Franchising is one way of many by which a business can expand. The key ingredient that a business must have that wants to consider expansion through franchising is something that someone would want to license from it to use in the operation of an independently owned business. Specifically, that something is a system for operating a particular successful business associated with a particular brand name (trademark).

Franchisors often operate corporate stores which they own and which replicate to various degrees the original business. The profitability model for these stores is usually equivalent to the financial modeling applicable to the original business.

For the franchisees of one of these businesses, its profitability model is similar. However, its ability to control aspects of its revenues and expenses is impacted by the system within which it operates. Those impacts are in the form of the financial costs controlled by the franchisor. Often, these costs are directly linked to the franchisor’s means for making money from its franchise system. There are various potential silos of charges which a franchisor can apply to a franchisee’s business. Each franchisor will pick and choose which silos best suit its system and its financial goals. These choices will fundamentally affect the attractiveness of its system to potential franchisees. Often, these costs are directly linked to the primary silos as discussed below.

1. Franchise Fee (Initial)
Most franchisors charge an initial fee. This is often equated to the initial fee for the grant of the license to operate the system using the franchisor’s system and trademark(s). Franchise fees range in size. Against this fee, the franchisor must consider that it will incur expenses in granting a franchise which can include such things as brokerage fees and the cost of compliance with the applicable statutory disclosure regime.

2. Initial and Ongoing Training
Franchisors utilize employees and others to train new franchisee operators/managers. Franchisees typically bear the cost in the form of a training fee. Franchisors may add a profit component to the training fee.

3. Ongoing Royalties/Fees
Franchisors typically charge a royalty as a percentage of the franchisor’s gross sales or as fixed fees charged periodically (usually monthly). The royalty or fee is reflective of the underlying licensing arrangement. Franchisees usually pay these amounts without regard to their own profitability. They become a cost of operating like any other unavoidable fixed or variable expense.

4. Advertising Fund
Franchisors typically maintain a fund to which franchisees contribute to permit the establishment and operation of advertising campaigns locally, regionally and nationally for the benefit of the system as a whole. Franchisees may be required to contribute a percentage of their gross sales, again without regard to their own profitability. These contributions are applied to the hard costs of advertising but are also often applied to cover the wages of franchisors’ employees administering the fund and other head office costs. Franchisors can charge for these services on something other than a pure cost recovery basis if they choose to.

5. Sublet Rent Upcharges
Some franchisors lease premises to be used by their franchisees in the operation of their businesses as a means of “land control”. They then sublet the premises to the franchisees. Franchisors with excellent covenants might be able to negotiate lower rents than could their independent franchisees. Some franchisors, if permitted by their leases, upcharge the rent paid by the subletting franchisees.

6. Supplies and Equipment
Franchisees typically use a variety of supplies and equipment mandated by the franchisor. Franchisors mandate this use for purposes of quality control and consistency of customer experience. They also do so in order to take advantage of collective buyer power. The benefit of this buyer power may or may not be shared with franchisees. Franchisors might upsell the products to their franchisees directly or indirectly. They can also seek rebates from the system suppliers which, again, they may choose to keep for themselves or share with their franchisees. They may negotiate for marketing dollars to be paid by product and service suppliers including for application to the costs of system conventions. They might create private label programs where they supply their goods for use to the system at prices they determine. Most franchisors oblige their franchisees to only procure supplies from approved suppliers enabling these arrangements. The franchisor’s expenses for its role in the supply chain can be covered as well through these arrangements.

7. Transfer and Renewal Fees
Franchisors often charge franchisees fees if they wish to transfer their agreements or renew them. Some of these costs will be applied to the costs the franchisor will incur in the transfer/renewal processes. Sometimes their administrative and legal costs are added to the fees introducing a profit element to the franchisor.

8. Build out / Purchase Costs
Franchisors often control the process by which franchised stores are built out or renovated. They may have affiliated businesses responsible for build outs or renovations. They may contract out the work and charge an upcharge to the franchisee responsible for paying for the work. These charges can cover hard costs such as the salaries of those franchisor employees managing this construction. The charges may well exceed the franchisor’s costs for being involved in the construction. As such, the build out or renovation of a store can yield profits for a franchisor directly and indirectly.

9. Events – Opening Date / Conventions
Franchisors usually mandate a franchisee’s participation in opening store promotions and system conventions. Franchisors can choose to charge for these events on something other than a costs recovery basis and thereby be another source of profit for them.

10. Interest Charges
Amounts which may be past due can attract a contractual interest obligation on the part of the franchisee in an amount that can exceed the franchisor’s own costs of borrowing. This creates another potential profit silo.

11. Compliance Systems
Franchisors are regularly engaged in the monitoring of franchisee performance. These processes, including staff visits, secret shopper programs, audits and compliance software programs, are an expense to the franchisor. Franchisors can seek to pass on the expense or other charges relating to the activity. Again, these charges may or may not include a profit component.

12. Fines / Rewards
As an aid to compliance and franchise improvement, franchisors may have a fine/reward system where franchisees are rewarded for system compliance and fined for non-compliance including mandatory payments for defaults which may do more than offset the costs of managing defaults.

Each of these potential charges can add to a franchisee’s costs of operating that it would not have if it was not part of a franchise system. The items paid for may or may not bring off-setting improvements to revenues that a franchisee could expect to earn if it operated outside of the system. Importantly, franchisees generally have little say on when or whether to incur these costs. They should make their decision to buy into a franchise having fully analyzed the potential impact of these charges weighed against the anticipated benefits of being in the system. These costs can impact the viability of franchises and their attractiveness in the marketplace. They can impact an existing franchisee’s willingness to invest in its own growth. Franchisors must balance these competing and interdependent considerations when devising and developing their systems and establishing these charges for maximum system efficiency. Their agreements with their franchisees must also permit them to have maximum flexibility to alter the charges they impose as market changes affecting the business occur.

At Sotos LLP, we help emerging and established franchisors understand these options, design systems to apply them and draft agreements and disclosure documents to reflect their expectations and best practices.