How to Vet Franchisors and Predict Your ROI on a Franchise Business
While every item on the franchise disclosure document (FDD) is important, some may be more important to you than others. One of the big-ticket items you should be paying attention to is money: what you must put into the franchise and what you get in return.
It would be wonderful if there were a simple calculation to figure out your cost benefit, but there just isn’t. Unfortunately, because the FDD is such a complex document, many prospective franchisees try to simplify it, and nowhere is this more apparent than in the items dealing with fees and services (Items 5, 6, and 8).
Frequently, prospective franchisees will focus on either the franchise fee or the royalty and compare it to the competitors’. At a quick glance, the lowest fee seems the most attractive. Unfortunately, that’s the equivalent of going to a used-car lot and buying the cheapest car you can find.
It’s a huge mistake to make your investment decision based on the initial franchise fee alone. While you want a franchise fee that’s reasonable and competitive, it’s only one component of your total investment, and in most franchises, it represents a relatively small fraction of that investment.
For most franchisors, the initial fee isn’t a significant profit center. They have costs associated with marketing the franchise, franchise sales, legal documentation, training their franchisees, and providing them with initial support until they’re up and operating -- all of which is theoretically covered by the franchise fee. So, while fees in the tens of thousands of dollars just to join the system may seem excessive, this isn’t where the franchisor makes its money.
Royalties should be much more important in your decision-making process. Let’s say you choose to pay a royalty that’s 1 percent higher than the fee of a comparable franchise offering. On sales of $500,000, that represents an additional $100,000 over the course of a 20-year agreement.
But shopping on the basis of royalty alone isn’t the answer, either. If you were to go to that same car lot and someone were to offer you a ten-year-old Chevy for $50,000, you’d think they were crazy. But if they offered you a brand-new Ferrari for that same price, you’d jump at it. The real question, then, is not price, but value.
At this point in your analysis, though, don’t try to assess the value. Just have a good understanding of the fees you’re likely to incur. In addition to the initial fee (found in Item 5), Item 6 of the FDD provides you with a table documenting all the fees the franchisor will collect from you. So, if the franchisor has a 5 percent royalty and a 1 percent technology fee, you’d pay a total of 6 percent. Go through this section closely to determine exactly what your commitments will be.
Also, be 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 (revenues minus the cost of goods sold). Some franchisors may have different definitions of “gross sales” -- for example, excluding taxes or gift card revenues.
The one set of fees you may want to view differently as part of this analysis are your advertising fees, referral fees, or national accounts charges. Unlike most other fees, these fees are geared toward driving revenue to your business. As such, you should view them as nonincremental (as presumably the franchisor has designed them); they’ll benefit you directly and are based on the franchisor’s assessment of what’s been historically necessary to drive business to your door.
This is also a good opportunity to take a look at Item 8 of the FDD, in which the franchisor must disclose any restrictions on the sources of products or services that will be imposed on you. Any franchisor that’s looking to control quality will dictate the sources of any products or services that will impact the integrity of the brand -- and that ultimately affects your costs, fees, and bottom line. Frankly, it’s generally in the best interests of the entire network to ensure that the franchisor enforces these brand standards.
On occasion, the franchisor may be one of several suppliers or even the sole designated supplier of certain products and services. Many franchisors will choose to sell products and/or services to their franchisees. This will also be disclosed in Item 8, along with the revenue (not profits) that the franchisor or its affiliates derived from those purchases. Item 8 is also where the franchisor discloses any rebates or other incentives it receives from designated suppliers.
When the franchisor sells to you, it should have the opportunity to make a reasonable profit from those sales. In many systems, the profit a franchisor makes on product sales may allow it to reduce the fees it charges in other areas, such as royalties. Likewise, we’ve seen a number of franchisors who will redistribute manufacturer’s rebates to their franchisees or who will contribute some or all of those rebates into their advertising fund for the benefit of all franchisees.
If the franchisee is acting as a captive channel of distribution for the franchisor, make a note of it here. Later in your diligence process, you can ask any franchisees you interview whether the franchisor’s pricing is reasonable.