What Is a Franchise Fee?
The franchise fee (also called the “initial franchise fee”) is the payment made by a franchisee to the franchisor for joining the franchise system.
While the definition of a franchise may differ at the state level, under the Federal Trade Commission (“the FTC Rule”), which defines franchising throughout the United States, a business relationship qualifies as a franchise if three criteria are met:
- The franchisor licenses its trademarks, service marks, trade name, logo, or other proprietary marks to the franchisee.
- The franchisor has “significant operating control” or “significant operating assistance” over the franchisee’s business.
- The franchisee makes a payment to the franchisor of at least $500 (annually adjusted) either before or within six months of opening the business.
The Third Element
This third element is usually met in one of two methods, and often both methods are present. One method could be an ongoing payment that the franchisee pays the franchisor throughout the life of the franchise agreement. It is normally referred to as the royalty payment, or continuing royalty, and can be calculated in many ways. In the majority of systems, it's simply a percentage of either the franchisee’s gross or net revenue. This payment, along with how often it is to be paid (weekly, monthly, quarterly, etc.) is disclosed in the franchise disclosure document.
The other method of meeting this payment criterion is the franchise fee. It is traditionally the initial payment that the franchise makes to the franchisor when they sign their franchise agreement and become a franchise. This fee can be any amount above $500 (it must be above $500 to trigger the “payment” element of the FTC Rule) and is generally in the range of $10,000 to $50,000. As with the continuing royalty, the franchise fee is disclosed up-front in the franchise disclosure document.
While many people equate the payment of the franchise fee with the initial services and support provided by the franchisor, that is not the case in well-crafted franchise agreements. The fee is merely a payment for joining the franchise system under the terms included by the franchisor and agreed to by the franchisee in the franchise agreement.
The best way to think of a franchise fee is to equate it to the initial fee paid to join a country club. The franchise fee is akin to the up-front cost of joining the country club, and the continuing royalty payments are akin to the ongoing fee to remain a member. The obligations of the parties to the others in both a franchise system and a country club are defined in the agreements, and in a well-crafted franchise agreement, the distinctions between services and fees are clearly defined and are materially separated.
The amount a franchisor sets as their franchise fee varies from industry to industry and most certainly within franchisors in the same industry. For the most part, a franchisor will set the franchise fee at a level that will enable them to market their opportunity to prospective franchisees, pay commissions to franchise salespeople, and then give them the resources necessary to provide initial support to franchisees. These costs generally include initial training, visits to approve the site and monitor the franchisee's site development, initial advertising, and opening support, among other costs.
In setting their fees, franchisors are also cognizant of the initial fees charged by their direct competitors and others targeting the same prospective franchisees, and also look at how they want to position their franchise in the marketplace.
For new franchisors that have not yet developed a robust pipeline of prospective franchisees where they can spread their costs over many franchisees, the initial franchise fee may not be a significant profit center. As their franchise system becomes better known and they have a more robust stream of potential franchisees, franchisors can begin to leverage their costs over a growing number of potential franchise candidates.
From a financial reporting basis, until the franchisor has substantially provided all of its contractually obligated initial support (generally indicated when the franchise is open for business), they cannot recognize the franchise fee as income.
For most franchisors the initial franchise fee is not negotiable but, like any contract, the amount of the franchise fee is whatever the two parties agree it to be. Franchising is all about consistent and sustainable replication, and if one franchisee has paid a lower franchise fee than others, it can cause relationship and other problems within the system. A good rule to follow in setting fees is to ensure that franchisees in similar circumstances should be treated in the same way.
However, there are a few situations where franchisors will often alter the amount of their initial Franchise Fee:
- Multi-unit development: When a franchisee agrees to open multiple locations throughout a defined period, this is traditionally called a multi-unit development agreement. In this type of agreement, it is not uncommon for franchisors to reduce the franchise fee for locations the franchisee is scheduled to open later on in the development schedule. For example, the franchisee will be required to pay the normal $35,000 franchise fee for the first two units it opens, but only $30,000 for units three through five. This operates as an incentive for the franchisee to open up more than one unit. It is also becoming more common for multi-unit franchisees that sign a development agreement also to pay a lower continuing royalty fee.
- Transfer fee: While technically not an initial franchise fee, a transfer fee is paid when a franchisee sells their business and transfers their rights as a franchise to another party. That “new” franchise will pay the franchisor a transfer fee, which is normally either a fixed amount or a percentage of the franchisor's then-existing franchise fee.
- Renewal fee: At the end of the term of the franchise agreement, depending on the franchisee’s right to re-up with the relationship per the terms of their contract, they may elect to renew the relationship with the franchisor. The initial fee they pay when entering into the successor agreement is generally referred to as a renewal or successor fee. Similar to the transfer fee, the renewal fee usually is a lower amount than charged to new franchisees.
- Founders club: Some new franchisors, when they first begin to offer franchises, recognize that their initial franchisees may look at their opportunity differently than they might look at a more established franchisor. To overcome any perceived additional risk and to prime the pump for franchise sales, you will occasionally see franchisors offer a reduced fee for what is often referred to as a “founders club.” For example, franchisors may discount their franchise fee for their first five or 10 franchises, or more frequently for those prospective franchisees that sign an agreement before a certain date; as an enticement to sign the agreement they offer a lower franchise fee to those inaugural franchises. These reduced fees are disclosed in their offering documents, provide a clear deadline or other parameters, and are less likely to cause problems with franchisees who sign later under a higher franchise fee.
While generally, franchise agreements are adhesion contracts (non-negotiable), there are several instances where the terms may be negotiable, and while not common, franchise fees may under the right circumstances fall into a negotiable category.
In establishing their fees, franchisors should calculate the anticipated financial returns for their franchisees and make sure that the level of return is sufficient for both the franchisee and the franchise system as a whole to achieve the desired financial results. It is, therefore, essential when setting initial and continuing fees that franchisors fully examine the economics of the relationship. Setting fees based primarily on those charged by direct competitors is one of the most common and significantly damaging approaches some new franchisors take and often results in fees that are either too high or too low, both of which can be damaging to the franchise system.