The Advantages of Franchising

Like all business models, franchising offers advantages and disadvantages to those people operating companies.  This post discusses three key advantages that franchising affords.  (Next month’s post will consider the disadvantages).  Would-be franchisees should consider these factors when deciding whether or not to buy into a franchise system because they explain why franchisors are interested in selling franchises.

Franchising provides a better mechanism than wage employment for choosing and incentivizing the people operating retail outlets.  Unlike employees, who are paid a salary, franchisees are compensated from the profits of their businesses.  By linking compensation directly to performance, franchising makes it easier for a company to find people with the right skills and motivation.  Those individuals who know what they are doing have a financial incentive to self-select into purchasing franchises, while those lacking in the skills and motivation have a financial incentive not to do so.

Franchising also provides a good incentive to get those people running outlets to work hard.  When compensation is directly dependent on how much effort a person puts into his or her job, as it is with franchising, those running outlets are less likely to shirk than if they are paid a fixed salary.   This difference in compensation motivates franchisees to do more than salaried managers to generate sales, control costs, and otherwise improve outlet performance.

Franchising facilitates the rapid growth of businesses, which is important when an entrepreneur wants to build a large retail chain quickly. Selling outlets to others provides a non-dilutive source of capital that does not require making regular interest payments on a loan.  Franchisors are able to pass off the cost of expanding to franchisees, who pay for the build out of locations, the acquisition of initial inventory, and other start-up costs. Even the cost of training employees and setting up centralized operations are passed on to franchisees in the form of up-front fees that franchisees pay to buy into systems.  By getting franchisees to cover costs, rather than borrowing money or selling shares, franchisors are able to expand more quickly than would otherwise be the case.

Franchising offers an attractive financial model to entrepreneurs building retail chains.  It offers relatively high returns at relatively low risk to the seller of outlets.  With franchising, the risk of failure of new outlets is borne by franchisees, not the person building the business.  Moreover, by allowing the system to expand to new locations quickly, franchising facilitates greater geographic diversification of the system, which also helps the system developer to manage risk.  Finally, selling outlets to others allows the parent company to hold on to the most attractive outlets and sell those that are less lucrative.

Franchising offers a high return on investment.  By reducing the amount that companies have to spend to set up and run locations, franchising allows chain developers to earn higher percentage returns than they can through outlet ownership.  Franchising demands little in the way of upfront investments because franchisees bear most of the major costs – facilities, employees, advertising, and equipment.  Moreover, operating profits per unit are often higher with franchising because the presence of an entrepreneur on site boosts revenues, reduces waste, and lowers labor costs.  Finally, franchising takes very little working capital because of the frequency with which franchisors collect royalties.

In short, retailers see three broad categories of advantages in franchising:  easier selection and motivation of outlet managers; faster growth; and a better risk-return trade-off.