Franchising is a business model in which many different owners share a single brand name. A parent company allows entrepreneurs to use the company's strategies and trademarks; in exchange, the franchisee pays an initial fee and royalties based on revenues. The parent company also provides the franchisee with support, including advertising and training, as part of the franchising agreement.
Franchising is a faster, cheaper form of expansion than adding company-owned stores, because it costs the parent company much less when new stores are owned and operated by a third party. On the flip side, potential for revenue growth is more limited because the parent company will only earn a percentage of the earnings from each new store. 70 different industries use the franchising business model, and according to the International Franchising Association the sector earns more than $1.5 trillion in revenues each year.
The franchising business model is used across many industries, but it is most popular in the fast food restaurants, hotel, and casual & upscale restaurants industries. According to an International Franchise Association study, franchisee-owned locations accounted for 56.3%, 18.2%, and 13.1% of each respective industry's total locations in 2001.
The franchising business model consists of two operating partners: the franchisor, or parent company, and the franchisee, the proprietor that operates one or multiple store locations. Franchising agreements usually require the franchisee to pay an initial fee plus royalties equal to a certain percentage of the store's monthly or yearly sales. Initial fees vary significantly across each industry, ranging from $35,000 for an Applebee's restaurant to over $85,000 to open a Hilton hotel. Royalty fees are also variable - for example, Intercontinental Hotels Group (IHG) franchisees are required to pay the company 5% of their yearly sales, while Applebee's franchisees pay 4% of monthly sales and IHOP franchisees pay a 4.5% royalty fee of weekly sales. The franchisee also covers the costs of actually starting and operating the store, including legal fees, occupancy or construction costs, inventory costs, and labor. Franchise agreements usually have a term of between 10 and 20 years, depending on the company.
The parent company authorizes the franchisee's use of the company's trademarks (for example, selling Big Mac's at McDonald's) as part of the franchising agreement. Additionally, the franchisor provides training and support as well as regional and/or national advertising.
Franchising becomes a much less desirable business model during rough economic times. First, franchisees must pay royalty fees based upon their revenue, regardless of whether or not they are earning profits, which adds to the franchisee's financial struggles in an economic downturn. Furthermore, slower sales cause parent companies to reduce expansion plans. For example, the 2007 Technomic Restaurant Industry Study blamed the poor U.S. economy as the reason why restaurants reduced funding for expansion by an average 1.4% during 2007.
Economic issues related to the 2007 Credit Crunch and subprime lending crisis drastically weakened the U.S. economy, which has led to lower levels of consumer spending, particularly in the restaurant dining industry. For example, many restaurants suffered from a decline in traffic and comparable store sales during 2007, like Applebee's, which attributes a 4% decrease in guest traffic and 2.1% decline in comparable store sales to weakened consumer spending. Additionally, a 2007 RBC Capital Markets Survey indicated that 39% of respondents reduced their frequency of restaurant dining because of lower levels of dispensable income in 2007.
Unlike the United States and many other Western countries, emerging markets are commercially underdeveloped and have significant growth opportunities. For example, the U.S. Department of Commerce estimated that over 75% of the expected growth in world trade over the next 20 years will come from developing countries, primarily large emerging markets like China. Furthermore, the rise of China's middle class, as well as India's booming per capita income provide significant new markets for franchises to operate. China's middle class is expected to almost double in the next two years, reaching 25% of the Chinese population in 2010, which is spurred by China's 700% growth in per capita income since the late 1980s. Furthermore, the Indian per capita income is expected to increase more than 300% by 2025.
As the wealth of consumers in emerging markets grows, so too will their appetites for consumer goods, as evidenced by India's 1,440% growth in its retail industry between 1991 and 2007. Also, as of 2007, India's franchising industry is expected to grow 30% annually as mega-franchising chains like Yum! Brands (YUM) have already established a presence in India. High levels of consumer demand, coupled with relatively low levels of competition, offer a lucrative opportunity for many franchisors to expand into emerging markets. Expansion via franchising is an attractive option for companies looking to expand abroad without incurring high costs. Additionally, international franchisees already possess many inherent qualities needed to succeed abroad, like the ability to speak the native language.