Why Pay Franchise Fees?

If there’s one topic guaranteed to create discussion among both franchisees and franchisors, it is franchise fees – both initial and ongoing. How are they calculated? What should they cover? How much should they be? Can they be reduced or increased?

All of these questions and more are sure to arise in any such conversation. In this article, we set out to explain the purpose of franchise fees and the value franchisees should receive from paying them.

Franchise fees can broadly be divided into two types: initial and ongoing.

The initial franchise fee

Nearly all franchises charge an initial or upfront fee, a one-off payment made by a new franchisee to the franchisor upon joining the franchise. The fee charged will vary markedly from system to system as it reflects the individual circumstances of that particular business.

However, it will usually pay for the right to use the franchisor’s trade name, trademarks and operating system for the period of the franchise term; services to help you establish your new business; access to the confidential operating manual; any specialist computer software or set-up; initial training for you, your partner and/or key staff; and on-site assistance and training at your location prior to or during the opening period. In many cases, the initial fee will also include a marketing programme to launch your new business, although sometimes this is accounted for separately.

The purpose of this fee is usually to recover the costs incurred by the franchisor in training you and helping you establish your new business, and to repay a proportion of the costs that they have incurred in developing the franchise system in the first place. However, in some cases, the franchise fee is set below cost for marketing purposes, on the basis that attracting good franchisees who will succeed and assist the growth of the franchise system long-term is more important than the immediate recovery of costs. If this is not an issue, an established franchise with a good brand may justify a premium and charge accordingly. 

Where buyers need to be vigilant is if the franchise fee is set at a higher level in order to provide an immediate return to a franchisor, rather than the franchisor expecting to make money from the ongoing success of the franchisee. If the franchisor has already made his money, he may be less likely to be concerned about the long-term future of the business.

As always, taking professional advice from a franchise-experienced accountant or consulting your bank’s specialist franchise division will help you to understand where your own chosen franchisor stands on this issue.

Ongoing franchise fees

Once a franchisee has joined the franchise system and begun trading, they will also be liable to pay ongoing fees. These fees may also be termed royalties, management service fees or ongoing franchise fees, and they are intended to pay for a variety of services.

The ongoing fees charged by a franchisor, and the services provided in return, also vary from franchise to franchise. Some systems provide a high level of support to franchisees: for example, computerised point of sale systems which not only offer easy financial and stock management but also ordering from suppliers. Where such a system is linked to the franchise support function, it enables the franchisor to monitor ongoing trends not just on a system-wide but also an individual basis, and to provide pro-active assistance to franchisees when required. Such a service is expensive to establish and maintain, but is extremely valuable to a franchisee and therefore will require (and justify) a higher level of ongoing fees.

On the other hand, a franchise business in an industry such as dog washing might require little individual support on an ongoing basis once each franchisee is established, although of course the franchisor still has a major role to play in such areas as co-ordinated marketing, supplier negotiation, research & development and communication. It might therefore be reasonable to expect that ongoing fees charged will be at a lower rate.

In addition to the ongoing fee paying for the provision of services, appropriate field support and the upkeep of the franchise support office, it should also include a measure of profit for the franchisor.

This should not be begrudged by franchisees: if the franchisor is not making a profit from the business, then there is little incentive for him or her to stay in business and support the ongoing development of the system. As long as the franchise is properly structured so that both franchisor and franchisees make a fair return on their investment over a reasonable period, everyone should be happy.

In some cases, ongoing fees may be charged separately for different services, such as:

• Management Fees
• Training Fees
• Conference Fees
• IT Fees
• Accounting Fees (where additional services are provided)

The most important thing about fees is not what they cost or what level they are set at, but what services they pay for. Any fee charged should be justifiable by the franchisor and shown to provide specific benefits to the franchisee of a value at least equivalent to the cost.

How are ongoing fees calculated?

There are a number of different ways that ongoing fees can be calculated, and all of them are perfectly acceptable providing they are fair and clearly understood by both franchisor and franchisees. The following are all commonly in use in New Zealand, with some systems combining one or more of the methods.

1. A straight royalty payment calculated as a percentage of franchisee turnover (not profit). Such a method requires the franchisee to declare their turnover and to pay the ongoing fee on a regular basis (often by direct debit from their account). This has the advantage of fluctuating with a franchisee’s sales, so your business pays more only as it grows.
2. A flat fee payment on a weekly or monthly basis. This is a very straightforward system and is commonly used in industries such as home services where the calculation of weekly turnover would be a difficult and time-consuming task for all concerned (not to mention open to abuse). In many systems, the level of fee varies within bands according to the size of the business.
3. A mark-up or margin on products provided. This means that franchisees pay only for what they actually buy, so offers many of the same advantages as method 1. If the franchisor is manufacturing or wholesaling product, a mark-up is reasonable providing the product remains competitively (preferably advantageously) priced compared to similar products available on the open market.
4. A commission or rebate paid by suppliers under a similar arrangement to method 3. In some systems, the franchisees pay no fees and the franchisor manufactures no product, but the approved suppliers pay rebates to the franchisor on all products supplied to franchisees. This is a perfectly acceptable arrangement providing it is transparent to franchisees, and providing franchisees buy only through the approved suppliers.
5. A fee, mark-up or margin on services provided. If the franchisor is providing, say, a central booking facility or debt collection services for the franchisees, these may be charged for separately. As with method 3, such services need to be charged for at a competitive rate.
6. A margin created by taking the head lease of a property and sub-leasing it to a franchisee. In some cases, this may be the only way a franchisee can get into a certain property, as some landlords prefer to deal with franchisors. Once again, this is perfectly acceptable (McDonald’s use this system) providing it is transparent to franchisees.

Marketing fees

In addition to the fees which are charged in one or more of the above ways for the services which the franchisor provides (and their profit element), many franchise systems also require franchisees to make a contribution to a marketing fund. This is not a revenue stream for the franchisor and should not be seen as such by either party. The franchisor is accountable to the franchisees for monies gathered and spent for this purpose, and franchisees may well be involved (either through a franchise advisory council or a special marketing committee) in deciding how they should be spent.

National marketing contributions are usually required in addition to any funds spent on local marketing by franchisees. Many systems will actually require both, and they are budgeted for accordingly.

Marketing contributions are usually collected via percentages, flat fees or margins. In addition, contributions may be made by third party suppliers, either directly into the fund as negotiated by the franchisor or through the provision of agreed joint promotional material for use by franchisees. Suppliers might also contribute to the costs of conferences, new product training, supplier expo’s or a variety of other activities.

Once again, it is wise to ensure that any such arrangement is declared to franchisees, as nothing is likely to upset a franchisee more than the ‘discovery’ that the franchisor has an additional source of income covering expenses which the franchisees might believe are coming out of the franchisor’s own pocket.

What’s the norm?

Having explained all that, one of the questions that is most often asked by prospective franchisees (and by some prospective franchisors) is, ‘What’s the normal level of franchise fees?’ Indeed, we sometimes hear of new franchise systems where the fees have been set at a certain percentage because the franchisor’s lawyer, in drawing up the agreement, had said ‘that’s what most other franchises charge’. Such an approach is incredibly dangerous, as I hope the above has demonstrated: fees need to be worked out on the basis of paying for essential services, rather than on the basis of any real or imagined ‘norm’.

In fact, the range of ongoing fees calculated on a percentage basis will vary considerably from 0% (where one of the other methods of generating revenue is used) to 15% or above (where considerable services are provided to the franchisee). While the average level of a turnover-based ongoing fee might be around 5-6% (excluding marketing contributions), this is meaningless without knowing what it pays for.

Prospective franchisees need to take advice (and consult existing franchisees) to determine whether the fee structure of any particular franchise represents value for money. Talk to existing franchisees as well to see if the support services are as promised.

Do I have to pay?

Because fees mean money, and the money flows from franchisee to franchisor, if there is any problem in the franchise then a disgruntled franchisee may be tempted to withhold paying their fees. This can occur if the franchisee feels they are not getting value for money, or if they are having some financial problems themselves.

Whatever the reason, withholding fees is a dangerous course of action because it will almost certainly put the franchisee in breach of their franchise agreement. If that happens, the franchisor may be entitled to terminate the agreement, potentially leaving the franchisee with very little.

In the event of any dispute or difficulties, therefore, it is far better to communicate with the franchisor and attempt to resolve problems amicably. Disputes may be resolved with the help of a mediator, while financial problems are best worked through with the assistance of the franchisor. They are likely to be able to identify the reasons for the problem and help to find solutions.

While the withholding of ongoing fees is an obvious cause of dispute, when fees are calculated on a percentage basis a franchisee can be tempted to under-declare revenue in order to pay lower fees. This is called ‘skimming’, and effectively means cheating the franchisor out of some of the fees due to him.

In addition to cheating the franchisor, some franchisees will try to cheat the IRD as well. The dangers of doing either should be obvious: the first is fraud and the second is tax evasion. The penalties for either are considerable. A franchisee caught skimming might lose their business, lose their investment, be subjected to a heavy fine or even end up in prison. Is it worth it to cheat the franchisor out of a few dollars?

Even if not caught, a franchisee who consistently under-declares turnover is going to find that, when the time comes to sell, they are unable to get the price for the business which it should command because the books do not tell the full story. That means that one of the biggest advantages of building up a successful business – the tax-free capital gain on sale – is going to have been partially squandered.

Human nature being what it is, however, skimming does go on to a certain extent in many systems. Where the ongoing fee is a flat one, or where the fee is gathered by means of a mark-up on products supplied, skimming is less of a concern but even then it can happen. When skimming becomes obvious, the franchisor has to take action for three reasons:

1. They need to protect the integrity of the franchise agreement.
2. They need to protect other franchisees against the actions of a rogue member of the group.
3. They need to protect the revenue stream that pays for vital support services for the whole group.

A franchisee tempted to skim needs to consider both the legal and the business implications of doing so. If franchisees across a system routinely skim their fees, who will be the loser? The franchisor requires a certain level of profitability in order to maintain interest in the business, so in many cases the lost revenue will come from the area of support services. Those support services are there to help franchisees improve sales, improve profitability and improve their competitiveness in the future. A franchisee who diverts funds from those areas damages their own business and those of their fellow franchisees.

Mutual trust

Franchise relationships are based not just upon a legal document but upon mutual trust between franchisor and franchisee. That trust has to be there in the beginning, and it has to be built upon over the years in order for both businesses to flourish.

Creating trust in the beginning requires the franchisor to be honest and open about the services they are going to provide to the franchisee and how those services will be funded. As long as that is clear from the start, there will be no nasty surprises – and no grounds for dispute – later on.

Maintaining that trust requires clear communication on an ongoing basis. If situations change – more or fewer services are needed, more or fewer sources of revenue become available – then by sharing that information both franchisor and franchisees are involved in the future of the system as a whole. And if everyone is properly involved, the chances of skimming by franchisees is reduced.

In summary

To summarise, there is no one level or method of collecting franchise fees that is applicable to every system. If you are looking at buying a franchise, don’t compare the level of fees to some notional ‘norm’ – instead, look at what the franchise fees are paying for. What is important is not how much they are, but how much value the services they pay for will bring to your new business.

Once you are operating your franchise, accept that the fees are there for a good reason – they are the fuel that enables the franchisor to drive your business, and those of the other franchisees, on to greater heights.

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