Latent Costs When Buying Into a Franchise System

Let’s be honest: when it comes to purchasing a business, money is everything. In our experience, we have found this particularly true when buying into a franchise system. 

In addition to simply paying the purchase price for a business, there are initial and ongoing costs involved in a franchise system which, when grossed, can become significant for a franchisee. Factoring these costs in whilst meeting scaling sales targets and maintaining adequate working capital can result in quite the financial jigsaw puzzle to grapple with.

It is critical a purchaser’s lawyer thoroughly inspects any franchise agreement for such latent or ‘hidden’ costs. Only then can the purchaser make a fully informed decision, knowing what costs are actually involved vis-a-vis their current financial position, business plan and experience. 

Naturally, the costs involved vary across different franchises given their differing needs and objectives. This article focuses on a few examples of costs an owner operated franchisee could face, particularly where they lease the premises.

Costs Related to a Leased Premises

A franchisor does not necessarily supply a franchisee with a premises having everything ready to go. The franchisee may have to purchase stock or lease initial equipment themselves. Depending on the terms of the franchise agreement, a certain fit out may need to be installed at the franchisee’s expense. In terms of the lease, the landlord may require certain refurbishment or redecorating to be completed. These costs can run up significantly. So too when reinstating the premises to its original condition upon the lease’s expiry. Where we may be able to assist you for example, is in negotiating with the landlord to agree that there are no refurbishment or reinstatement requirements beyond that set out in your Franchise Agreement. 

Initial Franchise Fee

An initial franchise fee is normally in consideration of the franchisor granting the franchise to the franchisee and entering into the franchise agreement. Beware, however, as some franchisors require this fee paid prior to executing the document. If so, a lawyer ought to at least ensure the franchisor provides in writing the payment’s purpose, the terms and conditions surrounding its refund, and who will be holding the fee.

Royalties or ‘Continuing Franchise Fees’

Royalties to the franchisor arise as consideration for using their intellectual property, having the benefit of their goodwill and any ongoing support and management the franchisor offers. Such royalties are typically a percentage (5% for example) of the franchisee’s gross sales, payable at the end of every week. It is critical you enquire both the franchisor and any existing franchisees as to exactly what support the franchisee provides in consideration for its royalties. There are franchisors and ‘franchisors’, you need to determine that the royalties represent good value in terms of actual support received.

Marketing and/or Advertising Fees/Contributions

Franchisors often have funds which all their franchisees contribute to, so as to market or advertise the entire franchise system generally. Usually being a percentage these payments vary however, depending on a franchisee's gross sales. In other words, a franchisee successfully increasing their gross sales could mean they can expect their contribution to increase proportionately. Moreover, any business plan must acknowledge the likes of a 5% marketing contribution in combination with royalties could mean 10% of gross sales being payable to the franchisor.

Franchisors can also specify minimum amounts required to be spent by the franchisee on local advertising and promotion, for example in the White/Yellow Pages. A franchisee must therefore ensure they maintain adequate working capital, as it can become onerous being obliged to spend money if cashflow becomes tight. 

As with our comments re royalties, you need to do your due diligence to ensure you are receiving good value for your marketing fees.

Renewal and Assignment Fees

Choosing to exercise any rights of renewal a franchisee may have can result in having to pay the franchisor a renewal fee upon signing a new agreement, or in some cases actually re-purchasing the franchise. These amounts can be significant. 

If a franchisee decides to sell the business, they need to know whether they will be charged an assignment fee by the franchisor. Such a fee could be a flat figure or a percentage of the sale price. In addition to the assignment fee, a franchisor may also require the franchisee to pay for any training the  purchaser must complete. 

Operation Fees

Depending on the franchise, the franchisor may charge certain ‘operational’ fees. Such fees can cover for example, managing any POS services or software licenses that are involved in running the business. It should be noted such costs can also be subject to variation, highlighting the need for a franchisee to stay up to date with the franchisor’s manuals and the liabilities of their business. 

Typically with hospitality franchise agreements, the franchisor can also direct a franchisee to enter into related agreements such as service and supply agreements. It is important to understand that this can remove both a franchisee’s ability to control which liabilities they take on, and their ability to ‘shop around’ and get the best deal. 

Ad hoc Fees

Franchisors can require franchisees to attend meetings concerning the franchise and undergo ongoing training. The costs associated with attending such meetings and trainings, for example travel and accomodation, are the franchisee’s responsibility and therefore important to be aware of.

The information on this blog is general in nature and does not constitute legal advice. For expert legal advice in drafting the right buy-sell agreement for your business, please contact Shane Rohde at [email protected], Rebecca at [email protected] or Liam at [email protected]

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