To negotiate a franchise agreement, the potential franchisee needs to fully understand the terminology used in the franchising industry. Often, new franchisees misunderstand the terms ‘Franchise Fee’, ‘Royalty Fee’, ‘License’ and ‘Marketing Fee’. Once understood, the potential franchisee can better negotiate the agreement and furthermore save a significant amount of money over time. This article is designed to teach the new entrepreneur about these terms and how the fees or rates are structured.
It is no secret; I am here to help the potential franchisee in their quest to be successful business entrepreneur. The franchiser has invested tens of thousands of dollars in legal and licensing fees to create a franchise agreement. The franchisee doesn’t have those types of dollars to review and negotiate a fair business contract. So to save the entrepreneur time and money, I have written a series of articles about the franchise agreement. Read the series and then find an attorney familiar with franchise law and negotiate with authority in settling with the franchiser. THERE IS NO SUBSTITUTE FOR GOOD LEGAL COUNSEL. FIND A GOOD ATTORNEY THAT UNDERSTANDS FRANCHISE LAW.
The following sections describe and illustrate the four key terms in a franchise agreement:
The Franchise Fee
When a potential franchisee wants to enter into an agreement with the franchiser, the franchiser charges a Franchise Fee. This is typically a one-time upfront fee to begin the process of the relationship. Often the franchiser is trying to recoup the initial cost outlays to establish the franchise system. For the franchisee, this fee is an expensive outlay that will take years to recover. Often this upfront fee is in the tens of thousands of dollars. For example, the HAAGEN-DAZS® SHOP franchise system requires a $30,000 franchise fee when signing the agreement. Think about this for a moment. This is ice cream. How long will it take to sell 300,000 cups of ice cream to repay this amount at 10 cents per cup? It isn’t like every dollar of the sale is pure profit. The franchisee still has to pay for the food, the supplies, labor, rent, insurance, utilities etc. before having any funds left over to begin the recouping of the initial franchise fee.
The following are examples of franchise fees charged by different systems:
This is a monthly fee usually charged on the revenue stream to use the franchise name or trademark. The most common amount is between 5 and 7% of the sales. Most franchisers require the royalties’ payment each month. Some organizations require a prepayment monthly based on the expected sales for the upcoming month. There are other methods for the royalty including a monthly flat rate or a flat rate plus a percentage of the sales. For the franchisee, this can be a significant portion as a ratio of the profit (margin) before the royalty fee. In more than three fourths (75%) of all franchise agreements, the royalty exceeds 50% of the total profit before the royalty fee. So franchisees should realize that their services is really doing not much more than supporting the franchiser through royalties. Remember the risk reward concept of business. Read more about risk in the following article: How Much is a Fair Profit – Risk.
In my accounting experience, the most common outcome is that the royalty is more than the profit leaving the franchisee with nothing more than heartache of owning a business.
The following are examples of royalty rates charged by popular franchise systems:
A license fee is similar to the franchise fee except it is charged to cover the cost associated with the brand of products sold or the technology used. In effect, the franchiser is merely a broker to a patent or trademark. Therefore the franchiser pays for the use of that brand, trademark, or patent and he passes this cost (and sometimes some profit off the use of the license) onto the franchisee by charging a license fee.
The license fee is typically an annual fee or some flat rate dollar amount. In many relationships, the franchisee must buy supplies or product from the franchiser and the license fee is a component of the inventory cost. A good example is the Subway system. The franchisee must purchase all meats, condiments, and supplies from Subway and thus the license element is built into the costs associated with these products.
Many franchise agreements have the license costs built into the royalty fee. However, there may be situations where this term will pop up and thus the franchisee needs to understand what it applies to in the agreement.
This is where it really gets overwhelming. Almost every franchise agreement requires the franchisee to conduct marketing in spreading the value of the brand or franchise name. So often a marketing fee is included because the franchiser manages the marketing and advertising for the franchises. In many situations the fee is broken down into two elements. The first is the national or regional campaign fee and the second is the local market fee. As an example, Dairy Queen has a percentage of sales associated with a national campaign to advocate its name and products. In addition, a local market campaign is conducted within the television zone. Those stores within that zone must contribute an advertising percentage of sales to this campaign. The national organization provides the commercial material and the local TV station adds in the list of local stores for patrons to visit.
This fee structure ranges from 2 to 5% depending on the nature of the industry and the number of franchisees involved. In some agreements, a flat monthly fee exists along with a percentage of sales.
The Big Picture
For the franchisee, the key is to understand the totality of the situation. In my experience, the cumulative sum of all this overwhelms the franchisee and in effect, he gets nickeled and dimed out of business. He ends up becoming a slave to the franchiser. The primary reasons for the relationship are as follows:
Higher income attributable to the franchise name, brand, logo, or trademark
- Reduction in the failure rate of business by using or exercising a known business plan and operational procedure i.e. a reduced failure rate
The cumulative effect of the Franchise Fee, the Licensing, the Royalty Percentage and the Marketing Costs can easily exceed 20% of sales. In many situations, the total effect exceeds 30% of sales. So if you are interested in a franchise relationship, make sure you understand the four above terms and not only what they mean but their impact on sales and ultimately your personal income. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.