What is the Franchise Fee and Why is it Necessary?
For those unfamiliar with franchising, the fee and royalty structures may seem superfluous, or even extravagant. Parent companies charge an initial franchise fee for new franchisees to join their franchising system. This fee amount varies between industries and franchise systems, but it is not based at random.
Let’s examine the franchise fee and why it is a necessary part of the franchising strategy. After understanding more about the franchise fee, entrepreneurs will be better equipped to enter a franchising relationship with a parent company.
The Franchise Fee Defined
As already mentioned above, the franchise fee is the payment made by a franchisee to the parent company for joining the franchise system. This is a simplified definition, but it adequately explains the fee and its connection to the franchisor and franchisee.
The Federal Trade Commission definition(“the FTC Rule”) that defines franchising throughout the United States, states that 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.
Item three in the FTC rule is the initial franchise fee, which is typically paid when the franchisor and franchisee sign the franchise agreement. This fee can be any amount above $500 (to meet 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 in the Franchise Disclosure Document.
One example that illustrates how a franchise fee works is an initial entry fee when joining a country club. In order to become a member of the club, an initial fee is paid. After that, ongoing membership fees are paid. In a franchise relationship, the initial franchise fee is the cost to become a member of the franchising system. Royalty payments are the regular, ongoing fees that enable the franchisee to enjoy the benefits of the franchise system which they have joined.
The Purpose of a Franchise Fee
A parent company that begins franchising to expand their business will view the franchise fee as a necessary vehicle for income as they prepare to support each new franchisee. The amount a franchisor sets as their franchise fee varies from industry to industry, and even among franchisors in the same industry.
In most franchising operations, the franchisor will set the franchise fee at an amount that will underwrite their efforts to market their opportunity to prospective franchisees, pay commissions to any franchise salespeople, and then provide the necessary finances to provide initial support to each of their franchisees.
These costs will include, among other things, providing initial training for each new franchisee, visits to approve the new site and monitor the franchisee’s site development, initial advertising, and opening support. These costs are compared to the initial fees charged by competing franchises in the area, and the amount is normally set where it will cover the necessary costs and still position the franchise competitively in the local market.
New franchisors without a base of existing franchisees may initially ask a larger franchise fee in order to provide what is needed. After obtaining several franchises, they are in a better position to spread the costs out and underwrite new franchise support from both initial franchise fees and ongoing royalty payments.
When setting initial franchise fees, franchisors should attempt to calculate the anticipated financial returns from each of their franchisees, and make sure that level of return is sufficient for both the franchisee and the entire franchise system to achieve the desired financial results.