What Is a Franchise Fee?
Definition & Examples of a Franchise Fee
A franchise fee is the payment a franchisee makes to the franchisor for the right to use the company's brand, products, and intellectual property. This can be done up front or on an ongoing basis according to the terms of the franchise agreement.
Instead of creating a business from scratch, a franchisee benefits from the brand recognition and systems that the franchisor has already built. But these benefits come with a cost. Learn more about the purpose of franchise fees and how they work.
What Is a Franchise Fee?
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” in 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.
As you can see, the third element means that a fee is required for a franchise agreement to be considered official.
How Franchise Fees Work
Franchise fees typically begin with an 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 (per the FTC Rule) and is generally in the range of $20,000 to $50,000. The amount will be disclosed upfront 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 usually not the case. The fee is merely a payment for joining the franchise system under the terms of the franchise agreement. Essentially, the franchisee must pay for the rights to all of the franchisor's assets that will help them succeed as a business. These assets hold a lot of value, so upfront fees can be expensive.
Because the franchisee will continually benefit from these assets, there will usually be ongoing fees as well. These can be royalty payments or marketing fees, and they 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 its frequency, is disclosed in the franchise disclosure document.
What Determines Franchise Fee Amounts?
The amount a franchisor sets as their franchise fee varies from industry to industry and even 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 and pay commissions to franchise salespeople, while also giving 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.
For new franchisors who have not yet developed a robust pipeline of prospective 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.
When Franchise Fees Vary
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 problems.
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:
When a franchisee agrees to open multiple locations throughout a defined period, this is traditionally called a multi-unit development or master franchise 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.
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 typical franchise 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.
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, some 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. These reduced fees are disclosed in their offering documents and provide a clear deadline or other parameters.
Are Franchise Fees Negotiable?
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—and when negotiating—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 approaches new franchisors take, and it often results in fees that are either too high or too low, both of which can be damaging to the franchise system.
- Franchise fees are any costs that a franchisee must pay to the franchisor to use its brand and resources.
- These can include large initial payments and ongoing percentages of revenue.
- The FTC requires an initial fee of at least $500 to consider a franchise agreement valid.
- These fees are usually set but may be negotiable in certain situations.