Franchisors make money from royalties on gross sales; franchisees are compensated from profits on the outlets that they own.
Thus, franshisors (the creators of the franchise) seek to maximize the level of sales generated across all of their franchised outlets. Franchisees (the owner/operators) seek to maximize the level of profits at their outlets. As a franchisor you will run smack into this conflict. It will be your job to find the balance point - you want to maximize the system-wide sales to hit to maximize your profit from royalities. At the same time you can't burn your franchisees by ignoring their bottom line.
Additionally as the franchisor (the overlord), you want to open as many outlets as possible to maximize sales. Your franchisees (the serfs - just kidding) on the other hand, don't want their territory infringed upon. This can be headed off somewhat with territory agreements - for example, McDonald's provides limits regarding how close franchises can locate to one another.
Watch Out for Free Riders, Hold-Ups, Under-Investment and Loss of Intellectual Property
Free riding happens when one franchisee doesn't deliver on the "brand name expecations" and brings the entire brand image down with him in the eyes of some customers. In addition the franchisee benefits. For example, say a franchisee cuts out a less profitable product that should be offered by the franchise consistently. A customer might perceive this as a lack of consistency across the brand. The individal franchisee benefits because he focuses on higher margin items while the brand gets kicked down a notch in some customer's eyes. To combat this you have to write in strong language surrounding quality standards into contracts and conduct audits.
Underinvestment in Advertising
If there is more than one kid on the block (kid being a franchised outlet), then franchisees tend to scale back on advertising. Why - if their are two Joe's Hamburger Stands in town and Joe's #2 starts a major marketing campaign, Joe's #1 will receive a benefit as well - customers will go to the closest one. Thus, the outlet that free-rides and spends zero on advertising comes out ahead.
To combat this, you write in minimum ad payments to support the brand name building.
This is a Hold-Up
"Hold-up occurs when one party takes advantage of another party's investment in specific assets to extract money from the second party." - Shane. Essentially, the franchisor puts the franchisee in a pickle by threatenting them with termination with a significant amount of equipment on the table. In the equation, it would cost the franchisee more to terminate and replace the equipment than to just continue paying increased royalties. This is a hold-up.
More Under-Investment - What the?
As a franchisee, if you put most or all of your net worth in an outlet, in theory you would be less likely to invest more instead wishing to diversify or say pay off your house. This can lead to under investment in the franchise model.
Property That You Cannot Touch - Intellectual Property
"In many retail businesses, the heart of the business's competitive advantage lies in its intellectual property. This intellectual property could be the firm's methods of operations, as is the case with Merry Maids cleaning service, or it could be the firm's equipment, as is the case with East Coast Original Frozen Custard's frozen dessert machines." - Shane
As a franshisor you must provide the franchisee with the intellectual property that provides the competitive advantage to the business. You have to show them what the intellectual property does in order to market it to them but at the same time you do not want to reveal too much - they can merely replicate it if you do.
Two things to protect you as the franschisor: patents and nondisclosure agreements with your franchisees surounding your trade secrets. But, in the end, "the more people who have access to information, the greater is the likliehood that the information will leak out, even if you sign nondisclosure agreements with the recipients."
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