Setting franchise fees

One of the more emotive aspects of any franchisor/franchisee relationship is that of the franchise fees. The setting of fees, both initial and ongoing, is very much a balancing act to ensure that both the franchisor and the franchisee achieve the rewards they deserve for their respective contributions to the business. If the relationship is to endure, neither party should get rich at the expense of the other. By Steve Felmingham, former director of business development at the Franchising Centre.

It should be remembered that the franchisor’s income does not go straight into its coffers as profit. The initial franchise fee it charges to the franchisee will be the mechanism by which it recovers its own franchise development costs and the specific costs relating to setting-up each franchisee in business (of which, more later). Of the on-going franchise fees, only a small proportion may be profit with the rest going to pay for the support and back-up that the franchisor is contractually obliged to provide to its franchisees.

Firstly, we will examine the situation from the perspective of the franchisor. The setting-up of a franchised network, perhaps involving the conversion of a company-owned chain, can be a complex, time-consuming and costly business for the franchisor at least in the short term.

At the outset, a prospective franchisor will have to cover the costs associated with putting all the necessary elements of the franchise in place. This might include advice from franchise consultants, franchise-proficient lawyers, accountants, trademark agents, and territory mapping specialists, etc. The components will include the drafting of the franchise agreement, the operating manual, brochures, prospectus and other promotional materials. Other costs may include the recruitment of specialist staff to oversee the franchise network and perhaps additional premises from which they can operate.

Having created the franchise structure, the franchisor will then incur further costs in promoting its offering and advertising for franchisees. This may involve a mix of media, including franchise exhibitions, websites, and advertising in newspapers and magazines. Having generated the enquiries, the franchisor will then have the costly task (both in terms of time and resources) of sifting through the responses. This will usually be through a highly objective recruitment process involving the assessment of the original application, several interviews and, in some cases, credit checks and personality profiling.

It is only at the end of this process that the franchisor will offer franchises to the candidates who possess the right qualities and the right amount of capital. The recruitment stage can be the most expensive of the whole process whilst the fledgling franchisor tries to discover the most effective mix of media and the right budget required to generate the number of candidates it needs to grow its network at the desired rate.

Having selected its candidates, the franchisor will then need to devote a considerable amount of time and effort to ensure that they are adequately trained and prepared to successfully launch and operate their businesses. The franchisor will have to ensure that it has the resources within its organisation to handle the throughput and that its staff are skilled in both the day-to-day operations of the proposed franchise business and their ability to train the candidates.

In reality, it will probably be some time before the franchisor’s income, both in terms of initial franchise fees and on-going fees, reaches a level that provides it with a profit. Hence setting-up a franchised network must always be seen as a medium to long-term strategy. Similarly, whilst the benefits of franchising from a prospective franchisor’s standpoint are said to include the ability to expand its business using other people’s capital (i.e. the franchisees) it is clear that a franchised network cannot be established without (at least initially) some reasonably significant levels of capital investment.

Initial fee

The selection and recruitment of a new franchisee will hopefully be just the beginning of a long-term commercial relationship. As such, the franchisor should not view the initial fee as a mechanism for making large profits. The franchisor should, instead, aim to make the bulk of its income over a longer period from the income and profits generated by its franchisees. The initial fee should, therefore, be viewed as a joining, or entrance fee, that at the same time enables the franchisor to recover a proportion of its development costs, and the specific costs, in terms of the training and recruitment, of setting-up each specific franchisee in business.

The initial fee is usually paid as a lump sum at the time the franchise agreement is signed and before the franchisee has received training, a copy of the operations manual, or commenced trading. Whilst the size of the fee is intended to recover the franchisor’s costs, it makes sense to keep the fee at as low a level as possible as the number of prospective franchisees, who can afford a fee of, say, £30,000 will always be smaller than those who can afford £10,000. A franchisor must take care that it does not price itself out of the recruitment market.

Knowing at what level to set the initial fee will be a problem for a franchisor in its early days. There is no standard pattern, although there may be an observed similarity between the fees charged by different franchisors in the same line of business. Whilst this is perhaps only to be expected, given that these companies probably had similar development costs, this may also be evidence of benchmarking with franchisors not wishing to place themselves at a commercial disadvantage by charging a higher fee than their competitors.

A further consideration for keeping the initial fee at a low level, often over-looked by overseas franchisors looking to enter the UK marketplace, is that having paid a large up-front fee a franchisee may be left with insufficient capital to invest in the business to make it successful. In such circumstances, the franchisor does run the risk of handicapping the franchisee’s business from day one, whereas if it had charged a lower fee it would be more likely to have the franchisee in the position to generate greater levels of profit and over the longer term to pay more in on-going fees.

In the past commentators have suggested that the initial fee element should be set in the region of 10 per cent of the total start-up costs of the franchisee’s business. Such a relationship is less relevant in the modern market, given the boom in the number of relatively low-cost service industry franchises in which the franchise fee may be the largest single cost element.

Initial franchise fees generally remain modest in the UK and it is standard practice to have fees that don’t vary according to the territory or location. It is quite a common temptation for a new franchisor to want to charge a higher fee for a territory with a perceived greater-than-average opportunity. Such a temptation should, however, be avoided in favour of a level playing field. There will be time enough for the franchisor to earn from its stronger territories through its on-going franchise fees or product markups.

One situation where the initial fee may be reduced or waived is where, in the absence of a fully-piloted franchise concept, the franchisor offers a special deal to the first of its test or development franchisees. Such franchisees are accepting a higher level of risk and may find the franchise system changing as any wrinkles are ironed out. This arrangement should not over-ride the principle that the franchise agreement should be the same for all. In such cases, any discounts or variation of terms should be covered by a side letter.

When a franchise network has reached maturity, and its initial development costs have been met from the up-front fees paid by the early franchisees, then the franchisor may start to make significant profits from franchise sales. Indeed, after a franchisor’s brand has developed and gained market strength there may be a case for increasing the franchise fee to reflect such progress. Market forces may also come into play in situations where the demand for the franchise exceeds the number of territories that are available. This can lead to a progressive elevation in the franchise price. Nevertheless, the fee should never be elevated to a level that deters buyers. The franchisee must always feel that he or she is getting good value for money.

On occasions, a franchisor may have asked the prospective franchisee to pay a deposit, which may or may not be refundable in full or in part. Such a deposit may be sought if the franchisor will be spending time and resources on the prospective franchisee’s behalf in perhaps helping it to investigate the viability of an area or territory, or find suitable premises.

A positive factor for a franchisor is that whilst its early overheads may be high its income should from that point grow faster than its expenses. The staff initially required to service five franchisees may also be sufficient to service, say, 15. Each new franchisee coming on board represents additional income and as the turnover of each rises the franchisor’s income will grow proportionally.

A franchisee can generally be regarded as a long-term contracted source of income to the franchisor. A franchisee having perhaps invested heavily in its new venture (and therefore having his or her neck firmly on the block) will normally be more highly motivated than an equivalent company employee. As a result, they can generally be counted on to direct their efforts towards continually boosting their turnover and thereby the income of the franchisor.

Another issue to consider is the supply of initial equipment and any other items that are necessary for the running of the franchisee’s business. Often the franchisor will supply such items or arrange their supply. In this situation it is considered unethical for the franchisor to regard the supply function as a source of hidden profit. The franchisor will nearly always be found out, and the whole relationship and trust between the franchisee and franchisor will be jeopardised.

Often a franchisor may achieve discounts or economies of scale through its bulk purchasing arrangements and, unless the franchise is based on mark-ups, these discounts should be passed on to the franchisees. It is generally considered acceptable for the franchisor to retain a modest margin or handling fee for buying in supplies, but the underlying ethos must always be to give the franchisees the best possible value for money.

Similarly retained commissions, retrocessions, or other kick-backs from suppliers should be avoided and certainly not hidden. It is better to declare these amounts and demonstrate how they are used for the promotion of the business.

In situations where the franchisor provides the franchisee with a turnkey business and equips the outlets ready to trade similar principles should apply. The franchisor should make no hidden profits and be prepared to provide full details of the costs it has incurred including, where appropriate, invoices from suppliers.

Initial and on-going support

As stated earlier, the initial franchise fee should be regarded as covering the cost of the franchisee’s recruitment, selection and training. The on-going fees, whether received as a percentage of turnover or a mark-up on goods supplied by the franchisor, should be partially utilised to fund the cost of providing the essential back-up and support to the franchisee’s business.

Initial practical guidance and support might include advice on finding, acquiring, designing and fitting out suitable premises. The franchisor might also provide guidance on the equipment required and where to obtain it. There might also be advice on training, business development, generating sales leads, marketing and advertising.

Training is of particular importance as the whole ethos of franchising is that a newcomer to the business will be operationally trained to run its business in accordance with the franchisor’s proven operating system and methods. The content and duration of the training programme varies from franchisor to franchisor, although it may involve on-the-job training in an existing outlet, or in the field. It could include classroom modules, sales training, learning how to use equipment or processes, and familiarity with or preparing the products. The training must enable the franchisee, in a relatively short period of time, to become expert in all areas of the business prior to opening.

The franchisee may also have to learn how to operate a small business, perhaps for the first time in their life. They may, therefore, need to be instructed as to how to keep accounting records, how to manage cash and stock, and aspects of recruiting, managing, training and coaching staff, as well as the various legal and fiscal requirements and obligations associated with running a business.

The franchisor may be expected and, indeed, contractually obligated, to provide certain continuing support services which, depending on the type of business, may include:-

  • Regular visits by the franchisor’s field support staff to assist in correcting, or preventing, problems and help the franchisee to develop their business.
  • Liaison with the franchisor and other franchisees to exchange ideas and experiences.
  • Continuing product research and development, including investigation of the marketability and compatibility of new products/services with the existing business.
  • Training and re-training facilities for the franchisee and perhaps their staff.
  • Market research.
  • National and local advertising and promotions.
  • Bulk purchasing opportunities.
  • Management and accounting advice.
  • The organisation of national conferences and regional meetings, and the publication of newsletters and other literature.

A franchise should be viewed as a long-term relationship in which the initial concept is being continually refined and developed over time with input coming from both the franchisor and the franchisees.

On-going fees

In return for its on-going support and as its primary source of profit, the franchisor will charge the franchisee an on-going fee. The most common method of doing this is to charge a management services fee which will be expressed as a percentage of the franchisee’s turnover. Alternatively, where the franchisor provides the products or materials that the franchisee sells or uses, it may take its return through mark-ups. Naturally, there are pros and cons with both methods.

Where the products can only be sourced through the franchisor and are competitively priced as a result of the franchisor achieving economies of scale then the franchisee may be quite happy with mark-ups. However, if the franchisee feels that the franchisor is making an excessive margin on the goods, or it discovers that the same or similar goods can be obtained more cheaply elsewhere, problems could easily arise.

Where a franchise involves a requirement or obligation to buy products from the franchisor – known as a product-tie – there could be competition law ramifications. Such product ties can, in certain circumstances, be deemed anti-competitive and so franchisors operating such arrangements will have normally made provision for them in their franchise agreements. The competition authorities will generally uphold product ties within a franchise environment, provided that the franchise agreement has a term, or break-clause, of no longer than five years.

However, the majority of franchisors derive their income through a management services fee, calculated as a percentage of turnover. To establish the rate of these fees, which again should be constant across the network, the franchisor needs to assess the financial performance of its pilot outlets in relation to the anticipated turnover, gross profit and costs of the franchised units. This gives rise to another careful balancing act. If the rate is set too high, the franchisees may well resent what they consider are excessive fees. Such a situation has led to disquiet in many franchise networks. On the other hand, if the franchisor sets the rate too low it could end up making insufficient profits and could lack the funds needed to adequately support its franchisees. It is of key importance that the fees are set at such a level as to allow the franchisor to afford to deliver the level of support which the franchisees need, and indeed deserve, without negatively impacting upon the franchisees’ operational profitability.

Based on the performance data available, or the performance expectations, for both company-owned and franchised outlets, the on-going fee should be set at a level that is long-term viable for both parties so that each may achieve a reasonable profit and return on capital. In setting the fee, it is also important to consider the percentage charged by other franchisors in the same sector. Unfortunately, would-be franchisees often simply look at the headline percentage figure and look no further to find out what this translates into in actual profit or the level of support services.

The range of management services fees that are charged varies enormously between different types of businesses, depending on their relative turnovers, profitability and margins. Convenience stores, for example, may have on-going fees of only a few percent because they operate with low margins, but high turnovers. Service businesses on the other hand, with wider margins, may be at the other end of the scale with fees as high as 25 per cent or more as they have very low direct costs.

The fee should, of course, also reflect the level and range of services provided by the franchisor. It should also be borne in mind that the higher the level of fee, the higher is the likelihood that franchisees will resent paying it, and the more they will expect in return.

The franchisor should recognise that it is likely to generate less income from a franchised outlet than it would from a company-owned one. This is a given since it is the franchisee’s capital that has established the unit and it is the franchisee who is exposed to all the day-to-day problems that occur.

When collecting the management services fee many franchisors ask their franchisees to complete a return showing daily sales and fee calculations. Some returns may also seek information as to sales by product or service type, and details regarding local marketing and sales activity. This not only provides the franchisor with information relating to the payment, but other data which can help the franchisor track what is going on in the network. At the individual franchisee level such data can be useful in identifying performance issues at an early stage.

Franchisors will also need to examine at some stage whether their franchisees are declaring all their income, particularly in franchises where some customers pay in cash. From a franchisor’s viewpoint, under-declaration of sales is the worst crime that a franchisee can commit. It will, of course, be a breach of the franchise agreement and technically grounds for termination. Most franchisors would forgive any accidental or inadvertent underdeclaration, whilst a tough line will be taken against any franchisees where substantial or repeated underdeclaration takes place. The onus is clearly on the franchisor not to rely totally on trust, but to build into the franchise some monitoring systems that make it harder, if not impossible, to hide turnover. Such fail-safe techniques include regular audits, mystery shoppers, spot-checks and modem-linked tills which feed details of all transactions electronically to the franchisor. Companies that fail to take such precautions are likely to be sowing the seeds for later difficulties.

Another means of taking on-going fees is by levying a fixed or a fixed minimum charge. Such a method is not recommended by franchising purists as it can be indicative of a franchisor who is happy with a minimum level of income, regardless of the success or otherwise of the franchisees. A system in which the franchisor is only successful if its franchisees are successful is clearly a more mutually beneficial approach.

Having different percentage management service fees for different franchisees within the same network is highly inadvisable. Differing fee levels encourage negotiation, lead to uncertainty, and breed discontent among franchisees. There are, however, examples of franchisors introducing tiered structures whereby franchisees are rewarded by having their fee percentages reduced for achieving targets or hitting turnover thresholds. The reduction tends to apply on the amount of turnover they achieve over the threshold, rather than on their entire turnover. Such structures can act as a good incentive to perform and are generally a positive tool when used sensibly. To work effectively, the thresholds need to be reviewed upwards from time to time as otherwise franchisees may achieve them simply due to inflationary trends without having achieved any actual increase in sales.

In conclusion, the on-going fee must be low enough so that the franchisee can pay it and still make a reasonable profit commensurate with the capital employed. The franchisee should also ideally continue to feel it is getting good value for money. On the other hand, the franchisor needs to cover the cost of the support services it provides and make a reasonable profit itself – a true balancing act.

Advertising levy

In addition to the on-going management services fee, or product mark-up, many franchisors take an additional, but generally smaller, percentage of turnover known as the advertising or marketing levy.

One of the principal advantages of becoming a franchisee is that you are part of a larger network, perhaps enjoying the benefits of strong brand recognition and national advertising. To assist the franchisor with the funding of this continuing brand development, franchisees are required to make a contribution in the form of a levy. By making it linked to each franchisee’s turnover, the more highly performing franchisees, which it could be argued have benefited most, make a larger contribution than the weaker performers.

It is important to get a degree of franchisee involvement in the control and expenditure of the money generated by the levy. Over time, the total of the contributions could be substantial and the franchisor should ensure that the fund is not only independently audited, but that there is a committee made up of franchisee representatives and the franchisor to budget and administer the fund. As the fund will ultimately benefit both the franchisor and the franchisees it makes sense for the former to also make a financial contribution. This should be on the same basis as that of the franchisees in recognition of the benefit being derived by the company-owned outlets. The franchisor might also top-up the fund with additional contributions, particularly in the early days.

Summary

Within the franchisee/franchisor relationship there are several financial transactions:-

  • The initial franchise fee
  • The on-going fees either calculated as a percentage of turnover, or taken (invisibly from the franchisee’s viewpoint) as a product mark-up.
  • The advertising or marketing levy.

In return for the fees, the franchisee will expect their franchisor to train them, set them up in business and provide an on-going support service, as well as continue to develop the concept as a whole.

It is essential that the fee levels are seen to be fair by all, and provide an adequate financial return for both the franchisor and its franchisees from the outset and over the long term.