unit Franchisee – When a franchisee purchases their first franchise they are considered a single-unit franchisee. This is the most common form of franchise ownership.
Multi-Unit Franchisee – If a franchisee finds success with their first franchise venture they may choose to open up a second, third or even fourth franchise from the same franchisor. When a franchisee owns more than one franchise unit they are considered to be a multi-unit owner.
Multi-Unit Area Developers – Multi-unit area developers are similar to multi-unit franchisees except that they agree, up front, to develop a certain number of franchise locations within a specified time period and area. This approach is best for franchisees who are looking for market exclusivity and have the resources to secure that exclusivity with the franchisor.
Master Franchisee – A master franchisee is very similar to a multi-unit area developer in that they are obligated to open a certain number of locations in a specified time period and area. The difference is that the master franchisee is also able, and sometimes obligated, to sell franchises to other prospective franchisees. The master franchisee then acts as a middleman for the franchisee and the franchise company.
Licensing vs. Franchising
One common area of confusion for prospective franchisees is understanding the difference between franchising and licensing.
Licensing is a broad term that businesses use for contracting purposes. Licensing gives the licensee a right to operate in cooperation with a brand, gaining access to the brand’s intellectual property, brand, design, and business programs. In exchange, the licensee pays royalty fees to the licensor. The licensor may have a say in how the intellectual property is used but not how the licensee operates their business. A licensor will grant a licensee the right to use their intellectual property but the licensor will not provide support or training or exert any control over how the licensee uses that intellectual property.
A franchise, on the other hand, is a legal and commercial relationship between the owner of a company (the franchisor) and an individual (the franchisee) who is starting a branch of that business using the business’ trademark logos and business model. Essentially, a franchise is an independent branch of the franchise company. The franchisee sells the product or service that the franchisor supplies.
What’s the Difference Between Licensing and Franchising? Learn More!
Franchise Opportunity vs. Business Opportunity
Another common area of confusion is franchise opportunity versus business opportunity. While at first glance they may sound very similar, there are some major differences. For instance, a franchise opportunity includes the licensing of trademark rights, offers robust training and operational assistance throughout the life of the contract, and can often cost more than a business opportunity due to the ongoing required fees.
While all business opportunities are different and can be hard to define, the main difference is that typically when someone pursues a business opportunity they are unlikely to receive the same level of support, training or guidance that a franchisee receives from their franchisor.
43 Common Franchise Terms You Need to Know!
Not All Franchises are Created Equal
There are thousands of franchise opportunities for eager entrepreneurs who see the appeal in the franchising model. However, not all franchises are smart investments. That’s why it’s important for prospective franchisees to research the opportunities they are interested in.
To help prospective buyers find the best opportunities, each year, Franchise Business Review surveys thousands of franchisees across hundreds of brands. Based on this research we are able to determine the best franchise opportunities on the market today based 100% on franchisee satisfaction. Details on this year’s top-rated franchise brands can be found on our Top 200 list.
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Franchisee Satisfaction a Key Consideration Among Potential Franchise Buyers
Franchisee satisfaction is a key driver for franchise buyers. Franchise owners are the ones with their ‘boots on the ground’ and their hands in the weeds of the day-to-day operations. They’ve hired staff and served clients. They’ve faced and overcome challenges. They are the true authorities on what it’s like to run the business.
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Franchisees Dustin and Rebecca Rauch on Operating a Caring Senior Service Franchise
“We were looking for a brand with a proven track record. One with many years in business; a smaller franchise system where we wouldn't be lost in the mix—as just another number; a brand that would be supportive; one we could work with as a team to the benefit of both parties; an opportunity with a low failure rate; and most importantly and brand that exhibits a desire for excellence in every way, starting at the top, and expects the same from their franchisees.”
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Cruise Planners Travel Franchise Is Growing to Meet 2023 Travel Demand
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- The Franchise Guide :
The Benefits of the Franchise Model
Franchising provides benefits for both seller and buyer. For franchisors, the primary benefit is the ability to use other people's money to expand the brand more rapidly than they could either on their own or through investors or lenders. The initial franchise fee and ongoing royalties they collect allow franchisors to build their brand without sacrificing control to outsiders or the pressure of repaying lenders. The fees and royalties are used to fund operations at corporate headquarters, train and support franchisees, market and advertise the brand, improve the quality of goods or services, and build the brand in the marketplace.
For franchisees, benefits include: a higher chance of success than in a sole proprietorship; shorter time to opening; initial training and ongoing support; assistance in finding an optimal site; the selling power of a known brand; lower costs through group purchasing; use of an established business model; national and regional advertising campaigns; customer lead generation through websites and centralized call centers; and a network of peers (fellow franchisees) to provide advice and moral support through a company intranet, annual conferences, and franchisee associations; and, increasingly, assistance with securing funding.
Potential downsides for franchisees include: lack of independence, from the goods and services they sell to the color of the paint on their walls; mandatory company-wide promotions that may not work in their market (price cuts, new products or services), yet cost money to implement; costly required redesign of their unit(s); and, after signing a 10- or 15-year contract, a change in management or ownership that takes the brand in a new, unwanted direction.
As with any business opportunity, there is no guarantee of success, and there are trade-offs to be made. In some ways, franchising is like paying condo fees instead of owning a home. In a condo association, monthly fees are pooled for common external maintenance (mowing, snow removal, roof repairs, etc.) – a tradeoff many are willing to make to free themselves to concentrate on their "core business" of living their lives (or business) within the walls of their condo (or franchise) unit. And unlike renters, who can be evicted (or corporate employees who can be fired or "downsized") franchisees have some power of their own: a franchisor cannot "fire" a franchisee who is operating in compliance with the franchise agreement.
"Follow the system" is a mantra in franchising and critical to a franchisee's success. Franchisees buy into the franchisor's operating system believing that if they follow it to the letter they will succeed and be profitable. Smart franchisors are always open to suggestions from their franchisees for change (as well as local or regional variations), but any franchisee departing from the "system" without franchisor approval risks violating the terms of the franchise agreement, which can result in revocation of the franchisee's right to do business under the franchisor's name. Franchisees also must agree to keep the franchisor's proprietary system and trade secrets confidential, as well as sign some type of noncompete agreement.
Not everyone is cut out for franchising. Some need total independence to succeed or fail on their own, while others prefer the tradeoffs found in working for a larger organization. For the franchise partnership to succeed, the buyer must be comfortable not only with the franchise model, but also with the culture, values, and goals of the franchisor — and vice versa.
In this light, many view franchising as a commitment much like a marriage. A good match between franchisor and franchisee, sharing mutual goals over the long term, is essential to the success of each franchise unit, and thus the brand as a whole — an essential factor that must be considered seriously by both parties before any contract is signed.
Franchise Guides »
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A Consumer’s Guide to Buying a Franchise
- Franchises, Business Opportunities, and Investments
File 591a_buying_a_franchise_sept_2020.pdf (534.69 KB)
When you buy a franchise, you may be able to sell goods and services that have instant name recognition, and get training and support that can help you succeed. But purchasing a franchise is like any other investment: there’s no guarantee of success.
The Federal Trade Commission, the nation’s consumer protection agency, has prepared this Guide to help you decide if a franchise is right for you. It suggests ways to shop for a franchise opportunity and highlights key questions you need to ask before you invest. The Guide also explains how to use the disclosure document that franchisors must give you — under the FTC’s Franchise Rule — so you can investigate and evaluate a franchise opportunity.
The Franchise Business Model
Is a franchise right for you, finding the right opportunity, selecting a franchise, the franchise disclosure document, evaluating potential earnings, before you sign the franchise agreement.
A franchise enables you, the investor or franchisee, to operate a business. You pay a franchise fee and you get a format or system developed by the company (franchisor), the right to use the franchisor’s name for a specific number of years and assistance. For example, the franchisor may provide you with help in finding a location for your outlet; initial training and an operating manual; and advice on management, marketing or personnel. The franchisor may provide support through periodic newsletters, a toll-free telephone number, a website or scheduled workshops or seminars.
Owning a franchise comes with defined costs, franchisor controls and contractual obligations.
In exchange for the right to use the franchisor’s name and benefit from the franchisor’s assistance, you will pay some or all of the following:
Initial Franchise Fee and Other Expenses
Your initial franchise fee will typically range from tens of thousands of dollars to several hundred thousand dollars and may be non-refundable. You may face significant costs to rent, build and equip an outlet and to buy initial inventory. You also may have to pay for operating licenses and insurance and a “grand opening” fee to the franchisor to promote your new outlet.
Continuing Royalty Payments
You may have to pay the franchisor royalties based on a percentage of your weekly or monthly gross income. Typically, you must pay royalties for the right to use the franchisor’s name, even if you are losing money. You may have to pay royalties for the duration of your franchise agreement even if the franchisor doesn’t provide the services it promised and even if you decide to terminate your franchisee agreement early.
You also may have to contribute to an advertising fund. Some portion of the advertising fees may be allocated to national advertising or to attract new franchise owners, rather than to promote your outlet.
To ensure uniformity, franchisors usually control how franchisees conduct business. These controls may significantly restrict your ability to exercise your own business judgment. A franchisor may control:
Many franchisors retain the right to approve sites for their outlets, and may not approve a site you select. Some franchisors conduct extensive site studies as part of the approval process and a site they approve may be more likely to attract customers.
Design or Appearance Standards
Franchisors may impose design or appearance standards to ensure a uniform look among their outlets. Some franchisors require periodic renovations or design changes; complying with these requirements may increase your costs.
Restrictions on Goods and Services You Sell
Franchisors may restrict the goods and services you sell. For example, if you own a restaurant franchise, you may not be able to make any changes to your menu. If you own an automobile transmission repair franchise, you may not be able to perform other types of automotive work, like brake or electrical system repairs.
Restrictions on Method of Operation
Franchisors may require that you operate in a particular way. They may dictate hours; pre-approve signs, employee uniforms and advertisements; or demand that you use certain accounting or bookkeeping procedures. In some cases, a franchise advertising cooperative may require you to sell some goods or services at specific discounted prices, which may affect your profits. Or, the franchisor may require that you buy supplies only from an approved supplier, even if you can buy similar goods elsewhere for less.
Restrictions on Sales Area
A franchisor may limit your business to a specific location or sales territory. If you have an “exclusive” or “protected” territory, it may prevent the franchisor and other franchisees from opening competing outlets or serving customers in your territory, but it may not protect you from all competition by the franchisor. For example, the franchisor may have the right to offer the same goods or services in your sales area through its own website, catalogs, other retailers or competing outlets of a different company-owned franchise.
Franchise contracts last only for the number of years stated in the contract. You can lose the right to your franchise if you don’t comply with the contract. You won’t have a right to renew unless the franchisor gives you that right.
A franchisor can end your franchise agreement for a variety of reasons, including your failure to pay royalties or abide by performance standards and sales restrictions. Many franchise contracts will give you a chance to “cure” an occasional failure to comply (like making one late payment) but keep the right to terminate your franchise for other failures. If your franchise is terminated, you’re likely to lose your entire investment.
Franchise agreements may run for as long as 20 years. Renewals are not automatic. At the end of the contract term, the franchisor may decline to renew or may offer a renewal that doesn’t have the same terms and conditions as your original contract. For example, the franchisor may raise the royalty payments, impose new design standards and sales restrictions, or reduce your territory. Any of these changes may result in higher costs, reduced profits or more competition from company-owned outlets or other franchisees.
Before you invest in a particular franchise system, think about how much money you have to invest, your abilities and your goals. Be brutally honest.
- How much money do you have to invest?
- How much money can you afford to lose?
- Are you purchasing the franchise alone or with partners?
- Do you need financing? Where will you get it? What’s your credit rating and credit score?
- Do you have savings or additional income to live on until your franchise opens and, you hope, becomes profitable?
- Does the franchise require technical experience or special training or education — for example, auto repair, home and office decorating or tax preparation?
- What special skills can you bring to this business?
- What experience do you have as a business owner or manager?
- What are your reasons for buying a particular franchise?
- Do you need a specific minimum annual income?
- Do you want to work in a particular field?
- Are you interested in retail sales or performing a service?
- How many hours can you work? How many are you willing to work?
- Do you intend to operate the business yourself or hire a manager?
- Will franchise ownership be your main source of income or a supplement to your current income?
- Are you in this for the long term?
- Would you like to own several outlets?
- Are you willing to let the franchisor be your boss?
There are many ways other than franchisors’ websites to find information about franchise opportunities, including visiting local franchised outlets, looking at franchise handbooks, attending franchise expositions and working with franchise brokers.
It’s always a good idea to visit franchised outlets in your area and talk to the owners about their experience with particular franchisors.
A “franchise opportunities handbook,” available from a library or online, will list available franchises by type of business and provide basic information about each franchise. You can use a handbook to find a franchise if you don’t know the type of business you want, or to see which franchises are available for the type of business that interests you.
Attending a franchise exposition allows you to see and compare a variety of franchise possibilities at one time. Before you attend, research the kind of franchise that may best suit your budget, experience and goals. When you attend, visit several franchise exhibitors who deal with the type of industry that appeals to you. Ask questions, including:
- How many franchised outlets are there? Where are they?
- What is the initial franchise fee? What are the additional start-up costs?
- Are there continuing royalty payments? How much are they?
- What management, technical and other support does the franchisor offer?
- What controls does the franchisor impose?
- How long has the franchisor been in business?
Exhibitors may offer you incentives to attend a promotional meeting to discuss the franchise in detail. These meetings can be another source of information and give you a chance to raise questions, but they may also expose you to high-pressure sales tactics. Be prepared to walk away from any franchise opportunity — and promotion — that does not fit your needs.
Franchise brokers may call themselves “business coaches,” “advisors,” “referral sources” or “sales consultants.” They often advertise on the internet and in business magazines, offering to help you select among various franchise options. Typically, a broker reviews the amount of money you have to invest and then directs you to opportunities that match your interests and resources. A broker also may help you finish applications and the paperwork to complete the sale. Brokers often work for franchisors, and are paid only if a sale is made.
Before you decide to use a broker, consider whether you need a broker’s services or could get enough information by shopping online or reading trade magazines.
What choices does the broker offer?
Some franchise brokers may claim to be able to match you with “the perfect opportunity” because they represent a wide range of business sellers. That may be true — or not.
Ask how many franchisors the broker represents. A broker who represents only a few franchisors will give you limited suggestions.
How does the broker select franchises?
Some franchise brokers may claim they will suggest only those franchises that meet certain standards. You may think this means that your risk is limited because the broker weeds out poor investments. In fact, some brokers represent any franchisor willing to pay them a commission for a sale. A broker who does that might direct you to a franchisor that is failing or doesn’t have a strong history.
Ask how the broker selects franchisors to represent. Ask to see the selection criteria and how many franchisors the broker has recently turned down.
How is the broker paid?
Some brokers earn a flat fee regardless of the price of the franchise they sell. Others earn a commission based on the cost of the franchise. These brokers may steer you toward a more costly franchise to increase their commission.
Ask who pays the broker and how the payment is calculated. Find out whether the broker earns a commission based on the cost of the franchise. If he or she does, consider whether the broker is suggesting a higher priced franchise in order to earn a larger commission.
Are the broker’s earnings claims reliable?
To convince you to buy a particular franchise, a broker may talk about how much money you can make. These claims may not be true or can be misleading. For example, the figures may be based on earnings in an area where there is high demand for the franchisor’s goods or services. Or the claim may be based on outdated industry data. In some instances, earnings claims may use gross sales figures, but when you consider likely expenses, you may find that actual earnings will be far less. Because earnings representations may be misleading, franchisors usually don’t allow their sales representatives to make claims about sales, income or profits unless the claims are included in the franchise disclosures the franchisor must give you.
The required franchise disclosures will list the names and contact information for the franchisor’s current and former franchisees. Talk to them, rather than relying on information from the broker alone. Ask about their experience with the franchisor.
Purchasing a franchise is like any other investment: it comes with risk. When you consider a particular franchise, think about demand for the products or services it offers, whether competitors offer similar products or services, the level of support you will receive and the franchisor’s reputation.
Is there a demand for the franchisor’s products or services in your community? Is it seasonal or evergreen? Could you be dealing with a fad? Does the product or service generate repeat business? Is the franchisor’s name so well known that it will bring in customers, or will you have to create a market for the franchise?
What’s the level of competition — nationally, regionally and locally? How many franchised and company-owned outlets are in your area? Does the franchise sell products or services that are easily available online or through a catalog? How many competing companies, including competing franchises, sell similar products or services at a similar price? Are those companies well established or widely recognized in your community?
Your Ability to Operate the Business
Sometimes, franchise systems fail. What will happen to your business if the franchisor closes up shop? Will you need the franchisor’s ongoing training, advertising or other help to remain in business? Will you have access to the same suppliers? Could you conduct the business alone if you have to cut costs or lay anyone off?
Buying a franchise gives you the right to associate with the franchisor’s name or brand. An established franchise with a well-known name — and good reputation — is more likely to draw customers than a relatively new or unknown franchise. If you invest in a franchise, you’ll be responsible for creating customer demand for its goods or services in your area.
- how long the franchisor has been in business
- name and brand recognition for the franchisor and its products or services
- whether the franchisor has a reputation for quality products or services
You’ll want to find out from the required disclosure document whether the franchisor has a federally registered trademark. If it doesn’t, a company using the same mark in your area could force you to change the name or mark of your outlet at your expense.
Complaints About the Franchise
It’s also a good idea to check whether consumers or franchisees have filed complaints against the franchise or franchisor with franchise regulators, Better Business Bureaus (BBBs) or local consumer protection agencies in your state or the franchisor’s home state. Read more about how to check out a franchise in “Additional Sources of Information” at the end of this Guide.
Training and Support Services
What training and continuing support does the franchisor provide? Does the training measure up to the training provided by other franchisors in the same type of business and for workers in that field? Can you compete with others who have more formal training? What backgrounds do the current franchise owners have? Is your education, experience or training similar? What do current franchise owners say about the quality and usefulness of the training they received?
Many franchisors that operate well-established companies have years of experience selling goods or services and managing a franchise system. Some franchisors started by operating their own business. There’s no guarantee, however, that a successful entrepreneur can successfully manage a franchise system. Find out how long the franchisor has managed a franchise system. Does the franchisor have enough expertise to make you feel comfortable? If the franchisor has little experience managing a chain of franchises, take promises about guidance, training and other support with the proverbial grain of salt.
A growing franchise system increases the franchisor’s name and brand recognition and may enable you to attract customers. But growth alone doesn’t ensure that franchisees will be successful. In fact, a franchisor that grows too quickly may not be able to support its franchisees with the services it promises them. Investigate the franchisor’s financial assets and resources. Are they sufficient to support you and all the other new outlets the franchisor plans to open?
Before you invest in any franchise, get a copy of the franchisor’s Franchise Disclosure Document (FDD). Under the Franchise Rule enforced by the FTC, you must receive the document at least 14 days before you are asked to sign any contract or pay any money to the franchisor or an affiliate of the franchisor. You have the right to ask for — and get — a copy of the FDD once the franchisor has received your application and agreed to consider it. Indeed, you may want to get a copy of the franchisor’s FDD before you spend any money to investigate the franchise offering. The franchisor may give you a copy of its FDD on paper, via email, through a web page or on a disc. The cover of the FDD must provide information about the available formats. Make sure you have a copy of the FDD in a format that is convenient for you, and keep a copy for reference.
Read each of the 23 numbered “Items” in the FDD. Don’t be shy about asking for explanations, clarifications and answers to your questions before you invest. Here are some key sections of the FDD:
Franchisor’s Background (FDD Item 1)
Item 1 tells you how long the franchisor has been in business and its likely competition. It also lets you know if there any legal requirements unique to the franchised business, like a requirement that you get a special license or permit. This will help you understand the costs and risks you will take on if you purchase and operate the franchise.
Business Background (FDD Item 2)
Item 2 identifies the executives of the franchise system and describes their experience. Pay attention to their general business backgrounds, their experience in managing a franchise system and how long they’ve been with the franchisor.
Litigation History (FDD Item 3)
Item 3 lists important information about prior litigation — whether the franchisor or any of its executive officers have been convicted of felonies involving fraud, violations of franchise law, or unfair or deceptive practices law, or are subject to any state or federal injunctions involving similar misconduct. This item will tell you whether the franchisor or any of its executives have been held liable for — or settled civil actions involving — the franchise relationship. If there have been many claims against the franchisor, it may mean the franchisor has not performed according to its agreements. Or it could show that franchisees are dissatisfied with its performance. Item 3 also should say whether the franchisor has sued any of its franchisees during the last year. That disclosure may indicate common types of problems in the franchise system. For example, if a franchisor sued franchisees for failing to pay royalties, it could be because franchisees weren’t successful, and weren’t willing or able to make their royalty payments.
Bankruptcy (FDD Item 4)
Item 4 discloses whether the franchisor or its predecessor, affiliates or any of its executives have been involved in a recent bankruptcy. If the franchisor or its predecessor or affiliate has declared bankruptcy, carefully review the franchisor’s financial statements in Item 21 of the FDD to see if the franchisor is financially capable of delivering the support services it promises. Consider having an accountant review the required financial statements too.
Initial and Ongoing Costs (FDD Items 5-7)
These items describe some of the costs involved in starting and operating a franchise, including deposits or franchise fees that may be non-refundable, and costs for initial inventory, signs, equipment, leases or rentals. It also explains ongoing costs, like royalties and advertising fees. In addition, ask or find out about:
- grand opening or other initial business promotions
- business and operating licenses
- product or service supply costs
- real estate and leasehold improvements
- required equipment, such as a computer system or a security system
- business insurance
- compliance with local ordinances, such as zoning, waste removal, and fire and other safety codes
- employee salaries
You’ll need to investigate other initial and ongoing costs that aren’t described in Items 5-7, such as the cost of accounting and legal help.
It may take several months to start your business, and it may take more than a year to break even. Some franchises never break even. Estimate your operating expenses for the first year and your personal living expenses for up to two years. Compare your cost estimates for the franchise with what other franchisees in this system and competing systems have paid. An accountant can help you evaluate this information. You may be able to do better with another franchisor.
Supplier, Territory and Customer Restrictions (FDD Items 8 and 12)
- These items tell you whether the franchisor limits:
- suppliers from whom you may purchase goods
- the goods or services you may offer for sale
- where and to whom you can sell goods or services
- your use of the internet to sell goods or services to customers within and outside your territory
- the right of the franchisor (or other franchisees) to use the internet to solicit customers or to sell in your territory
These kinds of restrictions may limit your ability to exercise your own business judgment in operating your outlet. If the franchisor does not limit the territory where each franchisee can sell, the franchisor and other franchisees may compete with you for the same customers by establishing their own outlets or selling through the internet, catalogs or telemarketing.
Franchisor’s Advertising and Training (FDD Item 11)
The FDD includes important summaries of the franchise system’s advertising programs and the initial and ongoing training the franchisor will provide. Talk to the franchisor and current franchisees to get answers to your questions.
Franchisees are often required to contribute a percentage of their sales to one or more national, regional or local advertising funds. Ask the franchisor what advertising it has done and what is being planned. Ask whether franchisees have any control over how advertising dollars are spent, and if all franchisees and company outlets contribute equally to the advertising funds. Find out if the franchisor gets a commission or rebate when it places ads. If there is a rebate, who benefits — you or the franchisor?
See what percentage of the fund is spent on:
- administrative costs
- national advertising
- advertising in your area
- selling more franchises
- other expenses
Read Item 11 to learn whether franchisees need the franchisor’s consent to develop and buy their own advertising. If they buy their own advertising, do they get a rebate or discount on their advertising contribution?
New franchisees typically count on the franchisor to provide all the business and operational training needed to run a successful franchise. The training you need depends on your business experience and knowledge of the franchisor’s goods and services. Check Item 11 for information about:
- the trainers and their qualifications
- who is eligible for training
- the cost of training new employees and who pays
- the length of training sessions
- the amount of time spent on technical training, business management training and marketing
- whether the franchisor offers ongoing training and at what cost
- whether support staff are available for trouble-shooting in your area and how many franchisees they are responsible for
- whether on-site individual assistance is available and at what cost
Be sure to talk with recent franchisees about the quality of training the franchisor provides. If — after you read the information in Item 11 and talk with franchisees — you still aren’t sure you’ll get the training you need, ask the franchisor if you can review the training materials. If the franchisor won’t provide them, even if you volunteer to sign a confidentiality agreement, consider a different franchise opportunity.
Renewal, Termination, Transfer and Dispute Resolution (FDD Item 17)
Item 17 covers important topics. First, it states whether you can renew your franchise at the end of the term, and, if you can renew:
- what you must do to qualify for renewal
- whether fees and other contract terms may change
Item 17 also explains what your obligations would be to the franchisor after termination. For example, after termination, restrictions in the contract typically will stop you from operating a business that would compete with your prior franchise, if the new business is within a specified distance of your prior outlet. The restrictions may also prevent you from operating a new business within a specified distance of any other outlets of the franchise. The restrictions may last as long as three years.
Additionally, Item 17 describes what you must do to get the franchisor’s approval if you want to sell your franchise. Lastly, it states whether you have the right to go to court if you have a dispute with the franchisor, or must use arbitration instead.
Financial Performance Representations (FDD Item 19)
Item 19 contains claims the franchisor chooses to make about the sales or earnings of its franchises for which there is a reasonable factual basis. The Franchise Rule doesn’t require a franchisor to provide sales or earnings information, but most do. Any claims the franchisor makes about sales, income or profits must be in Item 19. No other spoken or written financial performance claim may be made if it doesn’t appear in Item 19. There are two exceptions to this:
- The franchisor may provide the actual records of an existing outlet you’re thinking of buying.
- The franchisor may add to the information in Item 19. For example, the franchisor may provide information about possible performance at a particular location or under particular circumstances.
For tips on how to evaluate this information, see Evaluating Potential Earnings .
Franchisee and Franchise System Information (FDD Item 20)
Item 20 provides charts showing growth and owner turnover in the franchisor’s system. If the charts show more than a few franchised outlets in your area have closed, transferred to new owners, or transferred to the franchisor, it could be due to problems with the franchisor’s support or because franchises aren’t profitable.
Current and Former Franchisees
Look for the required disclosure of contact information for current franchisees and franchisees who have left the system during the franchisor’s last fiscal year. Talking to these people may be the most reliable way to verify the franchisor’s claims. Visit or phone as many of them as possible to chat about their experiences. Some current franchisees may be reluctant to talk to you if they’re having problems. If that’s the case, try contacting others on the list.
Some franchisors may give you a separate reference list of franchisees to contact. To ensure you get the full picture, you may want to contact a number of franchisees listed in the disclosure document and some on the separate list. Talk to several franchisees who have been in business just over one year. They’re in the best position to tell you: their total investment
- whether they were able to open their outlet in a reasonable time
- whether they were satisfied with the franchisor’s training, opening assistance and advertising
- whether the franchisor provided ongoing help and assistance
- whether they have been able to break even
It’s also a good idea to talk to several franchisees who have been in business for five years. Ask:
- how long it took them to break even, earn a reasonable income and recoup their investment
- whether the franchisor is providing the services and assistance it promised and fulfilling its contractual obligations
- what problems, if any, they are having with the franchisor
- whether they would invest in another outlet
- whether they’re satisfied with the advertising program
- whether they are satisfied with the cost, delivery and quality of goods or services they must buy from the franchisor, its affiliates or sole approved suppliers
It’s worth tracking down former franchisees (using contact information from Item 20), although some of them may have signed confidentiality agreements that prevent them from talking with you. Prior owners can tell you:
- the problems they had with their outlet
- whether they broke even or made a profit
- when and for how long they operated the outlet
- their business background
- why they left the franchise system
Some franchisors may buy back failed outlets and list them as company-owned outlets. If you’re thinking about buying an existing outlet that the franchisor acquired from a prior franchisee, ask to see the financials showing the outlet’s actual operating results. The franchisor must tell you who owned and operated the outlet for the last five years. If a franchise has had several owners in a short time, perhaps the location isn’t profitable or the franchisor hasn’t supported that outlet as promised. Contact as many of the previous owners as possible to learn about their experience operating the outlet that failed.
Associations of a franchisor’s franchisees are an important source of information. Franchisors are required to list in the FDD the associations they sponsor or endorse and independent associations that ask to be listed. An association, whether it’s sponsored, endorsed or independent, can provide information about the relationship between the franchisor and its franchisees. You may want to ask members of a franchisee association about:
- the kinds of system problems or issues they discuss
- system problems they successfully resolved
- any problems franchisees face in the operation of their outlets
- any problems franchisees have with the franchisor
Financial Statements (FDD Item 21)
Item 21 provides the franchisor’s three most recent audited annual financial statements. If you know how to read financial statements, this information will give you a good understanding of the franchisor’s financial health. If you don’t, it’s a good idea to hire an accountant to review the statements and explain them to you. Investing in a financially unstable franchisor is a significant risk; the franchisor may go out of business or into bankruptcy after you have invested your money. An accountant can help you understand whether the franchisor:
- has steady growth
- has a growth plan
- makes more of its income from royalty payments from successful existing franchisees or from the sale of franchises
- devotes sufficient funds to support its franchise system
You may want to know how much money you can make if you invest in a particular franchise. A franchisor isn’t required to disclose information about potential income or sales. If it does, the law requires it to have a reasonable basis for the claim when it’s made and to include the claim in Item 19 of the FDD. If a franchisor makes a claim that has a reasonable basis, the FDD also must disclose:
- the source and limitations of data that support the claim
- any important assumptions on which the claim is based
Be sure to ask the franchisor for written substantiation that supports the claim. The franchisor is required to provide substantiation if you ask. An accountant can help you determine whether the claims are reasonable, and if they apply to how you plan to operate your business. When you review earnings claims, consider:
Is the Earnings Claim Typical for a Franchise in this System?
Suppose a franchisor claims that franchisees in its system earned $50,000 last year. The claim may be deceptive if it doesn’t represent the typical earnings of franchisees. The FDD should tell you how many franchises the franchisor has, how many it surveyed to get that figure, and the number and percentage of franchisees who reported earnings at the level claimed.
If a franchisor claims that its franchisees earn an average income of $75,000 a year, that tells you very little about how individual franchises performed. Using an average figure may make a franchise system look more successful than it really is, because the high incomes of just a few very successful franchises can inflate the average for all franchisees.
Some franchisors provide figures for their franchisees’ gross sales. These figures don’t really tell about the franchisees’ actual costs or profits. An outlet with high gross sales on paper might be losing money because of high overhead, rent and other expenses.
Franchisors often don’t have data about their franchisees’ net profits. If you get profit information, ask if it’s based on information from company-owned outlets. Company-owned outlets often have lower costs because they can buy equipment, inventory and other items in larger quantities at lower prices or may own, rather than lease, their property.
Earnings may vary with geography. If a franchisor provides franchisee sales or income figures, ask if any of the supporting data came from franchisees in your area. The FDD should state whether there are geographic differences between the franchisees whose earnings are reported and your likely location.
Keep in mind that franchisees have different skill sets and educational backgrounds. The success of some franchisees doesn’t guarantee success for all.
Reliance on Earnings Claims
Franchisors may ask you to sign a statement — sometimes presented as a written interview or questionnaire — that asks whether you received any earnings or financial performance representations during the course of buying a franchise. If they told or gave you any information about how much your franchise may earn, report it fully on the questionnaire or other statement. If you don’t, you may be waiving any right to contest the earnings representations that were made to you and that you used to make your decision to buy.
The franchisor’s disclosures may change between the time you receive the FDD and the time you sign the franchise agreement. For example, the franchisor may have updated its FDD each calendar quarter and must update the FDD after its fiscal year ends. You have the right to ask for a copy of any updated information before you sign the franchise agreement. An updated FDD may reveal new lawsuits were filed by or against the franchisor, changes in the franchisor’s management or training teams, more current financial performance data or other useful information.
Additional Sources of Information
Accountants and Lawyers
In addition to reading the franchisor’s FDD — including any updates — and speaking with current and former franchisees, consider talking to an accountant and a lawyer. An accountant can help you understand the franchisor’s financial statements, develop a business plan, assess any earnings projections and the assumptions they’re based on, and help you pick a franchise system that is best suited to your investment resources and your goals.
A lawyer can help you understand your obligations under the franchise contract. These contracts usually are long and complex. A problem that comes up after you have signed the contract may be very expensive to fix — if it can be fixed at all. Choose a lawyer who is experienced in franchise matters, and rely on your lawyer or accountant for a recommendation about whether to buy a particular franchise.
Banks and Other Financial Institutions
If you need financing to buy a franchise, a bank lender may be able to provide you with a Dun & Bradstreet report or similar financial profile of the franchisor. The bank also might obtain sales and profit information from the franchisor, even if the franchisor won’t give you that information. However, some franchisors give banks unrealistic, overstated profit projections so the bank will provide financing to expand the franchise system. Remember that bank approval of a franchise loan doesn’t necessarily mean the franchise is a safe or good investment.
Better Business Bureau
Check with the local BBB in the cities where the franchisor has its headquarters and the city where you’re thinking of buying a franchise. Ask whether there are complaints on file about the franchisor’s products, services or personnel.
Several states have registration or disclosure laws that regulate the sale of franchises. Some states have laws meant to protect franchisees after they buy. The FDD should include information about any such laws in your state. If the information isn’t in the FDD, check with your state Attorney General’s office, office of consumer affairs or state securities division.
The FTC works for the consumer to prevent fraudulent, deceptive and unfair practices in the marketplace and to provide information to businesses to help them comply with the law. To file a complaint or to get free information on consumer issues, visit ftc.gov or call toll-free, 1-877-FTC-HELP (1-877-382-4357); TTY: 1-866-653-4261. Watch a video, How to File a Complaint, at www.ftc.gov/video to learn more. The FTC enters consumer complaints into the Consumer Sentinel Network, a secure online database and investigative tool used by hundreds of civil and criminal law enforcement agencies in the U.S. and abroad.
The FTC’s Business Center gives you and your business tools to understand and comply with the law. Regardless of the size of your organization or the industry you’re in, knowing — and fulfilling — your compliance responsibilities is smart, sound business. Visit the Business Center at business.ftc.gov.
Opportunity to Comment
The National Small Business Ombudsman and 10 Regional Fairness Boards collect comments from small businesses about federal compliance and enforcement activities. Each year, the Ombudsman evaluates the conduct of these activities and rates each agency’s responsiveness to small businesses. Small businesses can comment to the Ombudsman without fear of reprisal. To comment, call toll-free 1-888-REGFAIR (1-888-734-3247) or go to www.sba.gov/ombudsman.
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What Is a Franchise?
- The Basics and Regulations
- Pros and Cons
Franchise vs. Startup
- Types of Corporations
What Is a Franchise, and How Does It Work?
Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.
Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom.
Investopedia / Mira Norian
A franchise is a type of license that grants a franchisee access to a franchisor's proprietary business knowledge, processes, and trademarks, thus allowing the franchisee to sell a product or service under the franchisor's business name. In exchange for acquiring a franchise, the franchisee usually pays the franchisor an initial start-up fee and annual licensing fees .
- A franchise is a business whereby the owner licenses its operations—along with its products, branding, and knowledge—in exchange for a franchise fee.
- The franchisor is the business that grants licenses to franchisees.
- The Franchise Rule requires franchisors to disclosure key operating information to prospective franchisees.
- Ongoing royalties paid to franchisors vary by industry and can range between 4.6% and 12.5%.
When a business wants to increase its market share or geographical reach at a low cost, it may franchise its product and brand name. A franchise is a joint venture between a franchisor and a franchisee. The franchisor is the original business. It sells the right to use its name and idea. The franchisee buys this right to sell the franchisor's goods or services under an existing business model and trademark .
Franchises are a popular way for entrepreneurs to start a business, especially when entering a highly competitive industry such as fast food. One big advantage to purchasing a franchise is you have access to an established company's brand name . You won't need to spend resources getting your name and product out to customers.
The franchise business model has a storied history in the United States. The concept dates to the mid-19th century, when two companies—the McCormick Harvesting Machine Company and the I.M. Singer Company—developed organizational, marketing, and distribution systems recognized as the forerunners to franchising. These novel business structures were developed in response to high-volume production and allowed McCormick and Singer to sell their reapers and sewing machines to an expanding domestic market.
The earliest food and hospitality franchises were developed in the 1920s and 1930s. A&W Root Beer launched franchise operations in 1925. Howard Johnson Restaurants opened its first outlet in 1935, expanding rapidly and paving way for the restaurant chains and franchises that define the American fast-food industry until this day.
There are more than 785,000 franchise establishments in the U.S., which contribute almost $500 billion to the economy. In the food sector, franchises included recognizable brands such as McDonald's, Taco Bell, Dairy Queen, Denny's, Jimmy John's Gourmet Sandwiches, and Dunkin' Donuts. Other popular franchises include Hampton by Hilton and Day's Inn, as well as 7-Eleven and Anytime Fitness.
Before buying into a franchise, investors should carefully read the Franchise Disclosure Document, which franchisors are required to provide. This document contains information about franchise fees, expenses, performance expectations, and other key operating details.
Franchise Basics and Regulations
Franchise contracts are complex and vary for each franchisor. Typically, a franchise agreement includes three categories of payment to the franchisor. First, the franchisee must purchase the controlled rights, or trademark , from the franchisor in the form of an upfront fee. Second, the franchisor often receives payment for providing training, equipment, or business advisory services. Finally, the franchisor receives ongoing royalties or a percentage of the operation's sales.
A franchise contract is temporary, akin to a lease or rental of a business. It does not signify business ownership by the franchisee. Depending on the contract, franchise agreements typically last between five and 30 years, with serious penalties if a franchisee violates or prematurely terminates the contract.
In the U.S., franchises are regulated at the state level. However, the Federal Trade Commission (FTC) established one federal regulation in 1979. The Franchise Rule is a legal disclosure a franchisor must give to prospective buyers. The franchisor must fully disclose any risks, benefits, or limits to a franchise investment. This information covers fees and expenses, litigation history, approved business vendors or suppliers, estimated financial performance expectations, and other key details. This disclosure requirement was previously known as the Uniform Franchise Offering Circular before it was renamed the Franchise Disclosure Document in 2007.
Pros and Cons of Franchises
There are many advantages to investing in a franchise, and also drawbacks. Widely recognized benefits include a ready-made business formula to follow. A franchise comes with market-tested products and services, and in many cases established brand recognition . If you're a McDonald's franchisee, decisions about what products to sell, how to layout your store, or even how to design your employee uniforms have already been made. Some franchisors offer training and financial planning, or lists of approved suppliers. But while franchises come with a formula and track record, success is never guaranteed.
Disadvantages include heavy start-up costs as well as ongoing royalty costs. To take the McDonald’s example further, the estimated total amount of money it costs to start a McDonald’s franchise ranges from $1 million to $2.2 million. By definition, franchises have ongoing fees that must be paid to the franchisor in the form of a percentage of sales or revenue. This percentage can range between 4.6% and 12.5%, depending on the industry.
For uprising brands, there are those who publicize inaccurate information and boast about ratings, rankings, and awards that are not required to be proven. So, franchisees might pay high dollar amounts for no or low franchise value. Franchisees also lack control over territory or creativity with their business. Financing from the franchisor or elsewhere may be difficult to come by. Other factors that impact all businesses, such as poor location or management, are also possibilities.
If you don't want to run a business based on someone else's idea, you can start your own. But starting your own company is risky, though it offers rewards both monetary and personal. When you start your own business, you're on your own. Much is unknown. "Will my product sell?", "Will customers like what I have to offer?", "Will I make enough money to survive?"
The failure rate for new businesses is high. Roughly 20% of startups don't survive the first year. About 50% last until year five, while just 30% are still in business after 10 years. If your business is going to beat the odds, you alone can make that happen. To turn your dream into reality, expect to work long and hard hours with no support or expert training. If you venture out solo with little or no experience, the deck is stacked against you. If this sounds like too big a burden, the franchise route may be a wiser choice.
People typically purchase a franchise because they see other franchisees' success stories. Franchises offer careful entrepreneurs a stable, tested model for running a successful business. On the other hand, for entrepreneurs with a big idea and a solid understanding of how to run a business, launching your own startup presents an opportunity for personal and financial freedom. Deciding which model is right for you is a choice only you can make.
What Are the Advantages of Franchises?
Some of the widely recognized advantages of franchises include a ready-made business formula to follow, market-tested products and services, and, in many cases, established brand recognition. For example, if you're a McDonald's franchisee, decisions about what products to sell, how to layout your store, or even how to design your employee uniforms have already been made. Some franchisors offer training and financial planning, or lists of approved suppliers. However, despite these benefits, success is never guaranteed.
What Are the Risks of Franchises?
Disadvantages include heavy start-up costs as well as ongoing royalty costs. By definition, franchises have ongoing fees that must be paid to the franchisor in the form of a percentage of sales or revenue. This percentage can range between 4.6% and 12.5%, depending on the industry.
There is also the risk of a franchisee being duped by inaccurate information and paying high dollar amounts for no or low franchise value. Franchisees also lack control over territory or creativity with their business. Financing from the franchisor or elsewhere may be difficult to come by and franchisees could be adversely affected by poor location or management.
How Does the Franchisor Make Money?
Typically, a franchise agreement includes three categories of payment to the franchisor. First, the franchisee must purchase the controlled rights, or trademark, from the franchisor in the form of an upfront fee. Second, the franchisor often receives payment for providing training, equipment, or business advisory services. Finally, the franchisor receives ongoing royalties or a percentage of the operation's sales.
Federal Trade Commission. " Franchise Rule Compliance Guide ," Pages 1, 24-119. Accessed Sept. 4, 2021.
International Franchise Association. " Royalty Fee Requirement Definitions ." Accessed Sept. 4, 2021.
Thomas S. Dicke. "Franchising in America: The Development of a Business Method, 1840-1980," Pages 12-13. UNC Press Books, 1992.
Thomas S. Dicke. "Franchising in America: The Development of a Business Method, 1840-1980," Page 119. UNC Press Books, 1992.
International Franchise Association. " Franchise Business Economic Outlook ." Accessed Sept. 4, 2021.
McDonald's. " Franchising FAQs ." Accessed Sept. 4, 2021.
U.S. Bureau of Labor Statistics. " Table 7. Survival of private sector establishments by opening year ." Accessed Sept. 4, 2021.
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A franchise (or franchising) is a method of distributing products or services involving a franchisor, who establishes the brand’s trademark or trade name and a business system, and a franchisee, who pays a royalty and often an initial fee for the right to do business under the franchisor's name and system. Technically, the contract binding the two parties is the “franchise,” but that term more commonly refers to the actual business that the franchisee operates. The practice of creating and distributing the brand and franchise system is most often referred to as franchising.
There are two different types of franchising relationships. Business Format Franchising is the type most identifiable. In a business format franchise, the franchisor provides to the franchisee not just its trade name, products and services, but an entire system for operating the business. The franchisee generally receives site selection and development support, operating manuals, training, brand standards, quality control, a marketing strategy and business advisory support from the franchisor. While less identified with franchising, traditional or product distribution franchising is larger in total sales than business format franchising. Examples of traditional or product distribution franchising can be found in the bottling, gasoline, automotive and other manufacturing industries.
Franchising Is About Relationships
Many people, when they think of franchising, focus first on the law. While the law is certainly important, it is not the central thing to understand about franchising. At its core, franchising is about the franchisor’s brand value, how the franchisor supports its franchisees, how the franchisee meets its obligations to deliver the products and services to the system’s brand standards and most importantly – franchising is about the relationship that the franchisor has with its franchisees.
Franchising Is About Brands
A franchisor’s brand is its most valuable asset and consumers decide which business to shop at and how often to frequent that business based on what they know, or think they know, about the brand. To a certain extent consumers really don’t care who owns the business so long as their brand expectations are met. If you become a franchisee, you will certainly be developing a relationship with your customers to maintain their loyalty, and most certainly customers will choose to purchase from you because of the quality of your services and the personal relationship you establish with them. But first and foremost, they have trust in the brand to meet their expectations, and the franchisor and the other franchisees in the system rely upon you to meet those expectations.
Franchising Is About Systems and Support
Great franchisors provide systems, tools and support so that their franchisees have the ability to live up to the system’s brand standards and ensure customer satisfaction. And, franchisors and all of the other franchisees expect that you will independently manage the day-to-day operation of your businesses so that you will enhance the reputation of the company in your market area.
When selecting a franchise system to invest in, you want to evaluate the types of support you will be provided and how well the franchisor is managing the evolution of the products and services so that it keeps up with changing consumer expectations. Some of the more common services that franchisors provide to franchisees include:
- A recognized brand name,
- Site selection and site development assistance,
- Training for you and your management team,
- Research and development of new products and services,
- Headquarters and field support,
- Initial and continuing marketing and advertising.
You want to select a franchisor that routinely and effectively enforces system standards. This is important to you as enforcement of brand standards by the franchisor is meant to protect franchisees from the possible bad acts of other franchisees that share the brand with them. Since customers see franchise systems as a branded chain of operations, great products and services delivered by one franchisee benefits the entire system. The opposite is also true.
Franchising Is also a Contractual Relationship
While from the public’s vantage point, franchises look like any other chain of branded businesses, they are very different. In a franchise system, the owner of the brand does not manage and operate the locations that serve consumers their products and services on a day-to-day basis. Serving the consumer is the role and responsibility of the franchisee.
Franchising is a contractual relationship between a licensor (franchisor) and a licensee (franchisee) that allows the business owner to use the licensor’s brand and method of doing business to distribute products or services to consumers. While every franchise is a license, not every license is a franchise under the law. Sometimes that can be very confusing.
In the United States, a franchise is a specific type of licensing arrangement defined by the Federal Trade Commission and also by several states. In the United States a franchise generally exists when:
- The franchisor licenses a franchisee the right to use its trade or service mark;
- To identify the franchisee’s business in marketing a product or service using the franchisor’s operating methods;
- The franchisor provides the franchisee with support and exercises certain controls; and,
- The franchisee pays the franchisor a fee.
The definition of a franchise is not uniform in every state. Some states for example, may also include a marketing plan or community of interest provision in the definition. The definition of what is a franchise can vary significantly under the laws in some states and it is important that you don’t simply rely on the federal definition of a franchise in understanding any particular state’s requirements.
Put another way, in a franchise a business (the franchisor) licenses its trade name (the brand, such as BrightStar Care or Sport Clips) and its operating methods (its system of doing business) to a person or group operating within a specific territory or location (the franchisee), which agrees to operate its business according to the terms of a contract (the franchising agreement). The franchisor provides the franchisee with franchising leadership and support, and exercises some controls to ensure the franchisee’s adherence to brand guidelines.
In exchange, the franchisee usually pays the franchisor a one-time initial fee (the franchise fee) and a continuing fee (known as a royalty) for the use of the franchisor’s trade name and operating methods. The franchisee is responsible for the day-to-day management of its independently owned business and benefits or risks loss based on his own performance and capabilities.
Investing in a franchise or becoming a franchisor can be a great opportunity. But before you select any franchise investment and sign any franchise agreement, do your homework, understand what the franchise system is offering and get the support of a qualified franchise lawyer.
Find out more about franchising by visiting our frequently asked questions page here .
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Our Business Model Empower Success
Continuous Income Opportunities
Convenience stores and gas stations serve nearly every segment of the population, 24/7, 365 — which is why 7‑Eleven continues to thrive, no matter the overall economic climate.
We’re Flexible: 3 Ways to Franchise
Business Conversion Program
Success made easy. We designed a model tailored to streamline processes and leverage the scale of your business so you can easily get up and running – and have lots of room to grow. We lease the store, land, and equipment to you, plus provide training and support.
Our business model makes it easy to franchise multiple stores. In fact, 33% of current Franchisees are multiples. If you’re qualified, you can convert more than 1 store from Day 1, or you can start with our traditional option and build your way up. No matter the path you choose, we’ll be here, supporting you every step of the way.
This is a great option for someone looking to convert existing properties — such as a gas station, liquor store, deli, convenience or small grocery store — into new 7‑Eleven stores. Or maybe you want to develop your own new sites. We’re also interested in real estate that’s currently vacant or waiting to be redeveloped into brand-new 7‑Eleven convenience stores.
Opportunity Is Waiting
New to franchising? Or just 7‑Eleven? Learn how you can get started on your journey to greatness.
With our fast startup times and first-class training, you’ll be celebrating your store’s opening sooner than you think.
7‑Eleven offers you the ability to transfer your resources, employees, and merchandise between your locations to address deficiencies and redistribute overstock — which can save you time, effort, and money.
Room to Grow
Unlike with some other franchises, qualified 7‑Eleven candidates can own or convert several stores from Day 1. Our tried-and-true business model makes it easy to franchise multiple stores.
Big Buying Power
7‑Eleven sources more than 1,000 new products every year. We go big so you can get the benefit of negotiated pricing and terms. As a franchise owner, you get to leverage our super buying power and offer your customers what they love at great prices — without cutting into your profit margins.
Extensive Training and Support
Our world-class support enables you to run your stores. You and your store designees will participate in six to eight weeks of C.O.O.L. (College of Operations Leadership) in-store training. After your franchises open, we continue to help provide assistance so you can focus on managing and growing your business.
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