The naked franchisor - calculating and collecting franchise fees

Franchising may be about relationships, but first and foremost it is about business - and the purpose of businesses is to make a profit. That applies not just to franchisees but to franchisors as well, and it is important that both parties remember that.

A franchisor needs to provide many services to franchisees, and these have to be paid for. However, in order to fulfil the profit requirement for the franchisor then he must receive an income greater than the amount he has to spend. Franchisees should not begrudge the franchisor his profits - after all, if the business were not successful for the franchisor too then he might as well shut up shop. But, equally, franchisees can reasonably expect to know where the franchisor's revenue is coming from. Such an approach reduces potentially damaging gossip and can create a foundation for progress.

For example, a few years ago I had a client come to my consulting practice who had a real problem. This franchisor had purchased the business from the previous franchisor, who had set it up himself with no outside assistance. The problem the new owner had was that although all the franchised retail outlets were making a profit and paying their royalties, those royalties were insufficient to sustain the franchisor. If it weren't for the fact that the franchisor was operating a retail outlet himself, which was subsidising the costs of the franchise system, the franchisor would have fallen over fairly early.

The impact of this was that the franchisor needed to concentrate on the performance of his own store in order to provide essential services to the franchisees. This is a reversal of the usual franchising dynamic, where the franchisees need to be as successful as possible for the franchisor to make money, and created an obvious division of focus.

It was easy enough for us to diagnose the problem, but to overcome it would require all the franchisees to agree to pay higher fees when the franchise agreement set out a lower amount. You can imagine that this was not easy, but by being open with the franchisees and demonstrating that if the franchisor company collapsed then their own businesses had little chance of survival, we did manage to achieve this minor miracle. The result was a much more soundly-based franchisor company with much more secure franchisees.

How much do you need?

When you first establish a franchise system, it isn't necessarily easy to work out what your fee structure should be. There is a natural tendency to wish to keep fees as low as possible in order to encourage new franchisees on board, and there is also often a lack of understanding as to just what time and resources will be required to provide vital support services to franchisees. I would say that a considerable proportion of new franchisors have long term difficulties because they don't establish their fees correctly.

Setting your fees is not as simple as opening up a franchise directory and seeing what your competitors are charging. Basing your fees on those of the ‘average' franchisor is even sillier. Unless you establish your fees based upon the economic realities of your franchise system, you're heading for potential disaster. Marketability against the competition does need to be a factor, but recruiting franchisees based upon a fee structure which is too low to cover costs and give you an adequate return only means your - and their - failure within a short period.

When calculating your fee structures, then, remember that your goal is not just to sell franchises. Your goal is to sell them in a way which allows you to meet your commitments, stay in business, and make a return on your investment. Your investors and your future franchisees are counting on it.
In developing your fee structure, a part of your decision rests on the questions of what markets you intend to enter and how many units you will be able to establish in, say, a year. Servicing a market that grows fifteen units in two years is cheaper than servicing a market that grows to fifteen in five years. You need to be very precise as to what the obligations and role of both franchisor and franchisees are, because usually an obligation can be equated to a cost.

There's more than one way to skin a cat

Let's look at franchisor income streams a little more closely. There are six recognised ways a franchisor can gain an income stream. These are:

1. From a straight royalty payment. This might be a percentage of turnover, a flat fee, or a percentage of profit (although this last is very rare and requires excellent systems).
2. From a mark-up or margin on products provided. Where the franchisor is manufacturing, importing or wholesaling product, a mark-up may reasonably be charged. However, the franchisor has to be careful that adding such a mark-up does not make the product more expensive to franchisees than product of the same quality available elsewhere.
3. From a mark up or margin on services provided. If the franchisor is providing e.g. accounting or debt collection services for the franchisees, these may be charged for. Again, such services should offer unique advantages over those available elsewhere for the same fee.
4. From a contribution to the national marketing or advertising fund. This should not be seen as revenue by the franchisor, as it is collected for a specific purpose and its use must be accounted for to the franchisees.
5. From a commission paid by suppliers. Some suppliers will offer a commission or rebate to the franchise system on product or services purchased by franchisees - see below.
6. From a percentage paid on revenue above a trigger point of turnover on top of the base rent. This is a more complex formula but is one which has been used to great effect.

The example quoted in the previous section of the franchisor who was subsidising the franchise system out of his own store is not unique. In fact, one of the best-known examples of a company underestimating the cost of its support services is that of McDonald's.

When pioneer franchisor Ray Kroc developed the McDonald's franchise system, he was so focussed on service and standards that his support structure rapidly became more expensive than the royalty revenue could pay for. Those early franchisees were reluctant to pay more for the privilege of having people come into their restaurants and tell them what to do, so raising the royalty levels wasn't an option. Instead, the company created a new revenue stream - it decided to take the head lease of all its sites, and sub-lease to franchisees at a profit. This not only increased the company's revenues, but also increased its hold over franchisees and made it easier to get good sites. The system is still in place to this day in many McDonald's locations, and is known and understood by the franchisees.

Each of the above six ways of generating revenue is perfectly fair and ethical. Most relate in some way to the sales or turnover - and therefore the potential profitability - of the franchisee, and therefore share his or her successes and risks. The problems arise if the franchisor tries to change things or does not declare where margins are being charged in a fair and transparent manner.

The consequences of getting it wrong

Let's look at another example of a New Zealand franchise system which didn't quite get its homework right. After a period of operation both the franchisor and franchisee in this system were doing exceptionally well. The franchisor had set out with specific objectives and had achieved them - in fact, it had exceeded them by a considerable margin.

The franchisees were doing even better, and were described as making ‘truckloads' of money - far more than had ever been anticipated by the franchisor. This extra franchisee income didn't escape the notice of the franchisor, who decided that they wanted more of a share of it as well. So the franchisor found a loophole which gave them an excuse for charging more fees on an imported supply line. They put on a very high margin and then demanded that the franchisees pay the extra price. Well, the franchisees being red-blooded Kiwis decided not to take this lying down. They engaged a legal advisor with every intention of pursuing the matter through the courts.

Unfortunately all this does nothing to enhance good relations. It could all have been avoided, of course, if thorough strategic planning had been carried out in the first place. All possible avenues of income should have been explored at the strategic planning stage and a fair and proper balance achieved - and adhered to.

Another case also indicates that total transparency is the best policy. A franchise system changed hands and the new franchisor had his bills for the provision of certain services queried by franchisees on the basis that they were too low. After some further investigation, it became apparent that the previous franchisor had been applying a large and undeclared mark-up on certain services supplied by outside parties. The franchisees were understandably upset, and looked to recover some of the mark-up from the previous franchisor through the legal process.

A franchisor has to be very careful about putting excessive margins on products or services if their franchise agreement states that franchisees can only purchase those products or services through the franchisor. If those same products or services can be obtained from other suppliers at a less expensive price, the franchisor could be deemed to be indulging in restrictive trade practice and could well be taken to task for contravening the Commerce Act.

And consider this. If that franchise depended upon those mark-ups to provide the franchisor with enough return on investment to make the franchisor profitable as well as provide vital services to franchisees, that return has just been slashed - all because the new franchisor tried to do the right thing. If he later needs to raise the royalty fee to make up for it, what do you think is going to happen?

Supplier rebates are a good idea

Of course, there is nothing wrong with taking a commission from a supplier providing that the franchisees know about it. Suppliers will want to reward good clients, and will also want to encourage good clients to buy even more. It is for this reason that, for example, a soft drink manufacturer might agree a rate to the franchise system of wholesale minus x%, with an additional y% to be paid to the franchisor in the form of a joint promotional budget or a contribution to the marketing fund or the franchise conference.

Such a contribution is to be welcomed by all concerned, as the combined benefit is likely to be greater than would be achieved from just a discount structure. In other cases, if the products which the supplier is providing have a fairly standard retail price and distribution price structure, the supplier will give a rebate rather than the possibility of devaluing that pricing structure by his own hands.

As sales grow, suppliers become more and more attentive and anxious to please in order to retain the business. They can become very inventive and creative in how they please the franchisor and network. Some give free holidays to the franchisor and/or to the best-performing franchisees. Others add more direct value through offering training courses to franchisees and their staff. Such courses are usually centred around their own products, but good sales training, for example, benefits everybody. I even know of one progressive supplier dealing with a somewhat inadequate franchisor who has set up a benchmarking and report system for the entire network, thereby filling in for the franchisor's lack of proper performance in that area. All of these are powerful benefits of belonging to a franchise system.
It needs to be pointed out, though, that there is also nothing wrong with a franchisor receiving a rebate which helps to cover his own costs and, ultimately, ends up on his bottom line. The sin (or at least unwise action) is for the franchisor to try and hide that there is a commission being paid. Sooner or later it will be discovered, and the shock of it will upset the franchisees, who rightly or wrongly, will think that they are being taken for a ride and will start to get suspicious about all sorts of other things.

In some cases, rebates or commissions may be offered to a franchise after the business has been established for some time when it reaches a large throughput of product or service. What does a franchisor do - keep the windfall for himself or share it? The franchisor might feel that this is payback time for all the effort he has put into getting the business to the level it has now reached. Equally, the franchisees might feel that they are the ones who have made the sale, provided the service and paid for the product, and they have at least an equal right to the funds.

Whatever the decision made, it must be communicated to the entire franchise network in an upfront straightforward manner. Again we get back to transparency. If it is hidden then, one way or another, the franchisees will eventually find out. When they do, they will be very disappointed, angry or even militant about it, and the franchisor will find it much more difficult to get a fair hearing the next time a genuine problem arises.

The naked franchisor

Franchising is a business relationship based on mutual trust, and nothing destroys trust faster than one party keeping secrets from the other. Every established franchisor knows how well their franchise grapevine works, and a rumour about hidden charges is the fastest way of spreading dissent and suspicion even in the most good-natured of systems. Even if there is nothing in the rumour, some damage will have been done - if only in a day's lost productivity. And some people will always believe that there is no smoke without fire.

This is why franchisors should declare their revenue streams to franchisees right from the very start. Franchisees might not always like what they are told, but if they know the truth and understand the reasons for any arrangements, there is no room for supposition or deceit.
Openness and transparency not only go a long way towards preventing franchise disputes - they also engender good communication and trust. The naked franchisor has nothing to hide.

 

This article first apeared in Franchise New Zealand magazine Volume 11 Issue 3 

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