Structuring Franchise Fees

A primer on franchise fees covering initial franchise fees, royalties and other revenue sources, and tax considerations.

Probably one of the most delicate areas is determining what a fair, profitable, competitive and saleable initial franchise and continuing royalty fee should be. Likewise it is hard for a company just beginning to measure the cost of services to be performed for the franchisee and the standard franchisor backup costs. It is especially difficult when you must project into the future for five, ten or twenty years.

(Lloyd T. Tarbutton, Franchising, The How-To Book, Prentice Hall, 1986)

Mr. Tarbutton has it exactly right. There are many factors to consider in setting amounts and rates. The main points are listed below, some of which are, obviously, “motherhood”.

The Initial Franchise Fee

The fees (both initial franchise fee – the “IFF” – and continuing royalties) to be charged by the franchisor should bear a close relationship to the value received.

First, let’s look at the components of an IFF:

• The company name, trade-marks, logos and so forth have a goodwill value that should continue to keep customers flowing in.
• Moreover, if the unit being franchised is an existing, long-established location with proven cash-flow, and not merely a fresh, unproven site recently identified as having potential, there is a multiple-of-earnings factor that should be reflected in the IFF.
• The value of a period of initial training to a new franchisee should be included in the IFF.
• If the franchisee is being granted an exclusive or protected territory in the conduct of its franchised business, the franchisor should normally be compensated for exclusion from further market penetration in such territory, either directly or by placing other franchised locations nearby. This compensation is normally part of the IFF. (In such case, however, the franchisee should generally have performance tests – usually gross sales levels – to be met on a continuing basis or face loss or diminishment of such exclusivity or protection.)
• The following accoutrements of most solid franchise systems also have special value that should be reflected in the IFF: specially-tailored accounting systems, manuals provided, special systems, and other important ancillary “connections” that the franchisor’s special business “know-how”, trade secrets and confidential information can access.

Royalties and Other Revenue Sources

Turning to the issue of continuing royalties, there are many ways to approach the issue. If, for example, the franchise system in question is really a product distribution franchise, and the franchisor is also the manufacturer, the return to the franchisor may simply be built-in to the price of the product. This is the way Baskin-Robbins’ master franchisee Silverwood’s (as it was then known – now Silcorp) started in Canada during the 60’s. Silverwood’s simply charged a one-half of one percent royalty to reflect some value for the use of the Baskin-Robbins’ trade-mark, but the real profit for Silverwood’s lay in the sale of ice cream product to the franchise network who could in reality acquire exclusively from Silverwood’s. More recently, the “I Can’t Believe It’s Yogurt” system based in the United States announced that it was moving to a “no-royalty” system. Whether or not the ICBIY program will succeed remains to be seen.

In the case of the non-product franchise systems – for example, those which provide services only – such an approach is irrelevant. Royalties will compensate the franchisor for provided ongoing support, assistance and advice, as well as for the continuing value represented by the trade-marks and other intellectual property. Intellectual property includes not only trade-marks, etc., but also business “know how”, trade secrets and confidential information. The operations manuals fall into this category, and the ideal situation arises when the franchisor continues to make improvements in the system, and shares these improvements with the franchisees by constantly keeping the manuals up-dated. There may also be regular meetings or conventions held, at which franchisees can share experiences in a convivial atmosphere, and even awards might be handed out to franchisees who excel in defined areas of their businesses.

The appropriate approach here would therefore almost always involve a royalty based on a percentage of gross sales (however defined), whether fixed or based upon a sliding scale that varies in accordance with defined mileposts or “break points”.

Obviously, great care must be taken in establishing the royalty rate, since the royalty stream will usually represent the greatest component of operating income for the franchisor. On the other hand, some flexibility exists at the outset with regard to current locations being converted to a franchise system, since there will also be rental revenue to compensate the franchisor/landlord for its investment in land and building. If the system later expands, however, and land and buildings are leased rather than purchased by the franchisor, other considerations will come to the fore. That, however, is beyond the scope of this memorandum.

It should generally be easier to establish a royalty rate or schedule when one is dealing with an established business. Looking at historical numbers, and factoring in a reasonable percentage increase for the greater return expected from a franchisee who, after all, has a higher stake in the business than an employed manager, one can then calculate the royalty extraction that is likely sustainable. What remains for the franchisee after all the dust clears should offer a reasonable rate of return on investment, a reasonable pay-back of original capital invested, and a reasonable wage or salary for his labours.

Royalties may also be paid on a monthly, bi-weekly or weekly basis, depending upon relative ease of administration and cash flow requirements. Frequently, the franchisee may be required to contribute to a national or regional advertising fund. In any event, the franchisor may allocate a portion of the contributions received to pay the costs of administration of the fund.

Finally, extra charges may be imposed for training additional staff, for supplying management talent as required, for supplying non-standard computer assistance or accounting help, and other items that are simply not included as “standard” fare in the franchise system. Leasing equipment, etc., to franchisees provides another possible source of revenue that should be factored in to the total revenue from system operations. Often, a renewal fee is extracted from a franchisee to compensate the franchisor for costs associated with administering a renewal. Likewise, if a transfer of a franchise is permitted, a franchise fee is normally extracted to compensate the franchisor for the costs associated with the transfer.

Taxes

One issue that the franchisor should not overlook in structuring fees is the impact of tax. The franchisor’s accountants should be asked to comment on the proposed fee structure (both IFF and royalty) and what the impact of taxation thereon might be expected to be. For example, must the IFF be taken fully into income in the year it is paid, or may it be amortized over the initial term of the franchise? The answer may affect decisions not only as to total amount, but also as to how and when the IFF is to be paid and received.

Conclusion

The NatWest Bank of England has long since identified the following list of five items as being key to a franchisee’s success (assuming, at least with regard to the first criterion, that the franchised location is “brand new”):

• The franchisor’s IFF should just cover start-up, development and training costs (no profit until franchisee makes profit);
• Royalties however calculated should represent not more than 25% of the franchisee’s net profit before management drawings, taxes and depreciation;
• The gross margins (not just sales) are important;
• There should be a sophisticated training program; and
• There should be reasonable contract terms (with a minimum initial term of 5 years, and reasonable renewal rights) and no overly burdensome terms.

There is a lot of wisdom in these points. A new franchisor would do well to try to meet these benchmarks if at all possible; it will minimize future problems.

Disclaimer : This document is intended to provide general information and should not be relied upon as legal advice. If you require legal advice we would be pleased to assist you. This document is subject to copyright.

© Sotos LLP 2009