One way to start a small business is to purchase a franchise. Most people think of fast-food establishments like McDonald’s or Subway when they hear the word franchise. However, there are over 900,000 franchise businesses in the United States, providing all kinds of good and services—everything from Anytime Fitness services to Z-Coil shoes. Buying a franchise is a big investment. You’re typically required to make an up-front franchise fee payment and then pay ongoing royalty fees to the franchisor throughout the life of your business.
These fees can be complex, and can vary greatly. But it’s important to understand the franchise fees because they can make or break your bottom line. The fees should be covered in full in the franchise agreement the franchisor asks you to sign. This is usually a lengthy document--often several hundred pages--written in dense legaleze. Fortunately, federal and many state laws require franchisors to provide prospective franchisees with a simpler, more readable Franchise Disclosure Document that supplements the full-blown franchise agreement. Remember, however, that it's the franchise agreement that governs your legal relationship with the franchisor, not the disclosure document. If there's anything you don't understand, ask a lawyer to explain it to you.
The Franchise Fee
The first substantial payment you'll have to make to the franchisor is the franchise fee. This is an up-front, one-time fee charged at the very beginning of the franchise purchase. Generally, it’s due when you sign the franchise agreement.
The franchisor, the person or company selling you the franchise, sets the fees. There’s no single formula franchisors use to determine the amount. As a result, franchise fees can vary greatly. Generally, franchise fees range between $10,000 and $50,000, but can go as high as $100,000. Fees at the higher end are common with well-known franchise businesses, like fast-food restaurants. Franchisees typically pay the fee by making a cash down payment, and take out a loan to finance the balance.
You are required to pay the franchise fee for the privilege of joining the franchisor’s “family” or “club,” and using its business system or product. This includes the franchisor’s trade name, trademarks, trade secrets, operating manuals, and other proprietary information or materials. Examples are the right to use a franchise restaurant’s trade name, recipes, and computer software system.
You will also be given help starting your franchise business. The amount and quality of such help varies, but it usually includes help with things like site selection, store or building construction and layout, equipment selection, finding business signs, computer software, and help with a grand opening marketing program. You, your manager, and sometimes your employees, will also be provided with initial training on how to operate the business.
The franchise fee is usually non-refundable. Unless the franchise agreement states otherwise, you won’t get the fee back under any circumstances. However, your franchise agreement may provide a refund if you decide to cancel the deal within a certain period, usually 30 to 45 days after you sign the agreement. Read your agreement carefully before you sign it. If it provides you with a right to cancel, make a note of the deadline. You’ll be able to back out of the deal without great financial loss until the deadline.
In addition to the one-time up-front franchise fee, you’ll be required to make periodic franchise royalty fee payments to the franchisor over the life of the franchise agreement. If your franchise fee is the cost of joining the franchisor’s business family, royalty fees are the cost of staying in the family. Obviously, the amount of such royalties are a key element when you’re looking at a franchise or negotiating your contract, so make sure you understand them.
The franchise agreement provides how much you’ll pay and when. Typically, the franchise fee is a fixed percentage of your monthly gross sales, but this can vary. For example, the fee can be a variable percentage of your sales that will go up as your sales increase; or it could go down as your sales increase as a reward for your good work. Some franchisors require you to pay a minimum royalty, regardless of the amount of your sales. Fixed fees that are not based on your sales are another option. Some franchise fees are a hybrid of these various methods. Payments may be due weekly, monthly, or quarterly. Some franchisors deduct their royalties directly from your bank account.
The amount of the fee varies, but, as a rule of thumb, they are usually around 5% to 6% of gross sales. However, they can be much more.
Contract terms also vary, but royalties usually cover items such as:
Most franchise agreements require you to keep adequate books and records so both you and the franchisor can calculate and verify your royalty fees. Periodic—weekly, monthly, or quarterly--sales reports are usually required, as well as an annual report. The franchisor may have specific forms or formats for you to use. You’ll probably be required to keep your records for a certain number of years, and agree to allow the franchisor to examine or audit your books.
Franchise businesses don’t always go well. What happens if you’re unable to pay the royalties when they are due? This should be covered in the franchise agreement. Likewise, terms covering overpayment of royalty fees should be covered in your contract, such as an immediate refund or a credit to your account.
