Usually the biggest angst, for the franchisor, in deciding these fees revolves around the franchisee and the on-going royalty. What is the right amount to charge? In the absence of any logical methodology, the company resorts to either copying others in the market or making the decision arbitrarily.
Granted that there is no right or wrong about the fees you charge (as long as the franchisee is willing to pay), it is good to make these important decisions within some framework. For both scenarios, I offer potential methodology. Outside of the investment to open a franchise location, there are two sets of fees generally charged to a franchisee: Initial fees and on-going fees.
Initial Franchise Fee
The initial franchisee fee is an important source of capital, especially for a young franchisor. Many times, mature franchisors will espouse the theory that the franchisor will not make a ‘profit’ on the initial franchisee fee and that a good franchisor should make it’s money on on-going royalties. There is some amount of truth that a good franchisor should make its money on on-going royalties, but that statement should be viewed from the perspective of organizational sustainability and not from the perspective of the initial franchise fee being a profit center or not. A franchisor must remember that a substantial amount of resources have gone into developing the franchise system and that investment has to be recovered, be it over a long period of time and many franchisees joining the system. There has to be a element of profit built into the initial franchise fee.
I offer three different approaches to determine your initial franchise fee:
- Cost based.
- Investment based.
- Length of franchise agreement.
Choose the one that makes you the most comfortable while not ignoring market and competitive factors. In other words you cannot be too low or too high compared to others in your sector.
Cost Based Approach In Determining Franchise Fee
This approach will account for all expenses associated with opening a franchise from the cost of granting a franchisee, the cost of providing initial training, the cost of support to be provided to open a franchisee plus the desired level of profit per location.
Cost of franchise granted + Cost of initial training + Cost of Support to open + Desired level of profit = Initial Franchise Fee
Investment Based Approach To Determining Franchise Fee
This approach takes a ‘big picture’ approach taking the total investment to open one unit and assigning a percentage of this investment as the franchise fee. With this approach, the initial franchisee fee is 10-20% of the total investment. The higher the total investment the lower the percentage charged as the initial franchise fee.
Length Of Franchise Agreement Granted Approach
With this approach, the franchisor takes the attitude that since the business format is being granted for a certain number of years, the company can calculate the initial franchisee fee as a cumulative fee for each of the years. For a 10- year agreement, the franchisor says, that it wants to receive an X amount for ‘licensing’ its trade-marks and know how. This is the thinking used in coming up with the franchise fee and not what is communicated to a franchisee.
The on-going royalty is important to a franchisor as in the long-term it is this fee that determines sustainability of the franchise system. Setting the fee too low can impede profitability and setting it too high can make the franchisees unhappy. Here are three approaches to determine your on-going royalty amount:
- Cost based.
- Revenue based.
- Return on investment.
Select the approach the best works for you without ignoring market realities.
Cost Based Approach To Determining Royalty
With this approach, the franchisor must have a clear understanding of what it will cost to support a franchisee. There are five steps involved to determine the royalty amount using this approach:
- Cost of providing support (including cost of personnel) when you have reached 20% market potential in terms of number of franchisees. If you believe that you can open 500 franchise units, then calculate the cost of providing support when you have 100 franchise units.
- Take the total cost calculated in No.1 above and divide by the number of units to come upcost to support one unit.
- Take the cost of supporting one unit (as calculated in No. 2 above) multiply by 3 to recover overhead and profit to come up with the average amount to be collected from each franchisee.
- Take the average amount to be collected from each franchisee (as calculated in No. 3 above and divide by average amount of annual sales expected from each location to royalty percentage.
- Compare this rate to direct competitors and other similar nature businesses prior to finalizing royalty rate.
Revenue Based Approach
Under this approach, the franchisor bases the royalty as a portion of the operating profit for each unit:
- Take percentage of operating profit expected of an average unit before any franchise owner compensation.
- Set the royalty percentage as being 20%–33% of the franchise unit profit. The greater the operating profit of the franchise unit, the greater the royalty rate the franchisor can set.
Return On Investment Approach
This approach of calculating the royalty rate has five steps:
- Take total investment to open one franchise unit.
- Operating profits at optimum level of sales (not at the ramp-up stage but when you have calculated the sales potential of the unit is reached).
- Take total investment from No. 1 above divided by 5 (for a 5 year return on investment), this will give you the desired rate of return per year.
- Take the operating profit from No. 2 above less the desired rate of return per year as calculated in No. 3 above to calculate the amount the franchisor can collect royalties.
- Take the amount the franchisor can collect as calculated in No. 4 above dived by the optimum level of sales from No. 2 above to percentage of royalty.
Determining the initial franchise fee and the on-going royalty is more an art form rather than a science. Three approaches have been offered for calculating each of the fees. It is not a matter of saying that one method is better than the other, but rather using the framework that makes the franchisor comfortable.
A good exercise is to calculate both fees using all the approaches offered and to see where the numbers shake out. While the calculations offered speak of optimum sales and average profits - I am not suggesting that an individual rate be calculated every time you grant a franchise, but rather complete the exercise ahead of time for the franchise system as a whole.
At the end of the day these fees have two primary purposes for the franchisor: to make a profit and be able to expand the franchise network. At the same time not considering the franchisees financial viability in determining these fees is a risky proposition for both the franchisor and the franchisee. Both parties must be able to see the ‘fairness’ of the fees set.
Harish Babla, Managing Director of Franchise Mind Corporation based in San Diego, USA.
Harish is a successful entrepreneur, a business visionary, an inspiring franchise leader, a mentor to many companies and a growth strategist who has honed his franchise skills in various capacities since 1983. Harish is passionate about growing franchise companies and helping others achieve their dreams of building successful global franchise companies by ensuring the highest standards of franchise excellence with a strong focus on growth and operating results.
Harish is a Certified Franchise Executive as designated by the International Franchise Association and conducts learning events and mentoring for numerous companies all over the world.
Harish can be reached at email@example.com.