How does a franchise business model and its financial liability function

Apr 05, 2024

Before running your business on a franchise business model, it is extremely critical to analyze and evaluate how does a franchise business model work.

However, as a franchise business owner, your tasks and responsibilities would be similar to that of a small business owner.

The only major difference between the two roles is that the franchise owner has to run the business according to a set pattern of strict rules and regulations which are usually set by the franchisor. 

The essential thing to know here is that not all businesses should not be operated in a franchise business model because the financial liabilities can become very difficult to handle because of the involvement of two parties.

How does a franchise business model work?

A franchise business is basically controlled by a franchisee who is an individual(s) who uses the branding, trademark, and business model given by a franchisor.

A legal bond or contract is signed between the owner of the franchise (franchisor) and the individual running the business (franchisee) and this establishes a commercial relationship between the two.

An alternate explanation for this is that the franchisee is allowed to use the business name and trademark of the franchisor with some conditions and rules. 

In exchange for the franchise rights — to sell the goods and services using the name, support, and functioning instructions of the franchisor, the franchisee is obligated to pay a royalty/ franchise fee to the franchisor.

Both parties have to sign an agreement that states all rules and conditions of the franchise business model and the other regulations put by the franchisor. Only after this, the franchisee is allowed to run the business.

Remember, how does a franchise business model work is basically as a branch of the parent company.

General financial obligations in a franchise model

1. Franchisor responsibilities

The franchisor possesses the following responsibilities:

Advertising and marketing of the entire brand nationally.

Research and development of new technologies and products and services for the whole brand.

Taking care of the franchise territories to make sure that the operations are carried out smoothly without harming any other area.

Provide training and training material for the franchisee and the employees working in the branch.

Franchisee performance evaluation.

Advise the franchisee on business operations whenever needed.

Providing development opportunities for the franchisee and the business.

Vendors and deals recommendations for the whole company.

2. Franchisee responsibilities

A franchisee is responsible for the following: 

Timely paying the royalty and franchise fee to the franchisor in order to run the parent company.

Searching, leasing, and constructing a suitable place to set up the franchise.

Recruiting and training the working staff. Mostly the franchisors provide managing employees and training material for entry-level employees, but the franchisee will be responsible to look after the whole process of training the entry-level staff.

Operating the business according to the standards and following the conditions posed by the franchisor.

How does financial liability function?

To understand business liabilities easily, just understand how you make payments for business-related things. There are two basic ways, either you would pay through your business accounts or borrow money.

So, borrowing money means you create liabilities, even on credit cards. A balance sheet will represent all your liabilities and that financial statement will represent the position and performance of your business at the end of the financial year. 

Small business liabilities or even financial liabilities, in general, can be covered up by transferring goods, services, or money.

This means that ultimately liabilities are paid out of either cash or any of your business assets. Hence, liability is always unfavorable for a business. 

Furthermore, when you sit to analyze your business's financial liabilities, do not just focus on the resolution of liabilities. This means, looking at the overall impact of those on the business.

Evaluate how an increase or decrease in business liabilities will affect your business and what impression these liabilities bring to the company and all the people concerned with it. 

Majorly, small business liabilities influence investors and equity research analysts. These are the people who are directly connected with purchasing, selling, investing, and advising on the stocks of the business.

This is why expert investors carefully evaluate the financial liabilities to determine the financial health of the company to make proper decisions accordingly. 

Now, when your franchise financial liabilities are not managed properly, the franchise becomes highly prone to go down. In situations where a franchisee files for bankruptcy of the branch, all the assets of the business become “bankruptcy estate”.

The bankruptcy estate will also include the franchise agreement of that branch, which is the greatest asset. The franchisor cannot back out from the contract until the franchise gets out of the bankruptcy state

Along with this, it does not pose that the franchisee will get to keep the franchise after its emergence. 

There are mainly two types of Bankruptcy filings, Chapter 7 and Chapter 11. 

When a Chapter 7 bankruptcy is filed, all the assets of the franchisee’s business are liquidated

The court would then assign a trustee to handle and evaluate the bankruptcy estate. The trustee is then supposed to value all the assets of the franchise and sell them to clear the debt as much as possible.

In many franchise cases under Chapter 7, the branch is under so much loan that it becomes worthless, so the trustee simply ends the contract

Here, the franchisee is deprived of control over the business, but all the debt it owes to the franchisor is duly paid off. 

The second scenario is when a Chapter 11 "reorganization" bankruptcy is filed.

The franchisee here can appeal the court to weigh down some debts, while the others can be paid off. Once the reorganization period ends, a lower business debt load is how it appears back.

This however happens only when the judge rules that the franchise can continue the business on the franchise agreement even after the bankruptcy.

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