Show Me The Money!
This article appeared in Issue 3#2 (January/February 2009)of Business Franchise Australia & New Zealand
Franchise Agreement Financial Obligations
Franchising can be an excellent way for someone to own their own small business. Owning a franchised business can offer many advantages over owning a non-franchised business, such as the comfort of operating a proven system, support from the franchisor and the network, assistance in establishing the business and training staff, and a greater likelihood of survival than other small businesses.
However, one must bear in mind that, unlike purchasing a non-franchised business, the costs associated with purchasing and operating a franchised business do not end once the purchase price has been paid.
In fact, the financial commitments involved in owning a franchise are quite distinct from those associated with other forms of small business. Apart from the initial franchise fee that is often payable when the franchise is granted, there are many other isolated or ongoing payments that a franchise owner is likely to incur throughout the operation of the franchise, and indeed even when the franchise comes to an end. It is crucial that, prior to committing to a purchase or entering into any franchise agreement, a prospective franchisee is aware of all the likely costs involved, and incorporates these into any budget or projections in respect of the franchised business.
Under the Franchising Code of Conduct (“the Code”), a franchisor is required to disclose to potential franchisees, amongst other matters, details of all the ongoing and isolated payments payable by the franchisee to the franchisor, including an estimate or likely range for each payment. The payments typically found in franchise arrangements include royalties, marketing contributions, training fees, transfer/assignment fees, renewal fees, documentation fees and franchisor’s legal costs.
The following is a guide to some types of financial obligations commonly associated with franchised businesses, however, the disclosure document and franchise agreement provided by the franchisor should provide a comprehensive listing of all the payments you will be required to make for the life of the franchise.
Purchase Price/Franchise Fee:
As with buying any business, a franchisee, as purchaser, must pay a purchase price for the business to the vendor. The vendor could be the franchisor, selling a brand new franchise or one which the franchisor has been operating, or it could be an existing franchisee selling their franchised business.
The purchase price is almost always payable upfront, before you receive the rights to own the business, and is a figure which generally reflects the current value of the business at the time it is being sold.
Where the franchisor is selling a brand new franchise, the purchase price is most commonly described as the franchise fee.
Most commonly, the franchise fee is paid upfront as an initial fee prior to commencing operating the business. In some cases, this fee may be payable by instalments. Sometimes the franchise fee is payable in two parts, with a small proportion of the full amount paid in the form of a deposit. Often a franchisor will request that the deposit component is paid in the early stages, such as at the time when the franchisee lodges its application, and before the franchisor releases confidential information, such as its disclosure document, franchise agreement, financial data or operations manuals to the franchisee.
I have seen some franchise agreements which make all or part of the franchise fee payable when the franchisee exits the system. But a once-off, upfront payment is by far the most commonly accepted way that a franchisor collects its franchise fee.
The franchise fee is the payment made to the franchisor for the privilege of being able to operate under the franchisor’s brand and trade in accordance with the franchisor’s systems and procedures. It is a payment for the franchise rights themselves, as distinct from a payment for the value of the actual business.
The amount payable as a franchise fee can vary dramatically between franchise systems. Franchised businesses with low start-up costs and overheads may be as little as $5,000, whereas businesses involving high overhead costs and expensive equipment can run up to several hundred thousand dollars.
Some franchisors include in their franchise fee the cost of the franchisor doing many things associated with the establishment of the franchise or franchise relationship, such as costs incurred in recruiting and training the prospective franchisee, analysing and identifying the territory and site, fitting out the premises with any necessary fixtures, plant and equipment, franchisee launch and promotion and other start-up costs. Other franchisors charge these sums separately.
Franchisees should bear in mind that they might be expected to pay additional start-up costs, which have not been included as part of the initial franchise fee, such as the costs associated with purchasing or leasing any necessary equipment, fixtures or real estate, payment of security deposits and the purchase of initial stock required to commence operation.
The franchise fee is typically the only, or at least the single largest initial payment, with most franchise systems relying heavily on the ongoing or recurring fees paid by franchisees to survive. Some of the more common recurring fees are described below.
Royalties, also referred to by such names as ongoing franchise fees, franchise administration fees or management/franchise service fees, are almost always present in a franchise system. These can either be a fixed periodic payment or a periodic payment based on a percentage of the gross income or sales of the franchisee. For royalties based on gross revenue or sales, the percentage charged can range from as little as 1% or less, to amounts of almost 20%. The royalty is ongoing for the life of the franchise and is generally payable on a weekly or monthly basis.
These fees can sometimes seem overwhelming and some franchisees begrudge having to constantly pay a proportion of their hard-earned income to the franchisor. Franchisees sometimes find it difficult to understand why the franchisor should be entitled to these payments, when they believe it is their efforts that generated the income.
However, franchisees must appreciate that royalties are paid to franchisors in part for the ongoing rights to use the franchisor’s intellectual property and business system and for the ongoing services that the franchisor provides. It may in fact be merely the franchisor’s branding on the shop that has attracted the franchisee’s customer base, or it may be the customer’s familiarity with the franchisor’s product alone that has encouraged their patronage, irrespective of the franchisee’s skills and service in operating the business.
These fees are also important for the continuing development of the system, allowing the franchisor steady cash flow which can be used in enhancing the product, system and network.
Marketing contributions, also called advertising levies or promotional fees or the like, are usually payable by franchisees where the franchisor maintains a marketing fund on behalf of the network. These contributions are collected by the franchisor for the purposes of marketing and promoting the franchisor’s business, for the benefit of the system as a whole. Again, marketing contributions may be flat fees or based on a percentage of the franchisee’s sales. They are ongoing and generally payable on a weekly or monthly basis.
Take note however, that franchise agreements often contain provisions which state that the franchisor is not obliged to spend these contributions on marketing, advertising or promoting the franchisee’s individual business.
Usually all franchisees in the system pay the same or similar amounts in respect of the marketing contribution. At times, a franchisor will collect marketing contributions on a case by case basis for each individual marketing activity, and only those franchisees that will benefit from a particular promotional campaign will be required to contribute to its cost. Sometimes the franchisor may also make marketing contributions to the marketing fund. This is especially common in circumstances where the franchisor owns or operates a franchised business, which is substantially the same as those operated by the franchisees in the network.
Under the Code, details of marketing contributions, including how these contributions are calculated, must be disclosed to potential franchisees from the outset. Other information which must also be disclosed includes details of who must contribute to the marketing fund, how much the franchisee must contribute, whether other franchisees must contribute at a different rate and the kinds of expenses for which the marketing contributions may be used.
In addition to paying marketing contributions, franchisees may also be expected to spend a certain amount of money undertaking their own marketing initiatives by way of local advertising and promotion of the franchisee’s own business within its local area.
Another recurring payment often seen in franchise agreements is technology fees. These fees can be imposed for such things as the franchisee’s use of the franchisor’s software, hardware and point of sale systems. The fee may also be charged in respect of the franchisor’s costs in maintaining its own website and/or intranet services, which can be accessed by each franchisee, and may even provide links to the individual websites of each franchisee. It may also cover the cost of the franchisor providing IT support and assistance to the franchisees within the network. Technology fees may be fixed or calculated as a percentage of gross revenue/sales and may be payable weekly, monthly or annually. They may also be variable depending on the size and location of the franchisee’s particular business and the extent to which the franchisee uses the franchisor’s technology.
In addition to the recurring payments outlined above, a franchisee should also budget for certain payments that they may be required to make under their franchise agreement, which are payable in a particular situation or in respect of a specific service. For instance, a training fee is often payable by franchisees for any initial training programs provided by the franchisor (although it is more common that the cost of initial training is covered by the franchise fee), as well as for any periodic training or refresher training provided during the operation of the franchised business. Many franchise agreements also require the franchisee to pay for the incidental costs of attending such training, such as accommodation and transport costs of the franchisee and its staff.
Another example of common one-off payments is a renewal fee which is charged by the franchisor when the franchisee exercises an option to renew the franchise for a further term beyond the initial period granted to it. A renewal fee may again be a fixed amount, or might be a percentage of the initial franchise fee payable under the franchise agreement.
Transfer or Assignment Fees
A transfer or assignment fee is payable to the franchisor when the franchisee transfers the franchised business to another person. The transfer fee may be a flat fee or a percentage of the sale proceeds received by the franchisee. Transfer fees are also commonly charged on a sliding scale, being higher if the franchise is sold within the first few years, and reducing if the franchise is sold closer to the expiry of its term. It is important to establish whether such a fee will be payable as it may affect the franchisee’s potential sale proceeds, or even the franchisee’s ability to sell the business at all. A franchisee wishing to sell its business should consider building the transfer fee into the sale price of the business.
Transfer fees are usually payable upon a changeover of the franchisee. Typically this will occur where the franchisee sells its business, however, consider that if the franchisee is a company, a substantial change in ownership or control of that company (e.g. where one shareholder buys out another) may be sufficient to constitute a transfer and trigger the franchisee’s obligation to pay the transfer fee, even though the franchisee remains the same entity.
Franchisees may be liable to pay a documentation fee, which is generally payable in respect of the franchising documentation prepared for and provided to the franchisee, including the franchise agreement, disclosure document, lease or occupancy licence and any ancillary agreements which the franchisee must sign in order to be granted the franchise. This fee will ordinarily cover the franchisor’s administrative and legal costs in having the documentation drawn up, executed, and stamped and registered where applicable.
A franchisor may also request payment from a franchisee to cover its costs and expenses (including legal fees) in various situations. Some of the circumstances in which franchisor’s costs may be payable are as follows:
- If a franchisee terminates the franchise agreement within the 7 day cooling off period after entering into the franchise, the Code allows for the franchisor to deduct its reasonable expenses prior to reimbursing the franchisee for all amounts paid by it, provided those reasonable expenses or their method of calculation have been set out in the franchise agreement.
- Upon the transfer or assignment by the franchisee of the business, or the franchisee’s renewal of the franchise agreement.
- Where a franchisor enforces its rights as a result of a franchisee breach.
- Franchisees should also remember to budget for their own legal costs and other expenses.
It is crucial that prospective franchisees read the franchise documents carefully and properly assesses all the financial obligations involved prior to, during and at the end of the franchise relationship. Careful and accurate budgeting should be undertaken with the assistance of an experienced franchising accountant or financial adviser. If this is done properly at the outset, franchisees can enjoy realistic financial expectations, and are less likely to encounter nasty surprises which cause unexpected cash flow difficulties.
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