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” All that glitters may not be a pot of gold…”
Opening a franchise business can sometimes operate as a business hack in terms o ramping up a business and having a ready-made customer base to serve from day one.
Other times it can feel like a vice grip on your throat. It all depends on the relationship you have with your franchisor.
The wrong franchisor can make or break their franchisee. Just ask Quiznos.
So how do you define the franchisor/franchisee relationship?
What Is a Franchisee?
Franchising is a system for expanding a business and distributing goods and services to meet higher consumer demand. It’s based on a relationship between the brand owner and the local operator to skillfully and successfully extend an already established business system.
Franchisees are small business owners who operate franchises, or businesses granted the rights to use the licensor’s method of doing business and trademark to offer, sell, or distribute goods, services, or commodities.
A franchise is also a contractual relationship between a licensor (the franchisor) and a licensee (the franchisee). While every franchise is a license, not every license is a franchise under the law.
How a Franchisee Works
The franchisee purchases a franchise from the franchisor. The franchisee must follow certain rules and guidelines already established by the franchisor, and in most cases, the franchisee must pay an ongoing franchise royalty fee to the franchisor.
A franchisee has four major responsibilities for the success of the system in which they are granted a franchise:
- To protect the franchised brand by operating the business in strict compliance with system operating standards
- To build a strong and loyal customer base by offering only approved products and services and by providing superior customer service
- To ensure that all employees are properly trained and the franchise is properly staffed at all times
- To advertise and promote the franchise and its approved products and services according to the guidelines provided by the franchisor
Attributes of a Successful Franchisee
Franchisees generally need the following attributes to be successful:
Willingness Learning New Skills
As the operating manager of a franchise, you will take on a multitude of roles, from trainer to watchdog to customer service provider to financial advisor. The franchisor sets the brand standards, but they are not responsible for how the franchisee’s day-to-day business is run. It is a steep learning curve, but if you can master these new skills, you can become a successful franchisee.
Ability to Follow System Standards
As a franchisee, you are chiefly agreeing to follow someone else’s operating system, often including specific requirements for what marketing materials to use, what suppliers you must work with, and what specific products or services you must offer. This, along with the licensing rights and restrictions on how you can use the franchisor’s intellectual property, is what you are investing in. In exchange for this ready-made operating system, a franchisee has to report their sales and expenses, follow instructions on how to present the products and services, and comply with the franchisor’s advertising requirements. Every day, week, month, and year, the franchisee will be following protocols set up by the franchisor. If the franchisee fails to meet those brand standards, they risk being in breach of their franchise agreement.
Understanding of Small Business
The former corporate middle manager who wants to be a franchisee has a broad understanding of business, knows how to work within a system, knows how to motivate staff, and certainly is no stranger to long hours. But a franchisee is essentially a small business owner, which means leaving behind the internal support services they have grown accustomed to, as well as the many benefits that come with employment at a larger company, such as retirement plans, paid sick days, expense accounts, and health insurance plans.
As a franchisee, your success is measured each day in your franchise’s performance, requiring more self-reliance than many corporate managers have had to demonstrate. However, a well-structured franchised system will provide a level of support that contributes to the franchise’s success.
- A franchisee is a small business owner with a license to operate under a franchisor’s trademark, trade name, and business model.
- Franchisees must follow certain rules and guidelines already established by the franchisor.
- In most cases, franchisees must pay an ongoing franchise royalty fee to the franchisor.
- Successful franchisees must wear many hats, be able to follow guidelines, and have an understanding of small business.
A franchise fee is the payment a franchisee makes to the franchisor for the right to use the company’s brand, products, and intellectual property. This can be done up front or on an ongoing basis according to the terms of the franchise agreement.
Instead of creating a business from scratch, a franchisee benefits from the brand recognition and systems that the franchisor has already built. But these benefits come with a cost. Learn more about the purpose of franchise fees and how they work.
What Is a Franchise Fee?
While the definition of a franchise may differ at the state level, under the Federal Trade Commission (“the FTC Rule”), which defines franchising throughout the United States, a business relationship qualifies as a franchise if three criteria are met:
- The franchisor licenses its trademarks, service marks, trade name, logo, or other proprietary marks to the franchisee.
- The franchisor has “significant operating control” or “significant operating assistance” in the franchisee’s business.
- The franchisee makes a payment to the franchisor of at least $500 (annually adjusted) either before or within six months of opening the business.
As you can see, the third element means that a fee is required for a franchise agreement to be considered official.
How Franchise Fees Work
Franchise fees typically begin with an initial payment that the franchise makes to the franchisor when they sign their franchise agreement and become a franchise. This fee can be any amount above $500 (per the FTC Rule) and is generally in the range of $20,000 to $50,000. The amount will be disclosed upfront in the franchise disclosure document.
While many people equate the payment of the franchise fee with the initial services and support provided by the franchisor, that is usually not the case. The fee is merely a payment for joining the franchise system under the terms of the franchise agreement. Essentially, the franchisee must pay for the rights to all of the franchisor’s assets that will help them succeed as a business. These assets hold a lot of value, so upfront fees can be expensive.
Because the franchisee will continually benefit from these assets, there will usually be ongoing fees as well. These can be royalty payments or marketing fees, and they can be calculated in many ways. In the majority of systems, it’s simply a percentage of either the franchisee’s gross or net revenue. This payment, along with its frequency, is disclosed in the franchise disclosure document.
What Determines Franchise Fee Amounts?
The amount a franchisor sets as their franchise fee varies from industry to industry and even within franchisors in the same industry. For the most part, a franchisor will set the franchise fee at a level that will enable them to market their opportunity to prospective franchisees and pay commissions to franchise salespeople, while also giving them the resources necessary to provide initial support to franchisees. These costs generally include initial training, visits to approve the site, and monitor the franchisee’s site development, initial advertising, and opening support, among other costs.
In setting their fees, franchisors are also cognizant of the initial fees charged by their direct competitors and others targeting the same prospective franchisees.
For new franchisors who have not yet developed a robust pipeline of prospective franchisees, the initial franchise fee may not be a significant profit center. As their franchise system becomes better known and they have a more robust stream of potential franchisees, franchisors can begin to leverage their costs over a growing number of potential franchise candidates.
From a financial reporting basis, until the franchisor has substantially provided all of its contractually obligated initial support (generally indicated when the franchise is open for business), they cannot recognize the franchise fee as income.
When Franchise Fees Vary
For most franchisors the initial franchise fee is not negotiable but, like any contract, the amount of the franchise fee is whatever the two parties agree it to be. Franchising is all about consistent and sustainable replication, and if one franchisee has paid a lower franchise fee than others, it can cause problems.
A good rule to follow in setting fees is to ensure that franchisees in similar circumstances should be treated in the same way.
However, there are a few situations where franchisors will often alter the amount of their initial franchise fee:
When a franchisee agrees to open multiple locations throughout a defined period, this is traditionally called a multi-unit development or master franchise agreement. In this type of agreement, it is not uncommon for franchisors to reduce the franchise fee for locations the franchisee is scheduled to open later on in the development schedule. For example, the franchisee will be required to pay the normal $35,000 franchise fee for the first two units it opens, but only $30,000 for units three through five. This operates as an incentive for the franchisee to open up more than one unit. It is also becoming more common for multi-unit franchisees that sign a development agreement also to pay a lower continuing royalty fee.
While technically not an initial franchise fee, a transfer fee is paid when a franchisee sells their business and transfers their rights as a franchise to another party. That “new” franchise will pay the franchisor a transfer fee, which is normally either a fixed amount or a percentage of the franchisor’s typical franchise fee.
At the end of the term of the franchise agreement, depending on the franchisee’s right to re-up with the relationship per the terms of their contract, they may elect to renew the relationship with the franchisor. The initial fee they pay when entering into the successor agreement is generally referred to as a renewal or successor fee. Similar to the transfer fee, the renewal fee usually is a lower amount than charged to new franchisees.
Some new franchisors, when they first begin to offer franchises, recognize that their initial franchisees may look at their opportunity differently than they might look at a more established franchisor. To overcome any perceived additional risk and to prime the pump for franchise sales, some franchisors offer a reduced fee for what is often referred to as a “founders club.”
For example, franchisors may discount their franchise fee for their first five or 10 franchises, or more frequently for those prospective franchisees that sign an agreement before a certain date. These reduced fees are disclosed in their offering documents and provide a clear deadline or other parameters.
Are Franchise Fees Negotiable?
While generally, franchise agreements are adhesion contracts (non-negotiable), there are several instances where the terms may be negotiable, and while not common, franchise fees may under the right circumstances fall into a negotiable category.
In establishing their fees, franchisors should calculate the anticipated financial returns for their franchisees and make sure that the level of return is sufficient for both the franchisee and the franchise system as a whole to achieve the desired financial results. It is, therefore, essential when setting initial and continuing fees—and when negotiating—that franchisors fully examine the economics of the relationship. Setting fees based primarily on those charged by direct competitors is one of the most common approaches new franchisors take, and it often results in fees that are either too high or too low, both of which can be damaging to the franchise system.
- Franchise fees are any costs that a franchisee must pay to the franchisor to use its brand and resources.
- These can include large initial payments and ongoing percentages of revenue.
- The FTC requires an initial fee of at least $500 to consider a franchise agreement valid.
- These fees are usually set but may be negotiable in certain situations.
A franchise agreement is a legally binding document that outlines a franchisor’s terms and conditions for a franchisee. Every franchise is governed by these terms, which are generally outlined in a written agreement between both parties.
The franchise agreement will govern everything about how the franchisee runs the new business and lay out what they can expect from the franchisor. Learn more about what’s in the agreement and what it will mean if you decide to franchise your business or become a franchisee.
What Is a Franchise Agreement?
In the United States, a business becomes a franchise if it meets the definition established by the Federal Trade Commission (FTC), known as the FTC Franchise Rule. Under the FTC Franchise Rule, there are three general requirements for a franchise agreement to be considered official:
- The franchisee’s business is substantially associated with the franchisor’s brand. In franchising, the franchisor and each of its franchisees are sharing a common brand.
- The franchisor exercises control or provides substantial assistance to the franchisee in how it uses the franchisor’s brand to conduct business. Because the franchisee is an independent contractor and not a joint employer, generally those controls cover brand standards and do not extend to the human resources of the franchisee, nor do they extend to how the franchisee manages its business—aside from meeting the requirements of the brand standards—on a daily basis.
- The franchisor receives a fee from the franchisee for the right to enter into the relationship and to operate its business using the franchisor’s trademarks. The fee can be an initial fee of at least $500 or it can be a continuing fee—with certain exemptions provided under the law.
Several states have also passed laws that define a franchise, and the definitions may include some relationships that do not meet the FTC Franchise Rule.
A franchise agreement is a license that establishes the rights and obligations of the franchisor and the franchisee. This agreement is designed to protect the franchisor’s intellectual property (IP) and ensure consistency in how each of its licensees operates under its brand. Even though the relationship is codified in a written agreement that is meant to last as long as 20 years, the franchisor needs to have the ability to evolve the brand and its consumer offering to stay competitive.
The agreement also needs to be flexible enough to allow the franchisor to make contractual modifications that reflect decisions in response to franchisees’ specific needs. However, there are no changes to the stipulation that franchisees must manage their independently owned businesses daily in accordance with brand standards.
How a Franchise Agreement Works
The franchise agreement needs to deal with some basic elements, including, but not limited to:
- Overview of the relationship: This includes the parties to the contract, the ownership of IP, and the overall obligations of the franchisee to operate its business to brand standards.
- Duration of the franchise agreement: This involves the length of the relationship, the franchisee’s successor rights to enter into new agreements, and the requirement to upgrade the franchisee’s location.
- Initial and continuing fees: Franchisees generally pay an initial and continuing fee to the franchisor for entering into the system and remaining a franchisee. Agreements also typically include a number of side fees. Most franchise systems provide for a payment to an advertising or brand fund that is used by the franchisor to market the brand to the public and for other contractually defined purposes.
- Assigned territory: Not every franchise agreement grants a franchisee an exclusive or even a protected territory, but specifics about the territory must be defined. Franchisors also need to deal with reservation of their rights within a franchisee’s territory, including alternative distribution sites and sales over the internet.
- Site selection and development: Franchisees generally find their own sites and develop them according to the franchisor’s standards. The role of the franchisor is generally to approve the location found by the franchisee and then approve, prior to opening, that the franchisee has built its location to meet design and other brand standards.
- Initial and ongoing training and support: Franchisors generally provide a host of preopening and continuing support, including training, field, and headquarters support, supply chain, and quality control.
- Use of intellectual property including trademarks, patents, and manuals: The IP of every franchise system is its most valuable asset, some of which will change as the system evolves. The agreement defines what is licensed to the franchisee, how the franchisee can use the IP, and the rights of the franchisor to evolve the system through changes to the franchisor’s operating manual.
- Advertising: The franchisor will reveal its advertising commitment and what fees franchisees are required to pay toward those costs.
- Insurance requirements: Franchise agreements will define the minimum insurance a franchisee is required to have prior to opening and during the term of the agreement.
- Record-keeping and the right to audit the franchisee’s records: The franchisor defines the records that it needs its franchisees to maintain, the software franchisees are allowed to use, and its rights to access and audit that information.
- All the rest: Some may call it boilerplate, but in well-developed agreements, it is not. Among the myriad issues contained in the franchise and other agreements are the franchisee’s successor rights, default, termination, indemnification, dispute resolution, resale rights, transfer rights, rights of first refusal, sources of supply, local advertising requirements, governing law, general releases, personal guarantees, and roll-up provisions.
Before Signing a Franchise Agreement
The FTC rule requires that franchisors provide to prospective franchisees a presale franchise disclosure document (FDD), which is designed to provide potential franchisees with the necessary information for purchasing a franchise. Considerations include the risks and rewards, as well as how the franchise compares with other investments.
Franchisors are required to provide the FDD to prospective franchisees at least 14 days before signing it. If the franchisor then makes any major changes to the agreement, it must allow at least seven days for the franchisee to review the completed franchise agreement before signing it.
The franchise agreement is long, detailed, and provided to prospective franchisees as an exhibit to the FDD well in advance of signing it to ensure they have time to review the agreement and get advice from their lawyers and other advisers.
Franchise Agreement Pitfalls
Franchising is about consistent, sustainable replication of a company’s brand promise, and an agreement must detail the many business decisions that go into creating a franchise system. It’s complex and, in most instances, a contract of adhesion, meaning an agreement that is not readily subject to change.
Because a franchise agreement is meant to reflect the uniqueness of each franchise offering and explain the dynamics of the intended franchise relationship, copying another franchise system’s agreement is likely the single biggest mistake a new franchisor can make.
In developing a proper set of franchise agreements, each of the elements of the franchise need to be evaluated. Prior to having the lawyers begin to draft the agreements, it is essential for the franchisor to first develop its business plan and decide on all of these important issues. For most franchisors, it is important that, in addition to working with qualified franchise lawyers, they first work with experienced and qualified franchise consultants to craft their franchise offering.
- A franchise agreement is a legally binding document that sets the terms of the relationship between a franchisor and franchisee.
- Franchisors must give a franchisee 14 days to review all disclosures before signing an agreement.
- Both parties should thoroughly review franchise agreements with the help of a lawyer before signing.