Determining the Initial Franchise Fee

By Steve Vandegrift, President

One common question our clients often ask is, “how do I determine the initial franchise fee?” Ultimately, many different factors impact the franchise fees charged by franchise companies. Some Franchisors make the mistake of determining their franchise fee based solely on what their competitors charge. Although on the surface this may appear to be a good strategy, the truth is that not all franchise systems are created equal.

When determining the initial franchise fee, it is important to remember that although initial franchise fees can help a company’s cash flow and assist in sustaining the company’s initial growth, these should not be the final factors. The royalty fee income and income generated 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. Franchisors that attempt to reap a huge windfall from the initial franchise fee may find that they are discouraging qualified candidates from looking past the initial fee.

With franchise fees wildly fluctuating even among similar type franchise companies, to a potential Franchisee the initial 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 determined based on a thorough evaluation of the specific factors outlined in this article, the franchise fee is more easily justified and understood by potential Franchisees.

When assisting our clients in franchising their business, part of our development process entails determining the appropriate franchise fee (and other fees) that balance the Franchisor’s financial needs with the needs of the Franchisee relative to the total initial franchise investment. At FranSource, we do this by evaluating a number of different factors as outlined below.

When determining the initial franchise fee, we initially evaluate the following:

  • The sophistication and uniqueness of the business model;
  • The potential ROI and profitability of the franchise business;
  • The initial training and support provided to Franchisees by the Franchisor;
  • The Franchisor’s costs and expenses associated with the acquisition and grant of a franchise; and
  • Anticipated demand for the franchise offering.

In addition, when determining the initial franchise fee, a Franchisor may also elect to include all or some of the following costs and expenses:

  • An allocation for the total costs and expenses incurred in developing the franchise operation.
  • An allocation for the costs and expenses incurred for the development of franchise advertising and marketing materials.
  • Franchise-related sales costs (i.e. sales commissions) and other related expenses (i.e. personnel costs).
  • Expenses related to on-site support provided by the Franchisor prior to and/or during the Franchisee’s grand opening period.
  • Other hard costs incurred by the Franchisor in establishing a new franchise (i.e. training materials, supplies, equipment) if these costs are included in the initial franchise fee.

As previously noted, the initial franchisee fee may also be based in part on the potential ROI and profitability of the franchise business. However, this information may only be shared with prospective Franchisees by Franchisors who have made the required disclosures in the ITEM 19 of the Franchise Disclosure Document (“Financial Performance Representations”). For Franchisors that do not make Financial Performance Representations, the company’s Franchisees may elect to share certain aspects of their financial performance with prospective Franchisees during the due diligence process. In either case, as the number of franchises increases, it becomes much easier for a prospective franchisee to evaluate the financial performance of the franchise business in relation to the initial franchise fee and the total franchise investment.

A related question is “what percentage of the Franchise Fee does a Franchisor typically ‘net?’”

This will vary in large part based on the cost and expense factors previously discussed. In addition, some franchise companies choose to “break even” on the initial franchise fee to reduce a Franchisee’s barrier to entry in terms of the total initial investment. Other Franchisors may actually choose to “lose” money on the initial franchise fee as they understand they will make it up many times over through the ongoing royalty fees generated from a successful Franchisee.

This being said, it is not unusual for a Franchisor to “net” 25% or more of the initial franchise fee after deducting all costs and expenses associated with the grant of a franchise. It is also important to remember that a portion of the franchise fee typically includes a recoup of certain expenses the Franchisor previously incurred, such as costs and expenses associated with the development of the franchise operation and production of franchise advertising and marketing materials. This often means that the net cash flow generated from the initial franchise fee may be much higher than the net profit when these additional expenses are included as a portion of the franchise fee. However, as additional franchises are granted and these development costs and expenses are fully recouped, the net profit generated from the initial franchise fee obviously increases.

Ultimately, determining the initial franchise fee is part art and part science. When establishing the initial franchise fee, Franchisors should carefully evaluate the above factors relative to their business model and franchise program. Doing so will help ensure that the initial franchise fee is fair to both the Franchisor and Franchisee and not a barrier to the company’s growth.

 

© 2016-2021 Stephen E. Vandegrift, all rights reserved

Steve Vandegrift is President of FranSource International, Inc., a full-service franchise development and consulting firm founded in 1997. FranSource works with both startup and existing franchisors, providing the comprehensive assistance and support required to develop, operate, and grow a successful franchise operation. You may email Steve at steve@fransource.com with your comments and questions.