The opinions expressed by Entrepreneur authors are their very own.
The following excerpt is from Mark Siebertbook The Franchisee Handbook: Everything You Need to Know About Buying a Franchise. Buy now from Amazon | Barnes and Noble | Apple Books | IndieBound
While each element of the Franchise Disclosure Document (FDD) is necessary, some could also be more necessary to you than others. One of the most vital things you must listen to is money: what you have to place into the franchise and what you’ll get in return.
It can be great if there was a easy calculation to calculate the cost advantages, but there’s not. Unfortunately, because the FDD is such a complex document, many potential franchisees attempt to simplify it, and nowhere is this more evident than in the sections regarding fees and services (items 5, 6 and 8).
Often, potential franchisees focus on either the franchise fee or royalties and compare them to competitors’ fees. At first glance, the lowest fee seems the most engaging. Unfortunately, this is the equivalent of going to a used automotive dealership and buying the least expensive automotive you could find.
Focus on royalties
Making an investment decision based solely on the initial franchise fee is a huge mistake. While you would like the franchise fee to be reasonable and competitive, it is only one component of the total investment, and in most franchises it is a relatively small part of that investment.
For most franchisors, the upfront fee is not a significant profit center. They incur costs associated with marketing the franchise, selling the franchise, legal documentation, training franchisees and providing them with initial support until they begin operating – all of which is theoretically covered by the franchise fee. So, while fees in the tens of hundreds of dollars just to hitch the system could seem excessive, the franchisor does not make money on it.
Royalties should play a much larger role in the decision-making process. Let’s assume you select to pay a licensing fee that is one percent higher than the fee in a comparable franchise offer. At $500,000 in sales, that is an additional $100,000 in a 20-year contract.
But purchasing based solely on royalties is not the answer either. If you walked into that very same car parking zone and someone offered you a ten-year-old Chevy for $50,000, you’d think they were crazy. But if they offered you a brand latest Ferrari for the same price, you’ll immediately say yes. The real query, then, is not price, but value.
Know the fees
However, at this stage of evaluation, do not try to guage value. Just take a good look at the fees you are more likely to pay. In addition to the initial fee (listed in point 5), there is a table in point 6 of the FDD documenting all the fees the franchisor will charge you. So if the franchisor charges a 5% licensing fee and a 1% technology fee, you pays a total of 6%. Please review this section rigorously to find out exactly what your obligations shall be.
Also make sure you understand how these fees are actually calculated. For example, while most franchisors charge franchise fees based on gross sales, some charge royalties based on gross profit (revenue minus cost of goods sold). Some franchisors may have different definitions of “gross sales” – for example, excluding taxes or gift card revenue.
The only set of fees chances are you’ll need to see in another way in this evaluation are promoting fees, referral fees, or national account fees. Unlike most other fees, these fees are designed to extend your organization’s revenue. Therefore, you must view them as non-incremental (because the franchisor likely designed them); they are going to directly profit you and are based on the franchisor’s assessment of what has been obligatory in the past to bring customers through your doors.
This is also a good opportunity to look at Section 8 of the FDD, where the franchisor must disclose any restrictions on the sources of products or services that shall be placed on you. Any franchisor searching for to manage quality will dictate the sourcing of any products or services that may impact brand integrity – and it will ultimately impact your costs, fees and profits. Frankly, it is generally in the interest of the entire chain to be certain that the franchisor enforces brand standards.
Section 8 of disclosure
Sometimes the franchisor could also be one of several suppliers or even the only designated supplier of certain products and services. Many franchisors will decide to sell products and/or services to their franchisees. This may even be disclosed in Item 8, along with the revenues (not profits) that the franchisor or its affiliates earned from these purchases. In item 8, the franchisor discloses any rebates or other incentives it receives from designated suppliers.
When a franchisor sells you a product, they need to have the opportunity to make a reasonable profit on that sale. In many systems, the franchisor’s profit from product sales may allow it to cut back fees charged in other areas, corresponding to royalties. Similarly, we have seen several franchisors who have redistributed manufacturer rebates to their franchisees or who have deposited some or all of these rebates into their promoting fund for the profit of all franchisees.
If the franchisee acts as an internal distribution channel for the franchisor, note this here. Later in the diligence process, you possibly can ask any franchisee you interview whether the franchisor’s price is reasonable.