January 1, 2009

Structuring Franchise Fees

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

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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:

  1. The company name, trade-marks, logos and so forth have a goodwill value that should continue to keep customers flowing in.
  2. 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.
  3. The value of a period of initial training to a new franchisee should be included in the IFF.
  4. 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.)
  5. 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.

Read on to learn more.