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How to Determine if Your Initial Franchise Fee is Really Appropriate?

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Franchising Law Bulletin

Many franchisors (especially new franchisors) often ask us what an appropriate amount would be for their initial franchise fee.

Obviously, because every franchisor is different and, even more so, because the initial services differ from one franchisor to another, there is no single answer to this question.

However, here are some principles to guide any franchisor in determining its initial franchise fee:

  1. The initial franchise fee should not be a source of profit for the franchisor, but rather a means of recovering various costs.

    Rather, a franchisor’s sources of profit should be from its royalties and from the various goods and services it provides to its franchisees.

    The initial franchise fee, which is generally payable at the signing of the agreement, constitutes a net disbursement for the franchisee.

    As such, it reduces the initial working capital of the franchised business.

    It is also an amount that cannot generally be financed in the long term since it is not used to acquire a tangible asset.

    It must therefore be paid out of the franchisee’s personal investment or out of the short-term financing (often the line of credit) of their business.

    Thus, it is in the interest of the franchisor and its franchisees to keep the initial franchise fee at a reasonable level so that the franchisee’s initial investments can be first devoted to the success of the franchised business.

  2. The costs that are recovered by the initial franchise fee are primarily:

    1. Costs incurred by the franchisor to recruit the franchisee, to negotiate with the franchisee, to support the establishment, launch and commencement of operations of the franchised business, and to provide those initial services to the franchisee that are not separately charged to the franchisee;
    2. The amortization of the costs of establishing and maintaining the franchisor’s franchising activities, such as, for example, costs associated with the preparation of franchise documentation, franchise agreements, franchise marketing and promotional materials, recruitment activities for new franchisees, etc.
    3. These costs must be spread over a certain number of franchisees, which is often based on the franchisor’s recruitment goals for the first two or three years of its franchise network.

      Once these initial costs are recovered, this amount will allow the franchisor to recover (again spread over a number of new the costs of updating and continually improving its tools for recruiting new franchisees and providing initial support for the establishment and launch of new franchised businesses.

    4. Beyond these costs, the franchisor may also want to leave itself some flexibility to cover instances of over budget costs and instances of unforeseen additional costs.

  3. It would be prudent for the franchisor to clearly specify in its franchise agreement which initial services are included in its initial franchise fee and which services will be charged to the new franchisee in addition to the initial franchise fee.

  4. Once an amount has been calculated based on the franchisor’s costs, the franchisor should also verify the impact of the initial franchise fee on the amount of personal investment required from the new franchisee as well as on the projected profitability of its franchised business to ensure that the initial franchise fee does not impose an undue burden on the franchisee or pose an undue obstacle to the profitability of the franchised business.

  5. Finally, the initial franchise fee must pass the market test, that is, the test of comparison with the initial franchise fee of other franchisors offering franchises similar to the one offered by the franchisor.

Indeed, although, as noted above, each franchisor is different and although the services offered by each franchisor to their new franchisees may differ (sometimes significantly), prospective franchisees will inevitably compare the initial franchise fees of various franchisors.

If a franchisor’s initial franchise fee is significantly higher than that charged by one or a few franchisors offering similar franchises, that franchisor must offer serious and credible reasons for the difference.

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