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Chapter 3. The Wealth-Creating Power of ... > How Do Franchisors Determine the Amo...

How Do Franchisors Determine the Amount of Franchisee Fees and Royalties?

Similar to the analysis franchisees conduct in assessing whether to pursue a franchise or standalone model, franchisors often ask, What should I charge for franchisee fee and royalty? The franchise fee is the one-time, upfront payment, and the royalty is paid as a percentage of sales as they occur over the term of the license agreement. The answer is to make the same PDV calculation as in Figure 3-1, but to interpret the results from a slightly differently perspective. If the PDV of the franchisee’s income stream is not greater than the PDV of the standalone operation, the concept is weak. If the PDV is greater, then we have a monetary value, which is essentially the difference between PDVs, to begin with and then to alter according to current market conditions. Hypothetically, if the franchise PDV is $1 million and the standalone PDV is $700,000, then the franchisor can reasonably charge a franchise fee plus royalty of $299,999 or less, depending on current market conditions. In the marketplace of franchise business opportunities there are presently approximately 4,200 franchises. The perceived strengths of the franchise and the respective costs of other business opportunities create the adjustments to the $299,999 difference between the franchise’s income stream and the outlet’s income stream.

Current market forces will of course naturally control how high a figure will be tolerated. The stronger the franchise is perceived to be, the closer to $299,999 can be charged. What part of the theoretical $299,999 should be franchise fee and what part should be royalty is generally the next question on the franchisor’s mind. Because the market does not supply perfect information, the prospective franchisee cannot know everything about a franchisor. However, in general, a higher franchise fee is a signal to the potential franchisee that the franchise is of high quality. For example, many home-cleaning franchises have a franchise fee of under $20,000, and Merry Maids is $32,500. Why? Such a difference in cost would signal the differentiated and higher quality aspects of the Merry Maids franchise. Which is better, a $10 bottle of wine or the $20 bottle? In reality, we don’t know which wine is better. But for many people, the price signals one as better than the other.

Some franchisors might attempt to charge a very high franchise fee to send a false signal of quality. The reality is that the market won’t sustain that fee if stores aren’t profitable.

The franchisee and franchisor are making the same bet that the franchise outlets will generate a faster-growing and more stable income stream than a chain of independent outlets. In general, although the perceived or actual strength of the operation will increase the royalty and franchise fee for the franchisor, it will also reduce the risk for the franchisee. You must remember that the marketplace is dynamic, and the PDV calculation must be reassessed often to monitor the marketplace. There are several risks to consider in pursuing a franchise as a business opportunity, but with the PDV exercise, you can gain a great deal of insight into the actual financial opportunity.

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