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Determining the Initial Franchise Fee

Written by: Steve Vandegrift

Article Overview: Many factors impact the franchise fee charged by a Franchisor. Some franchise companies make the mistake of setting their franchise fee based solely on what their competitors are charging. Although this may appear to be a sound strategy, the problem is that not all franchise systems are created equal, regardless of whether they operate in the same industry...With Franchise Fees wildly fluctuating even among similar type franchise companies, to a potential franchisee the Franchise Fee may appear to be based on a "throw it out there and see if it sticks" approach. However, when the Franchise Fee is properly established based on a thorough evaluation of specific factors, it can be easily justified (and understood) by a potential franchisee.

Determining the Initial Franchise Fee

Many factors impact the initial Franchise Fee charged by a Franchisor. Some franchise companies make the mistake of setting their franchise fee based solely on what their competitors are charging. Although this may appear to be a sound strategy, the problem is that not all franchise systems are created equal, regardless of whether they operate in the same industry.

When establishing the initial Franchise Fee, it is important to remember that although the Franchise Fee can certainly help a company's cash flow and assist in sustaining the company's initial growth, the royalty fee income and income from the sale of products and/or services to Franchisees should be the major source of revenue in terms of the long-term profitability of the franchise operation. Companies that attempt to make a huge profit from the initial Franchise Fee may find that they are discouraging qualified candidates from looking past the huge fee.

When assisting clients in franchising their business, part of the development process entails our determining an appropriate Franchise Fee (and other fees) that balance the franchisor's financial needs with the needs of the franchisee relative to their total initial investment. We do this by evaluating a number of different factors.

With Franchise Fees wildly fluctuating even among similar type franchise companies, to a potential franchisee the Franchise Fee may appear to be based on a "throw it out there and see if it sticks" approach. However, when the Franchise Fee is properly established based on a thorough evaluation of specific factors, it can be easily justified (and understood) by a potential franchisee.

When determining the initial Franchise Fee, we evaluate the following:
1. The sophistication and/or uniqueness of the system;
2. The potential ROI and profitability of the Franchise Business; and
3. The Franchisor's costs and expenses associated with the acquisition and grant of the franchise.

When considering differences in the initial Franchise Fee of two similar franchise companies operating in an established industry (i.e. pizza), the third category is where much of the difference between franchise fees can often be found.

The Franchisor's costs and expenses may include:
• Allocation for franchise development costs
• Allocation for franchise advertising and marketing expenses
• Franchise acquisition costs including sales costs (i.e. sales commissions) and other related expenses (i.e. marketing materials, personnel)
• Expenses related to training new franchisees and/or providing on-site support or site selection assistance prior to or during the franchisee's grand opening period. Franchisors may choose to include some or all of these expenses in the initial Franchise Fee.
• Other hard costs incurred by the Franchisor in establishing a new Franchisee (i.e. training materials, supplies, equipment) if these costs are inclusive of the Franchise Fee.

As stated previously, the initial Franchisee Fee may also be based in part on the potential ROI and profitability of the Franchise Business. Of course, this may only be shared with a prospective franchisee by Franchisors who have made the required disclosure in the Disclosure Document relative to "financial performance representation." Otherwise, these factors will only be tangible to prospective Franchisees once there are a number of franchises operating under the franchise system.

For franchisors who do not make financial performance representations (and the majority do not), the company's franchisees may choose to share their financial performance with prospective franchisees. So as the number of franchises increases, it becomes easier for a prospective franchisee to evaluate the financial potential of the franchise. This is why it is common to see Franchisors increase their Franchise Fee over time. As the number of franchises increases, the franchise business gains more credibility (and believability) for potential franchisees. In essence, later stage franchisees are investing in more of a "sure thing," which can justify a higher Franchise Fee.

So the question remains, what percentage of the Franchise Fee does a Franchisor typically "net?"

Again, this will vary greatly in large part based on the factors discussed. In addition, some franchise companies choose to "break even" on the Franchise Fee to reduce a franchisee's barrier to entry in terms of the total initial investment. Others franchisors may actually choose to "lose" money on the Franchise Fee with the justification that they will make it up many times over with the ongoing royalty fee generated by franchisees.

This being said, it is not unusual for a Franchisor to "net" 25% or more of the total Franchise Fee (officially "gross profit"). It is also important to remember that a portion of the Franchise Fee normally includes a recoup of certain expenses that the Franchisor previously incurred (i.e. franchise development costs, production of advertising and marketing materials, advertising costs, etc.). So the net cash flow generated from the Franchise Fee is normally higher than the gross profit. As a result, the gross profit generated from the Franchise Fee increases as additional franchises are granted and some of these costs are fully recouped.

There is an art and science to establishing the initial Franchise Fee and other fees associated with the franchise (i.e. continuing royalty fee and advertising fees, which I discuss in another article). When establishing the Franchise Fee, franchisors should carefully evaluate the various factors discussed in this article as they relate to their franchise. Doing so will help ensure that the initial Franchise Fee is fair to both the franchisor and franchisee instead of a reason to question the Franchisor's true motives.

© 2009 Stephen E. Vandegrift, all rights reserved

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Article Tags: acquisition, cash flow, franchise business, franchise companies, franchise fees, franchise operation, franchise systems, franchisee, franchisees, franchisor, initial franchise fee, initial growth, initial investment, mistake, royalty fee, sophistication, sound strategy, term profitability, type franchise, uniqueness



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