Licensing and Franchising

Licensing And Franchising, What Is The Difference And Does It Matter?

Licensing and FranchisingI’ll start with the basics and explain what franchising and licensing mean, and then it will be much easier to understand the difference between the two. However, there is widespread confusion about an aspect of franchising and licensing which is caused by the difference between the laws in the USA and the UK. So, I will be clearing up the confusion that I see in many articles online.

Franchising

Franchising is a way to scale a business once the business model is successful and proven. You can franchise most types of business, provided it is possible to give instructions for others to follow, using an Operations manual.

Under a franchise, the owner (franchisor) retains control of the brand and grants permission to the franchisee to use its successful business model and brand. In exchange, the franchisee puts up the initial capital for the business, helps to promote the brand and pays a recurring fee. The franchisor supports its franchisees by providing training, know how, marketing and other resources and skills.

A franchise agreement will usually give the franchisor the ability to control how the business is run. For example, if a customer visits a branch of McDonald’s while on a trip abroad, expecting the familiar service they are used to at home, it is important that they should not be disappointed. Any unpleasant surprises due to changes in the business format could damage McDonald’s brand generally, not just that of the outlet. For that reason, McDonald’s franchise agreement (and franchise agreements of other organisations generally) contain strict quality control provisions.

Given that the franchisee will be putting up the initial capital for the business, paying the franchisor a fee, and will be promoting the franchisor’s brand, the franchisee naturally expects to end up with a successful business simply because they are following the successful proven path of the franchising business. In return, the franchisee agrees to strictly comply with the established ways of running the business as stipulated in the operations manuals.

The franchisor is expected to provide support to its franchisees in the form of marketing, access to trusted suppliers, systems, and other resources and skills. Training becomes a core part of your business activity once you take on franchisees.

Franchising a business involves finding franchisees with the necessary skills and experience to operate branches of the same business. McDonald’s is a classic and the best-known example of a business that has grown through franchising. By contrast, Starbucks chose to grow by opening its own branches. This requires a lot more capital to achieve than franchising.

An essential element of a franchise relates to the formalities involved in setting it up. There is often a steep initial capital outlay involved in order to get ready to franchise.

Licensing

Licensing is essentially how you exploit intellectual property. Franchising is a type of licensing arrangement.

Licensing of intellectual property (IP) is at the heart of a franchise contract.  So, in fact, a franchise is licensing of a business format in a particular way. Typically, this will comprise giving permission to the licensee to use its know-how and other confidential information, trademarks, logos and designs, and copyright materials. For some businesses, there may be patents, too. In return, the franchisee follows instructions and operates their business in the agreed way.

Licensing is simply the terminology for exploiting intellectual property in a way that involves retaining ownership of that Intellectual Property while granting permission to a third party to make specific uses of it. The equivalent to licensing for the physical property is renting out a house say and getting rental income in return.

The details of the terms and conditions in a licensing agreement will vary considerably depending on the business transaction you’re aiming to achieve.

The type of licensing agreement you need depends on the IP you are licensing as well as on the type of business arrangement you’re setting up.

Is the IP a brand, or technology, or content, designs, or a business as a whole or something else?  This determines the type of clauses the licence agreement needs to incorporate.

Before you embark on licensing it’s essential to ensure you have the necessary intellectual property rights in place.

That means securing ownership, which involves taking different actions depending on the IP in question. This is a whole other subject which is discussed in various other posts on this site, including in the article What is Intellectual Property and Why Does it Matter to You

Licensing can be an excellent way to introduce a new revenue stream to your business. Here are some quick examples of how it might be used:

  • Where a business wants to enable others to make use of its technology or products
  • Where computer software is ‘sold’ to consumers – it effectively involves a licence to use the software.
  • Merchandising – which is common in the entertainment industry, involves licensing third parties to use characters or names from films for example, on different types of product.
  • Sponsorship whereby sponsors allow you to use their brand during promotions.
  • Endorsement or product placement arrangements whereby a business is paid for promoting another business’ product such as by using it in a TV program.

And it’s also used when a business wants a franchise style expansion format, without the high set up costs and formalities involved in franchising. So, licensing business formats is possible so that it’s effectively franchising under a different name.

Back in the 1850s the inventor of the sewing machine, Isaac Singer, granted licences to entrepreneurs to sell his machines in different parts of the USA. He also offered training in the use of the machines. In this case, the IP licensed was a patent, a brand name and know how. This arrangement was so similar to what we associate with franchising today that some people even consider Singer the father of franchising.

I will cover this question of business format licensing later in this article.

Another example of how licensing can be used involves giving access to your methodology for doing something. This is pure know-how licensing. It could be used by a car wash that has developed a successful process for getting its customers to opt for hot wax and other optional extras. By licensing a proven process and know-how to other car wash businesses in return for royalties each month or a one-off payment, a business can generate income from its proven way of promoting hot wax so more customers buy it.

Such licensing transactions as well as other types of licensing mentioned earlier, such as of software like Microsoft Office – are all ways whereby a third party is given the right to use something on the terms and conditions of the licence. The licensee will not own anything more than a right.

The terms and conditions need to be carefully drafted by someone who understands intellectual property, and commercial transactions.

I would caution strongly against a do it yourself approach with licensing agreements, such as using someone else’s document for your situation. Using the wrong terminology, such as giving an exclusive licence to someone can destroy the owner’s rights to exploit its intellectual property. There are all sorts of considerations that go into the presence of certain clauses in licensing agreements, so make sure you use a competent lawyer to help you.

Brand licensing

For those that have built up a brand name, one way to scale their business is to issue a licence to a third party to deliver a related product under their brand name. So, a successful fashion designer might license a perfume manufacturer to create a perfume range for its label.

Another option if you have a successful product or brand, is to grant a licence to someone to sell your product under their own brand name. An example is the model Twiggy producing a range of clothes for Marks & Spencer. Similarly, a cook such as Nigella Lawson could grant a licence to a company selling cooking utensils and crockery to use her name on its products. An established licensing model is explained in an article involving Disney’s licences to use its characters (and its brand) on third party merchandise.

Luxury brands are highly sought after for licensing, as their brand brings a cachet to the product to which they lend their name. But brands should beware of veering too far away from their market or offering licences too liberally. Pierre Cardin is a classic example of this. By engaging in indiscriminate licensing, it devalued its brand and lost much of its cachet.

Licensing covers many possible business arrangements because it is simply a way to make income from intellectual property – that is from know-how, ideas, creative output, reputation, patents, trademarks, designs, methodology and so on depending on what you have available. It has many applications which franchising isn’t designed to address.

To give yourself the strongest position make sure you have properly protected that IP, and have chosen good names that can contain the value of the brand.

The Virgin Group

Certain comments in the FT illustrate some of the complexities faced by successful brands which have grown through licensing and franchising.  One of the key issues, is how ownership, control and use of the brand can be spread between different businesses.  The FT article, Virgin group: Brand it like Branson, is a fascinating look at some of the hurdles faced by Richard Branson and provides some revealing information.

For example, the group makes about £120m a year from licensing its brand to other companies.  Some of those companies are publicly concerned about the fact that damage to the brand as a whole, could impact their business, and that they have little power to prevent it.  Virgin America, in its IPO prospectus, explains that:

“The ‘Virgin’ brand is not under our control, and negative publicity related to the Virgin brand name could materially adversely affect our business”

The Virgin brand has been valued at roughly £1bn and is an excellent case study for anyone hoping to grow their business through licensing and franchising.

Given the dearth of information available to educate brand owners on how these two strategies differ and overlap. I decided to write this piece to clear up the widespread confusion that exists online about the difference between licensing and franchising and why that matters.

Now that I’ve explained what franchising and licensing mean and highlighted some different situations when licensing might be used, I want to focus on the confusion that exists.

Why the Distinction Between Franchising and Licensing Matters

It’s perfectly possible to set up the same type of arrangement as a franchise using a business format licence instead. So, a franchise-like arrangement can be achieved with a licence.

However, because in the USA franchising is heavily regulated. There are hefty fines if you attempt to pass off what is essentially franchising by another name, namely as licensing. So, only use the business format licence instead of franchising if you’re in the UK or other countries where franchising isn’t heavily regulated.

It’s not possible to escape the regulators’ attention by passing off a franchise as a licence because the law looks at the essence of an arrangement rather than its name. It’s not what you call something that matters. It’s about the substance of the transaction.

Most books on franchising and licensing are written by US authors and many blogs online are either US articles or written by people who don’t understand this fundamental reason why it’s not permissible to use licensing in the USA to replicate a business format.

Therefore, there is this confusion whereby people believe that licensing is incapable of giving them a business format arrangement to replicate an existing business. They assume that there is something inherently different about franchising.

They don’t realise that franchising is a type of licensing arrangement. That it’s simply because in the USA franchising is the only option for licensing your business format.

Business owners in the UK can, therefore, be misled into believing that franchising is their only option. They don’t appreciate that they’re completely free to use licensing instead of franchising to achieve the same ends.

Why License Instead of Franchise?

Franchising gives you the potential for national and international expansion, rapid growth with lower capital outlay.  However, franchising is not an appropriate strategy for every business.

When it works, it is highly effective, but for franchising to work you need to get it right. You could waste a lot of money, not just the franchise set-up costs, but also in resolving disputes if you jump into franchising before you’re completely ready.

Nobody wants to waste time and energy embroiled in litigation, but it can happen when business performance doesn’t match expectations. Even a successful litigant in court will be substantially out of pocket given the high cost of legal proceedings. So, everyone loses when a case ends up in court. Even if a solution is negotiated between the parties, just the fact that a dispute arises can absorb a lot of time and money and cause real anxiety and stress.

It’s true that franchising is a relatively low-cost way of expanding a business, when compared to the capital required to grow on your own. However, it is not a no-cost means of expansion. It requires quite a big capital outlay initially in setting up the franchise. There are hefty costs to set up the franchise and develop the operations manual. You’ll need marketing literature, and to promote the business to attract potential franchisees. These costs are sizeable and likely to require a loan.

For businesses in the UK, the option exists to use licensing instead and work towards franchising in a way that will help you to create a better business anyway, rather than putting all your attention on franchising

My suggestion, if it would work for your business model, is to give yourself time to evaluate whether franchising is the right option by testing the waters with licensing first. This does involve some costs but working towards franchising gradually will both improve your business anyway and give you a way to test whether the arrangement is right for you. By licensing your format you get the chance to iron out kinks before you jump both feet first into franchising.

If after trying out business format licensing you decide franchising is the right option then there will be less work to do to prepare your business for franchising because you will have already done much of the work. You will have sorted out your systems, protected your IP, put it into a holding company (which is a good thing to do anyway to shield your IP), systemised your processes so you can provide an Operations manual to your licensees, and tested the arrangement in real life. You will know what issues are thrown up when licensees are using your business format. You can also decide whether the new roles required of you as a licensor – such as to train and educate licensees – suit your temperament and inclinations.

So, you will be much clearer whether franchising is the right step to take after you’ve tried licensing, and if it’s not, then most of your costs in setting up a licence will be worthwhile because these are steps anyone should take to create a better business.

Conclusion

Licensing is a type of legal agreement for exploiting IP that is highly flexible. Using lawyers who understand the intellectual property you can set up any type of licensing arrangement you like.

When it comes to licensing a business format, whereby you grant a third party the right to replicate your business, the important point is that franchising traditionally involves a number of formalities and costs that you can avoid when you choose the licensing route.

Licensing can be done in a less prescriptive way, and you can customise an arrangement to suit your own needs and license as much or as little of your business as you like. You can test he waters with licensees you know, and benefit from the practical experience this will provide.

There is little difference between licensing and franchising if what you’re aiming to achieve is to enable a third party to replicate your business format. You can use either route if you’re in the UK and make the arrangement so close to franchising that it would be difficult to distinguish between the two. But as explained earlier this is not feasible in the USA.

Given that franchising is extremely expensive to set up, licensing can be a good way to start the process if you’re interested in the possibility of franchising your business. Rather than diving straight into franchising with all the due diligence and formalities and costs that it entails, you could start with licensing and if the arrangement suits you, you can then move on to franchising as a second step.

Whether you are licensing or franchising, the important thing is to start by protecting your IP. Your brand, patents, know how, trademarks etc. are precious assets, which should not be shared casually, and should first be appropriately protected. The terms on which you grant licences or franchises need to be carefully considered. Here at Azrights we specialise in supporting businesses that want to use licensing to scale their business.


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