One common question our clients often ask is, “how do I determine the initial franchise fee?” Many different factors impact the initial franchise fee 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 sound strategy, the truth is that not all franchise systems are created equally.

When determining the franchise fee, it is important to remember that although franchise fees can help a company’s cash flow and assist in sustaining the company’s initial growth, these should not be the only factors to consider. The royalty fees paid by franchisees and the 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 fee.

With franchise fees 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.

Part of our franchise development process entails determining the appropriate franchise fee (and other fees) that balance the franchisor’s financial needs with the needs of franchisees related to the total initial franchise investment. At FranSource, we do this by evaluating several different factors, including:

• The sophistication and uniqueness of the business model;
• The potential ROI and profitability of the franchise business for franchisees;
• The initial training and support provided to franchisees by the franchisor;
• Expenses related to on-site support provided by the franchisor prior to and/or during the franchisee’s grand opening period.
• The projected franchise marketing costs associated with the acquisition and grant of a franchise; and
• Anticipated demand for the franchise offering.

In addition, when determining the franchise fee a franchisor may also elect to consider the following costs and expenses in the calculation:

• An allocation for the total costs and expenses incurred in developing the franchise operation.
• Franchise-related sales costs (i.e. sales commissions)
• Other 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 noted above, the initial franchisee fee may also be based in part on the potential ROI and profitability of the franchise business. However, financial information may only be shared with prospective franchisees by franchisors who have made the required disclosures in ITEM 19 (“Financial Performance Representations”) of the FDD. 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 franchise sales process.

A related question clients sometime ask is, “What percentage of the franchise fee does a franchisor typically ‘net?’” This varies in large part based on the cost and expense factors previously discussed. In addition, some franchise companies elect 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 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 franchisees.

As noted previously, a portion of the franchise fee typically includes a recoup of certain expenses the Franchisor incurred in acquiring a new franchisee, such as those associated with the development of the franchise operation and franchise marketing costs. 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 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. Doing so will help ensure that the initial franchise fee is fair to both the franchisor and franchisee and does not present a barrier to the company’s growth.

If you would like to learn more about FranSource’s franchise development process and services, please contact us for additional information.