FEE SETTING FOR UNIT FRANCHISE AGREEMENTS – STRIKING A BALANCE
CO-FALL 2009Author :
John Sotos 
Lawyer, Sotos LLP
John Sotos is a lawyer with Sotos LLP. He specializes in domestic and international franchise, licensing and distribution law with a large national and international client base. Represents franchisors in connection with franchise transactions, workouts, defaults, purchases and sales of franchise networks, master franchising and creditor and debtor rights on both franchisor and franchisee insolvencies.
Structuring Franchise Fees
"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, 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 services of most solid franchise systems also have special value that should be reflected in the IFF: proprietary-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
Depending on the franchise system, there are different ways to approach the issue of continuing royalties. 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 car factories make their profits from car and part sales.
In the case of 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 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".
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.
Common mistakes in franchise fee setting
Far too many start-up franchisors who neglect to obtain expert advice approach fee-setting by copying the practices of the most well-established competitor in the marketplace that may have hundreds or thousands of units in the market. Others engage in marketing gimmicks such as charging slightly less than the major competitors or worse, engage in semantic games, by for example, unbundling initial franchise fees and taking out the cost of training or site selection, so that they can advertise a notionally much lower initial franchise fee than those charged by competitors. At the end of the day, none of these approaches are equal to the task of delivering a healthy and balanced franchise system that allocates risk and reward appropriately.
Proper fee setting
Sustainable royalty fee setting is a bottom-up exercise
The starting point of the fee setting exercise should always involve an examination of the unit profitability of prospective franchisees before determining appropriate franchise system fees. This can be done by looking at actual performance of corporately-owned units with appropriate adjustments for anticipated franchisee investment and a reasonable percentage increase for the greater return expected from a franchisee operator who generally performs better than a corporate manager. Once absolute franchisee profitability has been determined, the franchisor can then apply fee factors that compensate the franchisor for the provision of on-going services as well as providing an acceptable rate of return and recouping the costs of franchise sales. Similarly, the franchisee financial analysis following adjustment for franchise system fees should provide an acceptable rate of return for the franchisee including reasonable debt-service assumptions amortization in order to arrive at recoupment of investment. In any event, total franchisor income should not exceed 25% of the franchisee’s income before interest, taxes, depreciation and amortization. If after undergoing such an exercise, there is insufficient profitability either to compensate the franchisee or the franchisor appropriately, then such a business should forget about franchising until unit performance is able to provide an acceptable rate of return for both franchisor and franchisee.
Royalties may be paid on a monthly, bi-weekly or weekly basis, depending upon relative ease of administration and cash flow requirements.
Frequently, the franchisee will be required to contribute to a national or regional advertising fund. In such cases, the franchisor may allocate a portion of the contributions 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
Franchising is the fastest growing method of doing business throughout the world today. In Canada, there are scores of new franchisors who start their franchising business each year. Many of these franchisor start-ups fail within the first few years from inception of franchising because of wholly inappropriate fee setting. If the fees are set too high, then the franchisor will face difficulty in attracting franchisees and growing the network. Conversely, if the fees are set too low while the franchisor may be able to attract new franchisees and experience reasonable growth, it will be unable to provide the necessary services to the franchise network without appropriate funds flowing to the franchisor. Heeding the above principles and seasoned franchise professionals will serve any start-up franchisor well.
"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, 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 services of most solid franchise systems also have special value that should be reflected in the IFF: proprietary-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
Depending on the franchise system, there are different ways to approach the issue of continuing royalties. 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 car factories make their profits from car and part sales.
In the case of 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 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".
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.
Common mistakes in franchise fee setting
Far too many start-up franchisors who neglect to obtain expert advice approach fee-setting by copying the practices of the most well-established competitor in the marketplace that may have hundreds or thousands of units in the market. Others engage in marketing gimmicks such as charging slightly less than the major competitors or worse, engage in semantic games, by for example, unbundling initial franchise fees and taking out the cost of training or site selection, so that they can advertise a notionally much lower initial franchise fee than those charged by competitors. At the end of the day, none of these approaches are equal to the task of delivering a healthy and balanced franchise system that allocates risk and reward appropriately.
Proper fee setting
Sustainable royalty fee setting is a bottom-up exercise
The starting point of the fee setting exercise should always involve an examination of the unit profitability of prospective franchisees before determining appropriate franchise system fees. This can be done by looking at actual performance of corporately-owned units with appropriate adjustments for anticipated franchisee investment and a reasonable percentage increase for the greater return expected from a franchisee operator who generally performs better than a corporate manager. Once absolute franchisee profitability has been determined, the franchisor can then apply fee factors that compensate the franchisor for the provision of on-going services as well as providing an acceptable rate of return and recouping the costs of franchise sales. Similarly, the franchisee financial analysis following adjustment for franchise system fees should provide an acceptable rate of return for the franchisee including reasonable debt-service assumptions amortization in order to arrive at recoupment of investment. In any event, total franchisor income should not exceed 25% of the franchisee’s income before interest, taxes, depreciation and amortization. If after undergoing such an exercise, there is insufficient profitability either to compensate the franchisee or the franchisor appropriately, then such a business should forget about franchising until unit performance is able to provide an acceptable rate of return for both franchisor and franchisee.
Royalties may be paid on a monthly, bi-weekly or weekly basis, depending upon relative ease of administration and cash flow requirements.
Frequently, the franchisee will be required to contribute to a national or regional advertising fund. In such cases, the franchisor may allocate a portion of the contributions 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
Franchising is the fastest growing method of doing business throughout the world today. In Canada, there are scores of new franchisors who start their franchising business each year. Many of these franchisor start-ups fail within the first few years from inception of franchising because of wholly inappropriate fee setting. If the fees are set too high, then the franchisor will face difficulty in attracting franchisees and growing the network. Conversely, if the fees are set too low while the franchisor may be able to attract new franchisees and experience reasonable growth, it will be unable to provide the necessary services to the franchise network without appropriate funds flowing to the franchisor. Heeding the above principles and seasoned franchise professionals will serve any start-up franchisor well.