Franchising as an investment: How does it work?

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Get a business model for the cost of royalties.

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Maybe you’ve got an entrepreneurial streak and a keen sense of the kind of business your local community needs. And perhaps you’re willing to spend the time, effort, and cash to get it started. Still, there may be gaps in your knowledge and resources that might prevent you from opening up shop, at least in a way that matches your vision.

On the flip side, there are well-established businesses that would be eager to expand into your area if only they had the right person (perhaps someone like you) with the time, capital, business acumen, and risk tolerance to become a local “owner” of their brand.

If this sounds like a reasonable deal—starting an entrepreneurial venture by piggybacking on an established brand—then maybe franchising is right for you.

A franchise is a business agreement in which a business (franchisor) grants another person or business (franchisee) the right to use its trademark brand and business systems in exchange for ongoing royalties and/or fees.

Think of it as opening up and operating your own business, but as an extension of another business. The franchisor sets the ground rules, operational structure, and royalty payments and/or fees, while you pretty much own and oversee everything else (with the exception of certain agreements where the franchisor retains a minor stake in your business).

For businesses that are looking to expand, franchising may be a cost-effective growth strategy with the added benefit of reducing risk and alleviating the various burdens that managing employees can often bring. Furthermore, the franchise model allows a business to leverage the local market knowledge and expertise of the franchise owner. Plus, unlike hiring a “branch manager” type, the franchisee has skin in the game—they’re putting their own capital at risk.

The franchise model can help businesses expand quickly, efficiently, and with less risk. The franchisee can hit the ground running with a proven business system and a relatively established brand.

If investing means allocating time, money, and other resources in search of a profit, then yes, owning a business is an investment. It’s much more intensive than purchasing stocks or bonds, though. And it isn’t for every investor.

So, why do it? It really depends. According to research from the Small Business Administration and the Federal Reserve, business owners tend to have a higher net worth than those who work for companies. Some people choose to buy a franchise while holding on to their regular nine-to-five (although that’s tough to do). Others opt to go all in, investing all their resources and energy into a franchise business.

The biggest advantage of becoming a franchisee is that you get to start a business, but skip past the growing pains associated with the start-up phase. What might that look like?

A proven or ready-made business system. Figuring out what to sell and how to efficiently source, produce, and sell it is a huge part of a business. If you buy a franchise, you’re essentially purchasing a business plan that works. All you have to do now is implement it in a way that meets the needs of your local market.

Immediate brand recognition. Depending on the popularity of the franchise brand, your business can benefit immediately from name recognition. This alone can save you the time and capital you’d otherwise spend introducing your business and your product to potential customers.

Marketing and ad campaigns. Some brands have enough recognition to create local word-of-mouth buzz; hence they don’t do much marketing or take out many ads. But some franchises, like McDonald’s (MCD), launch massive campaigns on a national scale, regardless of the popularity of their brand. Such costs can add up when you’re doing it on your own. So if your franchisor handles most of the costs in addition to providing guidance on local marketing strategies, you can consider it a real plus.

Economies of scale. When you join a franchise network (depending on the franchise), you get to benefit from the network’s collective purchasing power, obtaining bulk goods and services from suppliers at a reduced cost. This is a key advantage that attracts many people to the franchise model; you get to plug into economies of scale that, if done on your own, could take a tremendous amount of time and money to build.

Overall, buying a franchise gives you a boost in strategy and resources while reducing several risks typically associated with building a start-up from scratch. Still, there are risks you should consider.

Start-up and ongoing costs can be expensive. Some franchises come with high start-up costs. Plus, you’ll have to pay ongoing royalties or fees to maintain the franchise. This can rapidly eat up your cash. Sure, you can take out a small business loan. But there’s no guarantee your franchise will succeed.

The franchisor’s rules can be constraining. If you’re the creative type who constantly develops new product ideas or improvements, the franchisor’s rules and restrictions may be too limiting. You can’t just tweak a product, make changes to your employees’ uniforms, or redesign your store without violating the terms of your licensing agreement. Remember: it’s your business, but it’s their brand.

You take on the franchisor’s reputational risks. Let’s say your franchise is part of a nationally recognized brand. Unexpectedly, some scandalous news about the company triggers a controversy, sparking an immediate and harsh backlash. No matter how successful or well-liked your business may be at the local level, the reputational risks of the brand can hurt your business prospects. If you’re willing to benefit from a brand’s reputation, you must also be willing to assume the reputational risks that come with it.

These are just a few of the pros and cons of becoming a franchisee. Consider each and every one before deciding whether franchising is right for you.

Does the thought of becoming a franchisee intrigue you? Do you have the capital, commitment, and cool demeanor to play by someone else’s rules in exchange for the right to use their patents, trademarks, and processes? Or would you rather develop your own business model, logo, and marketing plan in hopes of launching your own brand (and maybe becoming the franchisor someday)?

If you’re going the franchisee route, make sure you choose the right franchise for your interests, personality, capital requirements, and location.