Have you ever wondered why a franchisor would charge an initial franchise fee or ongoing royalties? Could you make more money by avoiding these costs and opening as an independent business?
There are costs associated with belonging to a franchise. It may appear that the costs are high, but the value typically outweighs the cost. The alternative costs of starting a business on your own is learning through trial and error while making costly mistakes or, long term, paying higher marketing costs as an independent to compete against established brands. In addition, there are the lost revenues resulting from not having the research and development resources to remain relevant in a constantly changing marketplace.
Initial Franchise Fee
Once you have been approved for a franchise and you are in the process of signing the franchise agreement, the franchisor will request you to pay an initial franchise fee.
Franchise fees are typically paid for the use of the brand and the operating system. It is the licensing fee to belong to the franchise system. Think of it as a membership fee to belong to the club. The Initial franchise fee will vary from $5,000 to $75,000. How much the initial fee is varies depending upon the amount of training and support that is provided to get the new franchised location up and running. In addition to the initial training and support, the initial franchise fee covers the cost of franchisee recruitment, territory analysis, site identification and your grand opening launch.
Typically the more established and recognized the brand of the franchisor the higher the initial fee but not always. Do your research. Look at competing brands and see what they charge to ensure that you are paying fair market value.
Ongoing Royalty Fees
Ongoing royalty fees charged by different franchisors will vary from 0% to 20% of gross sales and usually paid monthly. The amount will depend upon the level of ongoing support and services that are provided by the franchisor. For example, some franchisors provide a centralized call center with order taking. This requires a greater cost that is addressed with a higher royalty. Where no royalty is charged, it is basically built into product sales in the form of mark-up or rebates on products.
Most franchises require the franchisee to pay a royalty for the right to use the franchisor’s trademarks and operating system. It is the franchisor’s portion or share of the revenues for allowing you to use the system. The franchisee benefits from using the trademarks and operating system to increase the value of their business assets and future income by being connected to an established brand. Customers are more receptive to products and services that are associated with a known brand, and this in turn will generate revenue. Once you have found a new customer, the operating systems are in place to assist you in keeping them as repeat customers.
Typically the more involved the franchisor is with the ongoing business operations, the higher the fee. The franchisor uses the royalties to develop an infrastructure that provides ongoing support to the franchisees through:
- Consulting, sharing of best practices
- Arranging suppliers to capitalize on purchasing power
- Research and development
- Operational reviews and ensuring brand consistency
- Field support
- Initial training programs
- Ongoing training programs
For a franchise system to be successful, royalties need to be both affordable for the franchisee and large enough for the franchisor to be able to fund the necessary support. There are numerous variations regarding royalty fees. Some franchisors charge escalating or declining percentages, based on different level of sales. Other franchisors do not charge a percentage of sales but instead charge a royalty based on a flat fee each month. Alternatively the franchisor may charge no royalty at all but instead earn revenues through a mark-up on product sales.
A flat fee royalty is often used when it is difficult for the franchisor to monitor the franchisee’s monthly sales. This system may seem attractive to the franchisee, allowing you to know exactly what your franchise costs are going to be each month. But the downside may be that there is no incentive for the franchisor to work with you to increase your sales.
Revenues to the franchisor through product fees are typically used when the franchisee is distributing a product manufactured or distributed by the franchisor. Examples of a product-based franchise are gas stations or automobile dealerships. Product franchising derives income from selling products wholesale to the franchisees with a profit margin for the franchisor built into the wholesale pricing. The franchisee is required to purchase the product from the franchisor in the license agreement.
It is not uncommon to at some point during your business’s growth to ask yourself, “Why am I paying these royalties?” The benefits to paying royalty fees will usually far outweigh the costs. A royalty is a cost of doing business as a franchise. It gives the franchisee the right to operate a business under a proven brand and business model with ongoing support and resources. Always do your due diligence when looking at any franchise opportunity and talk to franchisees. Not all franchises are the same. Ask both the franchisor and franchisees the necessary questions to ensure that the value for the royalty is there.
Wayne Maillet is a franchise management consultant and founder of the consulting company Franchise Specialists. Respected within franchise circles, he brings a realistic, practical understanding of business and franchising. This article is based on excerpts from his book, Franchising Demystified. The book can be ordered through most book retailers or directly from the publisher at www.franchisingdemystified.com