Franchisor and franchisee: what each side gets

Most new cars in the United States are sold by a dealership that does not belong to the automaker. The dealer is a separate business that has signed a franchise agreement with the automaker. Anyone who wants to understand how a dealership earns money, or how it could be bought or sold, needs to understand that agreement first. This article explains who the two parties are and what each side gets and gives up.

The two parties

In a franchise relationship there are two sides. The franchisor is the automaker, or its authorized distributor. The franchisee is the dealer. Wikipedia's article on car dealerships says dealers typically sell under "a franchise agreement with an automaker or its authorized distributor," and that economic theory treats dealers as franchisees and manufacturers as franchisors.

The dealer owns its own business. It hires its own staff, carries its own inventory and answers for its own results. The automaker owns the brand and builds the vehicles. Neither can do the other's job without the other, which is why the agreement between them is so detailed.

What the dealer gets

The main thing the dealer gets is the right to sell a brand. AutoNation, a public dealer group, describes its franchise agreements in its annual report as granting the store "a non-exclusive right to sell the manufacturer's or distributor's brand of vehicles."

A dealer also gets its supply. AutoNation states that it relies "exclusively on the various vehicle manufacturers for our new vehicle inventory." A dealer cannot buy new cars of a brand from anyone else. The agreement is what opens the supply line.

Some automakers also give dealers financial help. The same report lists "floorplan assistance" among the direct financial help that manufacturers provide. Floorplan is the loan a dealer uses to hold its new vehicle inventory, and the assistance reduces what that loan costs.

What the dealer gives

In return, the dealer accepts a long list of duties. AutoNation's report says the agreements "impose numerous operational requirements and restrictions relating to inventory levels, working capital levels" and other matters. The automaker decides how much the dealer must keep on hand and how much money the dealer must keep available to run the store.

The report also says manufacturers can set performance standards for sales volume and sales effectiveness. A store that falls short of those standards can be at risk when the agreement comes up for renewal. A separate lesson in this series covers sales standards in more detail.

Facilities are another cost. The report says manufacturers "impose minimum facility requirements that can require significant capital expenditures." Showrooms, signs and service areas often have to meet the automaker's standards, and the dealer pays for them.

What the automaker gets

The automaker gets local sales and service reach without owning thousands of stores. Wikipedia describes the arrangement as one that can benefit both sides: automakers gain local reach, and dealers gain a product to sell. The dealer does the work of meeting buyers, handling trade-ins and servicing vehicles in its own market, using its own capital.

The automaker also keeps certain rights in the agreement. AutoNation's report says the agreements give the manufacturer the right to terminate the agreement or to decline to renew it "for a variety of causes." They can also give the manufacturer a right to acquire a store at fair market value in some situations, and the report notes that the manufacturer has the right in some cases to establish new franchises or relocate existing ones.

Where the relationship can go wrong

Wikipedia points out that both sides can take advantage of the other. After a dealer has invested heavily in a showroom and inventory, the article says "The franchisor can act opportunistically by imposing constraints and burden on the franchisee." In the other direction, a dealer with little local competition can provide weak service or pass higher costs back to the manufacturer.

This is the reason the law steps in. Dealers invest a great deal that cannot be moved to another brand, so their position is weaker than it first appears. The automaker, for its part, wants someone in each market who will serve customers well.

How state law balances it

State franchise laws set limits on what the automaker can do. AutoNation's report says that under state franchise laws "it is unlawful for a manufacturer to terminate or not renew a franchise unless 'good cause' exists," and that the company relies on the protection of state franchise laws in the states where it operates.

Wikipedia reports that all 50 states and the District of Columbia had enacted some form of law restricting direct sales from manufacturers to consumers by 2010. It also says most states restrict new dealerships that would compete with existing ones, and that all states impose severe limits on a manufacturer's ability to end a franchise relationship.

These laws are debated. The same article notes that some economists describe them as a form of rent-seeking that raises prices and limits competition. Both views are part of the picture, and this series reports them without taking a side.

What this means for a reader

If you are learning how dealerships work, the main point is that the franchise agreement is a trade. The dealer gets a brand, a supply of vehicles and legal protections. The automaker gets a local operator who spends its own money on facilities, inventory and staff. Neither side holds all of the power, and state law shapes where the line falls.

When you read about any dealership or dealer group, ask which brands it holds, how long the agreements run, what standards apply, and which state's law governs. Those answers tell you more about the business than the size of the lot.

This article is general education about how auto dealerships work. It is not an offer to sell securities and it is not investment advice.