Franchise Fees: The Money Question That Can Make or Break Your Franchise The single most important aspect of your business plan are the fees you charge your franchisees. Discover how to charge enough on the initial fee and royalties to make money without scaring away potential franchisees.

The following excerpt is from Mark Siebert's book Franchise Your Business. Buy it now from Amazon | Barnes & Noble | iTunes

Mark Siebert delivers the ultimate how-to guide to employing one of the greatest growth strategies ever -- franchising. Siebert shares decades of experience, insights, and practical advice to help grow your business exponentially through franchising while avoiding the pitfalls. In this edited excerpt, Siebert offers some tips on determining your initial fee and your royalty.

The single most important aspect of your business plan are the fees you charge your franchisees. Amazingly, many franchisors spend far less time than they should on these make-or-break decisions. But carefully consider the following: A mistake of just 1 percent on a royalty can mean the difference between success and failure.

Let's say you set your royalties 1 percent below the optimal number and that your franchisees' average unit volume is $500,000. If that's the case, this 1 percent mistake will cause you to lose $5,000 per franchise each year. This $5,000 has no associated cost, so it comes right off the bottom line. Moreover, your franchise contract will likely be for five, ten, or maybe 20 years -- so you're committing to that mistake for a decade or more. If, during that time frame, you sell 100 franchises, you could be looking at a cumulative loss of perhaps $5 million to $10 million.

In franchising, there are a number of ways you may end up generating revenues from your franchisees, including:

• An initial franchise fee
• An ongoing royalty
• Markups on products sold
• Advertising fees
• Territory-based fees (subfranchising, area development, etc.)
• Contract-based fees (transfer fees, renewal fees, technology fees, etc.)
• Fees for services provided
• Rebates from vendors to the system
• Sharing in National Account revenue
• Financing
• Real estate fees or markups

While not every franchisor will take advantage of all the above revenue streams, each of these should at least be considered in developing your franchise structure. Following are some general guidelines on the two major components of the fee determination process.

Initial Franchise Fee

The initial franchise fee should be treated primarily as a cost-recovery tool rather than as a profit center. Since franchising is, in principle, about creating long-term relationships, the initial fee should be low enough to avoid erecting unintentional barriers to entry. Remember, in franchising, each franchisee (if properly nurtured) represents a virtual annuity to you. A single franchise sale, over the course of the relationship, may generate tens of thousands of dollars in revenues for you each year. So while you may receive a nice fee upfront, the real return comes from this ongoing relationship. The last thing you want to do is price your franchise out of the market and discourage qualified candidates from moving forward.

While the costs a franchisor might incur in selling, starting up, and servicing new franchisees will certainly vary depending on the nature of the franchise, a franchisor might expect that it will incur costs for franchise marketing, sales commissions, legal advice, collateral materials, site selection, initial training, field support, and travel.. A franchisor should account for all these expenses in determining its ultimate cost-per-franchise sale.

Once you've estimated your anticipated costs, you should examine the franchise fees being charged by your franchise competitors and determine how directly comparable these competitors are in terms of reputation, market presence, services provided, investment profile, and similar factors. This will ensure that the fees you charge are competitive with the other franchises prospective franchisees are most likely considering as alternatives.

Royalty Determination

Royalties are the primary source of revenue in most franchise systems and are most commonly charged as a percentage of the franchisee's gross sales. In some systems, however, franchisors collect a flat fee monthly royalty. In others, they collect a flat fee or a defined percentage of sales, whichever is greater. And in still others, they collect a percentage of gross margin instead of a percentage of gross sales. In systems where proprietary product sales are at the heart of the franchise concept, markup on the sales of these products to franchisees may entirely eliminate the need for any royalty on their sales to the end user.

We've seen all kinds of royalty structures. We've seen structures in which the percentage charged is graduated upward (increasing with higher levels of franchisee revenues) and ones in which it's graduated downward (decreasing as franchisee revenues increase). From a structural standpoint, the franchisor has a great deal of flexibility.

Regardless of the structure chosen, the royalty you charge will be one of the most critical financial decisions you'll ever make as a franchisor. It's such an important decision that at the iFranchise Group, determining that number often takes weeks, encompassing six different steps:

1. The process starts with an analysis of comparable franchisor fee structures. This analysis must go beyond simply looking at what the franchisor charges; it must also account for what the franchisee receives. To do this, you must thoroughly examine the franchise disclosure document of each competitor to determine what each is offering in return for these royalties. This examination must account for the entirety of the fee structure, so if other fees are being charged or products sold at a markup, these fees should be included in the analysis.

2. The second step is determining how you want to position your offering in the marketplace. Do you want to be viewed as low-cost, low-support franchise? A premium offering? Your fees will, at least in part, help solidify that perception in the franchise prospect's mind.

3. Of course, financial modeling of various royalty approaches is essen­tial to a proper analysis. Our typical process involves a spreadsheet that may be 16 pages or more in length, including line-by-line cost estimates, hiring plans, projected salaries, franchisee support requirements, structural decisions, month-by-month development schedules, franchisee cash-flow models, and month-by-month fran­chisor cash-flow models. The modeling process needs to account for specific support requirements, target markets, speed of growth, targeted franchisees, franchisor philosophy, organizational structure, and many other factors.

4. Once the core financial model is developed, we conduct a financial sensitivity analysis. Essentially, this involves testing financial models under a variety of altered, generally conservative assumptions. For example, you might want to test the model under different assumptions for your average franchisee revenues. You might want to determine what would happen if your franchisees' costs were impacted by an increase in the pricing of one of your major goods. And, of course, you'll want to test your model on a variety of different fee assumptions. Since no one can predict the future with any certainty, this what-if modeling allows you to understand what might happen under a variety of circumstances.

5. Next we attempt to quantify the value proposition perceived by your franchisees and compare that to what they'll be paying you. While some of this value proposition will be composed of intangi­bles (e.g., your ability to help them minimize risk), it always helps to understand that there's a cost/value element at the heart of every franchise relationship. So you'll want to ask yourself how much money franchisees can save through your purchasing power. How will they benefit from your national accounts program? How will your existing marketing help them improve sales? How much would they have to spend to develop your brochures, ad slicks, radio spots, or collateral materials? What's the value of your existing relationships, brand, client list, and track record? What about the value of the many lessons you've learned that will save them time, money, and mistakes?

6. Finally, at the end of this process, you will want to reverse engineer your royalty by looking at both the value proposition you are deliv­ering and your franchisee's ROI.

Ultimately, the best royalty and initial fee structure will be optimized around providing a reasonable return for both the franchisor and the franchisee while allowing you to offer a level of support to the franchisee that will ensure quality and give them the best chance of success.