Franchising 101: The Basic Terms, Tips, and Facts You Need to Get Started

The franchise industry is overflowing with opportunities, but it can be an intimidating world to enter for those who are unfamiliar with the dynamic environment. Although we can’t cover everything there is to know about franchising in one article, this crash course in basic franchising terminology, facts, and tips should get you off on the right foot.

Useful franchising terms

1. Franchisor

A company that is choosing to expand via franchising and is offering the opportunity to investors who want to run a location or territory of the business.

2. Franchisee

An individual who chooses to invest in a franchise to become a business owner.

3. Master franchisee/developer/sub-franchisor

An individual or organization that is selected by the franchisor to be in charge of building out an entire territory. This person or entity is responsible for recruiting new franchisees and for providing them with training and ongoing support. In exchange, the franchisor shares a portion of the initial franchise fee and the royalty fee revenue.

4. Conversion franchise

An independent business that joins the umbrella of a franchise system in order to capitalize on the brand and the systems.

5. Franchise fee

The initial fee that a franchisee pays to the franchisor in order to become a franchisee. This fee secures the right to do business as a franchisee.

6. Royalty fee

The ongoing fee that a franchisee pays to the franchisor. It typically is a percentage of monthly franchise sales, but it can also be a flat, predetermined fee.

7. Franchise broker/consultant

Their sole job is to help individuals select the right franchise from the hundreds of opportunities that exist. Some just help narrow down the search while others are directly involved in the sale. Before working with a broker or consultant, be sure that he or she is fully knowledgeable about the industry and has your best interests in mind.

8. Discovery day

The day when potential franchisees are invited to visit company headquarters and meet the franchise team. It’s a crucial step in the decision process. At this time, potential franchisees can find out more about the company culture, see the company operations, and get the answers to any remaining questions they may have.

9. Protected territories

A promise by the franchisor regarding limitations on the development of competing locations near a franchised location. A typical promise: that it will not grant other franchisees or itself develop competing businesses within a defined geographic area. Most small and midsized franchises offer some form of territorial protection.

10. IFA

The International Franchise Association is a Washington, DC-based association dedicated to the franchising industry. The IFA is an excellent resource if you’re researching, starting, or buying a franchise.

11. FDD

Once known as the UFOC (for “Uniform Franchise Offering Circular”), the Franchise Disclosure Document is perhaps the single most important document that you’ll come across when making your franchise investment decision. The FDD is required by federal and state laws to be delivered to all prospective franchisees. In the FDD, the franchisor discloses detailed information about the franchise offer, the franchisor company, and the franchise network.

More about the FDD

12. Sections of the FDD

The FDD is divided into 23 sections called “Items.” All of the Items are important to the decision to purchase a franchise, but pay special attention to Item 3, Item 19, and the franchisor’s financial statements.

Item 3 specifies the company’s history of litigation and arbitration, while Item 19 discloses the franchisor’s financial performance representations—if the franchisor makes these claims. If a company has a lot of litigation, Barry Kleiman, a business coach and franchise consultant with The Entrepreneur’s Source, advises investors to inquire about the culture of the company and whether the franchisor treats franchisees like customers or employees.

As for Item 19, franchisors are not required to disclose financial performance information, and Kleiman estimates that only about 35% of franchisors include performance data in Item 19. “Whether included or not, it's important to validate with current franchisees about the earnings potential of the business model you are considering,” he says. (Be sure to read more about the importance of Item 19.)

13. Current and former franchisees

The names and contact information of all or at least many of the company’s current franchisees are listed in the FDD. And, perhaps even more importantly, the FDD includes the names and limited contact information of franchisees who have left the system in the past year.

14. Additional items

Additional items include information about fees and costs, contractual obligations, the growth (or shrinkage) of the entire franchise system, and the history of the company.

Franchising facts

15. Franchising is a booming industry

According to the IFA, there are over 700,000 franchised businesses across 300 different industries, creating millions of jobs and generating over $2 trillion to the US economy. “Franchising is a large driver of our economy as a whole,” says Paul Steck, former president of franchisor Saladworks. “The franchise model works in a myriad group of industries, including health care, food service, car care, personal grooming, and education, to name a few.”

16. Franchising is a highly regulated industry

“Your rights as a franchise prospect and franchisee are highly protected,” says Steck. “While this protection varies by state, franchisors are bound by many laws and regulations designed to protect you.”

17. Tap into the #1 source

To get the information you need, especially information about the franchise’s earning potential, talk to current and former franchisees. “Franchise sales staff and anyone involved in the sales process are forbidden to give earnings information beyond what is listed in the Franchise Disclosure Document,” says Tom Scarda, a franchise consultant with FranChoice. In order to get the most accurate information, ask franchisees how they make money in their concept, what has to be done to make it, how long it takes to make it, and the like, advises Scarda.

18. Average contract length

The average length of a franchise contract is 10 years.

19. Understanding business opportunities

A regulated “business opportunity” is not the same thing as a business format franchise. While a franchise is a type of business opportunity, not all business opportunities are franchises. While franchises offer ongoing training and support, the licensing of trademark rights, assistance with marketing, and other ongoing help, a business opportunity is a one-time transaction in which the buyer is buying products or services that enable him or her to start a business.

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Money matters

20. In-house financing

In-house financing is when a franchisor offers financing through its own loan program directly to potential investors.

21. Third-party financing

Third-party financing is offered by an outside source, whether a bank, the SBA, or another outside lender. Many franchisors develop relationships with third-party lenders which allow the lenders to become familiar with the opportunity, increasing the chances for franchisees to obtain financing.

22. Franchisees have access to credit

Since franchise businesses are more stable and historically more successful than non-franchise businesses, access to credit is easier and more abundant,” says Geoff Hill at Roark Capital Group.

23. Tap into your 401(k)

"You may be able to tap into your 401(k) to fund your franchise. “Benetrends, Guidant Financial, and FranFund are three companies that provide 401(k) rollover guidance,” says Brad Neave, a former consultant at FranNet.

24. Financial incentives available for veterans

If you’re a veteran, you may be able to get a discount on the franchise fee as well as other types of assistance. Many franchises offer special incentives to veterans. In addition, the IFA’s VetFran program, a special program designed to help veterans transition back to civilian life, currently has more than 600 franchise companies participating by offering veterans special incentives.

Additional buying tips

25. Use the internet, trade shows, and trade publications

Use the internet, franchise trade shows, and trade publications when searching for the right opportunity. A wealth of information about what industries are hot, how franchisors rate in franchisee satisfaction, and information on the brand in general can be found online, but don’t limit yourself to just the internet. Consider attending trade shows where you can meet company executives. Also check out trade publications that have more detailed information about franchises in specific industries.

26. Be wary of “steering”

“Talk to a variety of franchise owners, not just those suggested by the franchisor, recommends Kathleen McDonald, principal at McDonald & Cabot, a franchise marketing and development firm. “This action by the franchisor is referred to as ‘steering’ and does not provide a broad overview of how the franchisor supports franchisees.”

27. Importance of a business plan

Even though you are buying an opportunity, you still need a business plan. “A new franchisee should always write a business plan,” says McDonald. “This exercise provides the franchise with a road map for the business. It also enables the franchisee to ‘own the numbers’ in relation to cost and revenue projections.”

28. Research the support system

A franchisor’s training program can teach you a lot about how to operate the business but can also reveal a lot about the long-term support you will receive as a franchisee. “More structure to the training program indicates a franchisor's commitment to maintaining brand integrity,” says McDonald. “A strong support system insures that this policy will continue long after the franchisee has opened his or her franchise business.”

29. Try to get your agreement, your lease, and your bank loan on the same schedule

“The franchisee should try to get these to match or at least be sure that your right to operate the business [the term of the franchise agreement] is not shorter than the lease, or that the financing doesn’t [run longer than] the term of the franchise agreement,” advises James M. Wilson, a business attorney who frequently works with franchisees. “Either of these situations can cause financial headaches that will come to life when the shorter-term item runs out.”

About the Author:

Sara Wilson is a freelance writer who specializes in issues related to small businesses. Contact her at wilson.sara@gmail.com. Franchise attorney Andrew A. Caffey also contributed to this article.