A Guide to Licensing and Franchising
Franchising and licensing are two strategies for growing your business. Generally, a franchise is an arrangement where the owner or developer of a concept (the franchisor) agrees to let others (franchisees) own and operate businesses based on that concept. Licensing, on the other hand, usually involves an arrangement between two parties where the licensor grants temporary use of a trademark, product or intellectual property for a specified period of time. More often than not, it involves manufacturing and marketing rights for technologies, inventions or processes.
Why use either strategy? Well, maybe you don't have the means to manufacture and distribute your great invention, or maybe there is a great market for your product overseas or throughout the nation that you simply don't have the resources to be able to satisfy. Whatever the reason, licensing and franchising arrangements can increase your earning potential, reduce investments in operations and research and development, reduce marketing costs, speed entry into new markets, and increase profitability. However, there are potential downsides as well, and we will examine them in more detail in the sections that follow.
This article looks at the differences between franchising and licensing and will help you decide if either is right for your business. In order to fully cover the pro's and con's of each strategy, we will first discuss franchising and then turn our attention to licensing.
I. Strategy #1: Should You Franchise?
When a young entrepreneur from Kentucky developed a special recipe for cooking chicken, the locals came running. His secret blend of herbs and spices as well as his grasp of a new technology, the pressure cooker enabled him to make chicken like no one had ever tasted before. And his customers loved it. But what eventually made Harland Sanders' recipe famous was his ability to franchise. After he did, Colonel Sanders became a household name, and Kentucky Fried Chicken could be found all over the country, eventually becoming the largest food chain in the nation in the 1960s.
The Colonel entered franchise agreements as a response to losing business to the new interstate highways that bypassed his restaurant and hotel. He realized that cutting deals with other restaurant owners to place his Kentucky Fried Chicken on their menus was a good strategy for getting his business back on the right track. This strategy soon evolved into the traditional franchising plan that we are familiar with today. However, what was a last resort for this determined entrepreneur has become the method of choice for many small business owners today, and they've turned their local businesses into national phenomena in the process.
If there's any doubt, check out what a once small Seattle coffeehouse has been able to accomplish through franchising. Nowadays, you can find at least one Starbucks franchise in every major city in the country, as well as overseas.
Many experts call franchising the small business choice for the 21st century. But before you leap into such an arrangement, there a few things to consider. Most important, you need to determine if your business is even franchisable. To be able to create a franchise, your business should satisfy at least three basic criteria. First, your business concept must lend itself to franchising. Second, your brand and trademarks must be strong. And finally, you have to be able to support the necessary training involved with franchising your business.
"If there is demand, and you get your
system down to where it can be passed on easily through training, hands-on procedures, and
then it can be franchised," Elliott says. "The concept has to be
transferable to others, meaning others can be trained or latch onto it and keep the
quality and the atmosphere consistent." To determine if your concept lends itself to
franchising, answer the following questions:
(Of course, if there isn't enough money to be made by both parties, the deal will never fly.)
To determine the strength of your trademark and
brand, answer the following questions:
*Note: If your trademark isn't federally registered already, you'll need to do so to protect yourself when you franchise. Likewise, you'll have to change the trademark if it is not easily recognizable or confusing. For instance, when a person sees golden arches in the shape of an "M," they immediately know it's a McDonald's restaurant. You'll want to strive to achieve such recognition for your company.
The third requirement, training, is probably the most important. When you start a franchise, your franchisees become not only your business partners, but also your customers, and they will expect high-quality service from you. Additionally, you will have to be dedicated to training new franchisees because their operation represents your business to the general public.
If you can accomplish this training and meet the requirements for a strong trademark and have a solid business concept, you are ready to consider franchising your business.
One business that has met all these requirements and established a successful franchise is Candleman, a candle boutique that specializes in one-of-a-kind candles. The company is now a chain found in shopping malls in all 50 states. But it wasn't always that way. Candleman started as one store in Brainerd, Minn..
Candle-making had always been a hands-on manufacturing process, which limited growth potential for a business owner in this market. In fact, until Candleman came along, candle-making had largely been a cottage industry. What did Candleman do to change that? Simple it came up with the "Candleman System," a collection of candle-making techniques combined with mass-marketing and merchandising strategies that became the basis for a strong franchising opportunity.
Candleman had to sell potential franchisees on a concept that didn't previously exist in the industry. However, it now had a product (candles), a process (the Candleman System) and a market (retail shoppers), and the company followed up with an aggressive plan to finance and train start-up operations to make candles and sell them in retail outlets. For people who wanted to start a business, the idea was attractive because it gave them a pre-established system, a proven strategy and a market with few existing competitors. All they needed to supply was time, hard work and a financial investment (things they would have had to do to start a freestanding business, anyway).
Candleman offers all of the basic tools to get franchisees started in business. First, there is start-up assistance, and the company relies on its experience to streamline the process for franchisees. It gives the new owner initial training and on-site operational assistance, as well as continued support throughout the existence of the franchise. Additionally, it offers marketing support and a strong trademark that represents high-quality hand-made candles, as opposed to lesser quality candles commonly found in gift shops.
Candleman franchisees pay the parent company a
franchise fee that offsets the costs of these support tools and adds to Candleman's
profit margin in the process. The price franchisees pay is predetermined through a number
of factors that all franchise organization must address, as you will learn later in this
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II. Understanding the Legal Side
Once you've determined that your business meets the basic requirements for franchising, you next need to learn what you're up against. These days, the law is both on your side and watching over you with a strict eye.
United States federal law dictates that certain requirements be met before you can start selling a franchise. In addition, 14 states have set additional requirements, which mandate that all franchisors register their franchises before any sale can be offered. These states also regulate the franchise relationship once it is formed, including franchise transfers, terminations and renewals, and territorial rights.
The states with added requirements are California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North and South Dakota, Rhode Island, Virginia, Washington and Wisconsin. This is significant because these states contain some of the largest markets in the country.
All franchise laws require the franchisor to submit a detailed disclosure document called the Uniform Franchise Offering Circular (UFOC). The circular is designed to be presented to prospective franchisees upon the first meeting between both parties, or within 10 days before any agreements or money can be exchanged.
To determine the legal franchising requirements
in your state, consult a legal professional who specializes in franchising arrangements.
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III. Anticipate the Costs and Plan It Out
The initial cost of starting a franchise can be quite hefty. But don't let that alone scare you away, since the money you could make over the long run could cover your costs many times over if your concept is successful. That said, the average franchise spends between $50,000 and $250,000 dollars in start-up costs. (Of course, the price is dependent upon the complexity of the business and the number of franchises you intend to sell.)
With such an expensive proposition before you, you need to carefully consider the costs and form a workable plan and budget to get you through the start-up phase, much like you did when you started your original venture. It is helpful to use a checklist of costs.
To get you started, determine whether or not you have the capital to cover the following franchising expenses and, if so, check them off as you go. You will have to do some research to determine what the value of these expenses will be for your particular company.
The next step is developing a franchising plan that will lead to regular growth and earn a favorable return on your initial investment. To get you started thinking about the important elements to include in your plan, answer the following questions:
Once you've identified the initial concepts for your franchise plan, the next step is to conduct a business review. A business review will help you determine whether or not your business presently meets or has the ability to meet all of the conditions you've just identified. The review does this by revealing your financial, marketing, operational and managerial strengths and weaknesses. It also identifies the opportunities and constraints on your business by recognizing the demand or the potential for demand.
This planning stage requires a great deal of thought and analysis. There is a myriad of organizations that specialize in helping businesses plan for franchising. To see some of the most recognizable, see the resources at the end of this workbook.
For additional reading on this topic, see Conducting A Market Analysis. These modules can be adapted to assist you in preparing your franchising strategy and business review.
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IV. How Royalties and Fees Work
Although starting a franchise requires a substantial financial investment, as a franchisor you have the opportunity to recoup your costs and make a profit from franchisees in the process. Franchise marketing helps you lower costs and enter new markets more quickly. In short, franchising allows you the opportunity to expand your business while sharing the financial burden with others.
This financial assistance comes in the form or a franchising fee and/or royalties. When you first begin marketing your franchise opportunity, the first question from potential franchisees will inevitably be, "How much is the fee?" You should have determined that figure during the pre-franchise planning stage (it is based upon your legal, accounting, marketing, operational and administrative expenses).
Most franchisors require an initial franchise fee and contributions to training costs, on-site startup and promotional expenses, and a monthly or weekly advertising budget. These should be worked into the initial franchising agreement. (Again, every situation is unique, and there is no set equation for determining these values.)
When you present your business plan to a franchisee, he or she will want to know some very specific information. You'll need to have the answers handy, preferable in your UFOC. Some questions that you should be prepared to answer include:
All of these questions, as well as many others, reveal vital information that will either make or break a franchise deal. They should not be taken lightly, and the answers should be clear and precise when presented to the potential franchisee.
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V. Types of Franchise Relationships
Once you have determined that a franchise arrangement is your best option for growth and you've calculated what investment is required from both you and the franchisee, the next step is to decide what type of relationship you want to establish. There are several types of franchise relationship, and which one you choose depends upon the nature of your business and the capital you have available. The three most prominent types of relationships are the business-format franchise, the product-distribution franchise and the conversion franchise.
In the business-format franchise, the owner licenses the entire business format, including operational procedures, products, trademarks, etc., to a franchisee. This is probably the most common type of franchise, and you'll find them extensively in the food service (Burger King), lodging (Econo Lodge), automobile maintenance (Jiffy Lube) and convenience store (7-Eleven) industries.
In the product-distribution franchise, the franchisor manufactures and sells finished or semi-finished products to a distribution dealer. In return, the dealer furnishes pre-sale service to customers, sells the franchisor's products, and refrains from selling competitive products. Examples of these types of franchises can be found in the automobile dealer and outdoor power equipment industries.
Conversion franchising involves the conversion of independent dealers or unaffiliated businesses to franchises. In this agreement, an existing business pays a fee in order to create a stronger brand identity or an advantage in regional or national marketing. The best examples of these types of franchises are real estate companies such as Coldwell Banker or Century 21.
There are also different types of franchisees to consider. The most common type of franchisee is called a single-unit franchisee. This type usually owns and operates a single franchise of your business. Even if they own more than one, each is set up independently at different times.
There are also area franchisees, however. These franchisees own and operate the rights to the franchise for a specific area. This type can also be broken down into more specific "development franchisees" and "master franchisees."
A development relationship grants the right to develop a specific number of franchises within a specific territory. Usually over a one-year period, the franchisee will develop a specific number of units and continue for a second period and a third, and so on, until the contract period is up.
In a master-franchise relationship, the franchisee takes on some of the franchising responsibilities for you. You grant the master rights for an area to the master franchisee, who in turn grants the rights for sub-franchises in that area. This process has been used in the United States, but is more common in international franchising.
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VI. Strategy #2: The Power of Licensing
Franchising isn't the only way for your business to leverage other companies to reach new customers, however. You can also license your products, technologies or trademarks to other manufacturers or sellers. Like franchising, licensing enables a business to reach customers that it normally wouldn't be able to on its own. It also enables businesses to defer the costs of production and distribution to someone else while still reaping substantial financial benefits.
Probably the most familiar licensing ventures are those in the sports merchandising and entertainment industries. The National Football League, and the National Basketball Association are two examples. They make fortunes in licensing agreements with apparel and toy companies. Smaller companies, such as the plethora of independent software developers cluttering Silicon Valley, also use licensing to get their software distributed by larger technology or hardware companies, or to get the software placed on workstations when they are purchased by consumers, creating an instant new customer base.
Although franchising involves licensing rights, you can take advantage of licensing strategies without entering into franchise agreements. When you license a product or technology instead of franchising it, you minimize the expenses involved with expanding your marketing and selling. In addition, in licensing arrangements, you may be selling the rights to an idea for a product or technology rather than the finished product itself which is a major contrast to the franchising concept.
To illustrate the licensing concept, let's examine the story of Bruce Johnson and the Breathe Right Nose Strip. After three years of working alone to develop the now famous plastic strips worn by scores of athletes and allergy sufferers, Johnson finally came up with a prototype. Realizing that his invention had the potential for mass marketing, he immediately set out to find a patent. However, his search turned up empty.
Not willing to give up, Johnson contacted a friend that worked at CNS Inc., a Minneapolis company that manufactures sleep diagnostic equipment. Johnson asked if the company would be interested in testing his product. After learning more about the product, CNS wanted more than that: They wanted to license it.
"It was a unique method of providing treatment that had a lot of potential," says CNS' Nick Nauman. "It was the combination of the scope of the need and the uniqueness of the product."
So Johnson sat down with the company to iron out a licensing deal. When the negotiations were complete, the single-prototype nose strip had quickly turned into a mass market product that would be distributed worldwide. The sweetest part of the deal for Johnson is that he barely had to spend any of his own money and has now turned huge profits on his idea. He didn't take the money and run, however. As a technical designer, Johnson still works on maintaining the product's quality, as well as customizing it for different market segments, while CNS manages the manufacturing, marketing and distribution.
That's what licensing is all about. Just as this phenomenal success story grew from a simple product designed by one man, it can do the same for your products and/or technologies. You just have to know how to go about developing such an arrangement.
To determine whether your company may be able to benefit from a licensing arrangement, ask yourself the following questions:
If you answered no to any of these questions, you may want to investigate the benefits of licensing. Let's examine the basic advantages of licensing in the manufacturing industry, since that is where most licensing arrangements are found. If your company manufactures computers, and you use traditional original equipment manufacturing (OEM) channels, you probably know that they deliver high returns on investment, but they also require you to pay a substantial amount of money and can potentially eat into your profits over the long haul. Likewise, marketing costs alone are high enough to diminish your profits substantially. Therefore, licensing these responsibilities to another company that can handle them more effectively may improve your cost-to-profit ratio.
Licensing also gives you the opportunity to utilize additional marketing and distribution channels in new geographic locations. While you may be handling these chores in your local area, another manufacturer may be able to co-market your products, along with their own, to audiences in other parts of the country or the world.
For example, TEVA Sports Sandals, the popular black thongs with nylon straps, can be found in shoe stores around the nation, but they were developed by an independent entrepreneur in Arizona named Mark Thatcher. An avid outdoorsman, Thatcher came up with the idea for the world's first "amphibious footgear" (meaning it can be worn in and out of water.) While it was a great idea, Thatcher ran into problems trying to market the new footgear.
Finding a manufacturer was the easy part. Thatcher simply went to a river gear supply store in Flagstaff and asked who manufactured the thongs they sold. The answer was Los Angeles-based California Pacific. He pitched his product idea to the outdoor apparel giant and soon walked away with a licensing agreement. Now, California Pacific manufacturers and markets the sandals all over the world, and Thatcher still owns the rights to the products. In fact, he now lives in Los Angeles and represents the sandals to potential distributors, all while turning a profit with very little personal investment to fuel the growth. He is also free to sell and distribute the products on his own if he has the opportunity.
Thatcher's licensing deal not only gave his products a distribution channel, it also associated his product with a prestigious name in outdoor marketing. Now, TEVA Sports Sandals are being taken seriously by the millions of customers California Pacific already had in its pocket. In addition, the large company was able to use its expertise, which Thatcher was admittedly lacking, to give the sandals an industrial quality and new features that Thatcher may not have been able to produce on his own.
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VII. Determine the Market
Before you can land a licensing deal, you have to have a product or technology - or at least a solid idea or plan for one. Licensees will be interested in your core product/technology if it either complements their existing offerings or represents a new growth market for their company. For example, California Pacific was able to attract Thatcher's footgear to their current product line to create new markets and new revenue streams. It simply made sense for them.
Likewise, Thatcher also had a core market in mind for his product: outdoorsmen. That meant the licensee was also purchasing an audience for the product and one that had symmetry to its pre-existing market. But what if someone else was already marketing a similar product? Chances are, the market would be smaller and, therefore, less attractive to the licensee.
How do you determine whether or not your product/technology has appeal to potential licensees? Ask yourself the following questions:
The answers to these questions should help you better understand what type of market potential your product has for licensing.
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The chances of securing a licensing arrangement before conducting extensive testing of the product or technology are unlikely. At the very least, building a working prototype is a crucial step in developing a successful licensing agreement. It can also be a scary step for the entrepreneur seeking the agreement, since he or she will have to foot the bill for all testing-related expenses.
When Johnson went searching for a partner for his nose strips, he asked CNS and several other companies to test a prototype of his product. The companies including CNS were willing to participate because Johnson had the foresight to demand that all testing companies sign non-disclosure agreements, meaning they couldn't tell anyone what they saw or copy the product for their own use. That important step protected the value of his invention for licensing purposes.
Although utilizing non-disclosure agreements is a legally binding safety measure, experts suggest that you still limit testing as much as possible. That way, if an agreement is not made with a prospective licensee, then you've limited the number of people who have had access to your idea.
How do you do limit exposure to your product or technology while still shopping your idea? For starters, you can send out one-time limited evaluation copies of the product for testing. This will speed up the process as opposed to the normal two or three-week waiting period.
You should also provide a framework of the type of deal you are seeking up front, so if potential licensees are not interested at that point, you can avoid having to share your proprietary ideas with them.
Pricing Your Product/Technology
Once you get past the investigation and testing phase and have settled on a few prospective licensees, you will need to put a price on its value to the company. This is a complex process that varies from one situation to the next, but the following questions will give you some ideas on how to name your price.
Of course, you'll need to keep in mind that price is also dependent on the current status of the economy, the average income of the target audience, the buying habits of the audience, and the location of the market.
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IX. Finding Licensees
Mark Thatcher hopped on a plane to California. Bruce Johnson called a friend. There are plenty of ways to find licensees, and none of them is right for every company. Finding the right one involves a little thought and hard work and a lot of trial and error. Depending on your budget, it might be wise to hire a reputable consultant to help.
But what should you be looking for? When it comes to choosing a licensee, it's best to search channels inside a specific industry. Just as Johnson took his nose strips to a medical equipment manufacturer, you should take an item such as clothing to an apparel manufacturer or candy to a food manufacturer. Why? Because companies already experienced in a related industry will be more accepting and more capable of incorporating your product/technology into their current operations. They will also know the industry better, including how to attract customers and make suggestions on how to improve your products to appeal to them, if necessary.
"At the time [Johnson introduced the prototype], we were making medical equipment and selling to hospitals," Nauman says. "When we took on Breathe Right, we had an opportunity to sell a consumer health care item."
But even more important than knowing how to choose a licensee is knowing how to approach one. It won't be enough to simply ask for the president of the company and make a pitch. To satisfy a licensee, you'll need to work two channels within the organization: marketing and technical. Both will need to be satisfied before a company will make any moves to license a product from you. Why? Because it has to know it can sell your product through its marketing strategies, and it has to know your product is of high quality and able to be reproduced and altered as demands change. Therefore, when making cold calls, find out who is in charge of the marketing department and the technical team and attempt to open the lines of communication with them. If you're able to impress those individuals, they will be able to help you move the negotiation process along.
In the early stages of approaching a licensee, you'll likely face resistance based on the prejudice that your product/technology is not theirs. Often called the "Not Invented Here" phenomenon, this bias can turn potential licensee cold on an idea before they know anything about it. Persistence is the only way to break through those troubled waters. If the idea is a fit for the company and it shows the promise of great financial returns they will be interested in hearing you out.
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X. Forming the Contract
Treading through all the murky water of a proposed licensing contract could take a great deal of time. However, the contract is the most important part of a licensing agreement. It determines who does what, who pays what, and how many rights each side retains. Therefore, the contract is worth all of the time, attention and costs that go into its formation. For the purposes of this discussion, we will hit on a few major contract-related issues.
The first thing to remember about contracts is that they should be made on your terms, drawn up by your attorney. The fine points can be negotiated later, but it's important that you start with control of the negotiations. If the company is interested enough to be at the bargaining table, they won't be turned off by reasonable demands. And since they have already signed a non-disclosure agreement, you have protection if the deal falls through at the bargaining table.
A second important point is that contracts should get straight to the point, and they should be arranged in a concise and logical manner for easy reference and interpretation.
Some terms that should always be included in a licensing contract are confidentiality, guidelines for joint marketing efforts, protection of trademarks, delineation of responsibilities and rights, terms of compensation (including fees and royalties) and an exit strategy.
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XI. Watch Out for "Biz Opportunities"
One of the dangers of franchising and licensing is that they can often be confused with fraudulent "biz opps," or business opportunities. You've probably seen them advertised in your local newspaper you may have even been taken in by one at one time or another.
Elliott himself admits to having been taken in once, a long time ago, by such a sham. "All the ads you see that promise to make money fast, generally do not perform. If it sounds too good to be true, in generally is," he says.
Legitimate franchise and licenses are identifiable because they are registered. To confirm the validity of your company, register with the International Franchise Association or the International Licensing Industry Merchandisers' Association. Note: Your UFOC is also proof of your credibility.
To further protect yourself and your investment, make sure you perform credit and investment background checks on your franchisees and licensees. After all, you will be relying on them to pick up monetary expenses for marketing and support throughout the process, and they must be dependable.
"There are a lot of franchises out there that are bad franchises because they try to use their own money and run out when it comes time to market," Elliott says.
That defeats your original purpose. You started this program to take advantage of an opportunity for growth with partners. If those partners can't pay, you can't grow.
You should also watch out for franchisees or licensees who have no interest in your market. If they aren't experienced, or willing to learn about your customer base, there remains potential for the deal to go sour.
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Rupert Barkoff, "The Fundamentals of Franchising" (American Bar Association, 1997)
Jeffrey Bradach, "Franchise Organizations" (Harvard Business School Press, 1998)
Ann Dugan, "Franchising 101: A Complete Guide to Evaluating, Buying and Growing Your Franchise Business" (Upstart Publishing, 1998)
Andrew Sherman, "Franchising and Licensing: Two Ways to Build Your Business" (AMACOM, 1999)
Carrie Shook and Robert Shook, "Franchising: The Business Strategy that Changed the World" (AMACOM, 1999)
Bison Franchise Database
Entrepreneur Magazine's Franchise 500
The Franchise Handbook On-Line
International Franchise Association
International Licensing Industry Merchandisers' Association
Small Business Resource Center - Checklist of Questions to Answer Before You Buy a Franchise (SeaQuest)
Small Business Administration - Franchise Workshop
USA Today Business Opportunities
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