DETERMINING FEES AND OTHER PRICING ISSUES

INTRODUCTION
Fees, their determination and management, in a franchise system represent an inherent weakness to the franchising strategy.

The business of the Franchisor is inelastic.

All businesses continually make permanent or temporary adjustments to the selling price they charge to their customers. They alter their products, merchandising or service mix in an effort to improve their financial performance. They work with suppliers to reduce their raw material costs and manage internal expenditures for the same reason. These are standard business strategies.

To a great extent, these strategies are unavailable to franchisors. Once franchise fees, royalty rates, or other fees are established, the franchisor is limited to the adjustments they can make, except with respect to their future franchisees, renewal franchisees or after long and expensive negotiations with their existing franchisees. The same holds true for the services franchisors provide to their franchisees. Many of the services were promised in the sales presentation, are included in the franchise agreements or have become standard in the franchise system. These are equally difficult to change without some disruption to the franchisee/franchisor relationship.

The establishment of fees in franchising is a balancing act. Setting the fees too high leaves little profit for the franchisees, and may make the sale of new franchises difficult. Setting the fees too low leaves the franchisor with insufficient revenue with which to provide the franchisees with the services they require, (and are anticipating based upon the franchise agreements) and leaves the system without the proper resources to continue in operation, expand and earn a proper return.

Often, it is this inelasticity which causes franchisors financial difficulty.

The problem is often compounded because of the methodology used to initially set the fees. Fees often are set simply to ensure they are competitive with other franchisors rather than set at financially justifiable rates to ensure profitability for both the franchisee and the franchisor. New franchisors often place greater emphasis on out-marketing the competition than on ensuring adequate revenue to out-service the competition.

A further problem is that all franchisees are not equal. Typically new franchisees require heightened services than do mature operators. The costs of servicing franchisees in markets which have achieved critical mass is less on a per unit basis than less established markets. Multi-unit franchisees offer the franchisor certain efficiencies which are not present in single unit operators and are therefore less expensive to service. Some markets are simply more financially rewarding because of the volume of transactions in each location is higher than a comparable location in another market. In essence, the higher "profit" franchisees are used to subsidize the higher "cost" franchisees.

Finally, when franchisor's prediction of expansion is excessive or when they underestimate franchisee failure this provides for an unrealistic basis upon which to project future revenue.

In an inelastic "industry" such as franchising, all of these factors make the establishment of uniform, and for the most part, fixed continuing fees problematic.

TYPES OF FEES
There are many potential sources of revenue available to franchisors. While each franchise system is different, these fees can generally include:

A. INITIAL FEES

• Deposit agreements
• Investigation or due diligence fees
• Breach of agreement fees
• Franchise fees
• Initial training fees
• Software and hardware income
• Site location and development related fees
• Equipment, initial inventory and materials income
• Promotional materials

B. CONTINUING FEES

• Royalty
• Training
• Staff Certification
• Field services
• Leases and property management
• Equipment and signage rental
• MIS and POS licensing fees
• Shared guarantee and gift certificate programs

C. POST TERM FEES

• Renewal
• Transfer
• Assignment
• Public offering related costs

D. ADVERTISING/MARKETING FEES

• Initial and continuing national/regional/local fund contribution
• Local store marketing requirements
• Yellow page requirements
• Supplemental contributions

E. PENALTY FEES

• Audit costs
• Interest rates
• Loss of Manuals
• Violations of trade secrets
• Management fees
• Administrative fees
• Insurance fees

F. HIDDEN FEES - franchisor profit on direct or indirect sale of inventory, supplies or materials to franchisees or rebates from suppliers.

This last category of fees being less hidden under the new NASAA disclosure requirements.

METHODS FOR DETERMINING CONTINUING FEES
As stated above, the determination of continuing fees is a balancing act. The fees must provide for adequate revenue to support the franchisor and at the same time be affordable by the franchisee.

The fees charged to franchisees are a product of the operations of the system at all levels. The determination of the structure and amount of fees should therefore be made as part of a strategic examination of the entire franchise system. This review of franchise fees is only a portion of that strategic examination.

As the future of the franchise system rests with the profitability of its franchisees, the first analysis should be the profiling of franchisee financial performance.

FRANCHISEE FINANCIAL PROJECTIONS
Every franchisee assumes that with hard work their investment in a franchise will result in income. Franchisors need to ensure that after paying the system's fee, the remaining income provides for an adequate return for the franchisee. The franchisor should determine for themselves what a minimum acceptable return for their franchisees should be.

To do this, unit financial modeling is required. While defining a typical or average unit performance will not ensure that the fee structure will be adequate for all franchisees, it is the primary tool available.

Initially, the unit financial models do not include any franchisee system fees. Once the analysis has been completed, an investment analysis is be performed to determine the units pre-franchise rate of return.

The difference between the pre-franchisee rate of return and the acceptable rate after fees provides a benchmark for the maximum charges affordable by the franchisee.

The actual fee structure for the franchisee can be made after financial modeling is completed, both for the franchisor and for the franchisee.

FRANCHISOR FINANCIAL MODELING
Financial modeling for franchisors includes an analysis of:

1. Existing system revenue
2. Anticipated system expansion and contraction
3. Examination of franchisor's services to the franchisees
4. Examination of service costs
5. Examination of other system costs
6. Examination of systems other financial and capital requirements
7. Determination of acceptable return for franchisor

Once the system costs and existing revenue is modeled, the franchisor can establish the additional income required to meet return their requirements.

In order to establish an acceptable balance between the franchisees return requirements and the franchisors return requirements, multiple financial modeling will be required for both levels until the required balance is achieved.

During this modeling, those services which the franchisor had planned to provide to the franchisee will be further examined for affordability. While every franchisor would like to provide their franchisees with every conceivable service some services are not cost effective for either party. During the modeling process, the final service package will be determined.

Cost centers are segregated into those which are primarily related to initial franchisee services and those primarily related to continuing franchisee services and other overhead.

The rationale for segregating costs is that healthy established franchisors should rely on continuing revenue to support the continuing system and should not need to rely upon initial franchise fees for that purpose.

Therefore, initial franchisee introduction costs (recruiting, training, site selection, site development, initial field services etc. ) should be evaluated in the context of initial fees while the franchisors continual service costs (field services, home office support, research and development, corporate expenses,.etc.) should be evaluated in the context of the continuing fees. This segregation will ensure that the franchisor remains financially healthy regardless of franchise sales.

At this point in the financial modeling the franchisor will be able to determine the gross fees required by the system and affordable by the franchisees. Finally, the franchisor can commence a determination of the financial structure of the continuing fees.

THE SUBJECTIVE DETERMINATION
The most important consideration to make in determining the continual fee structure is subjective. How should the fees be structured so that the total of the fees collected by the franchisor and paid by the franchisee provide a satisfactory return for both.

USER FEES
Franchisors examine their continuing services and make a determine of whether certain services should be provided on an ala carte basis with user fees charged. This determination will vary based upon management's franchise system support objectives.

Should ancillary services such as continuing education, additional field support, MIS/POS support and enhancement costs, etc. be included in the royalty or are they treated as user fees?

If they are to be charged separately as user fees, are they to be provided on a cost pass through basis or does the franchisor include a margin of profit into the costs?

Does the franchisor charge for the cost of travel and staff salaries for requested field support? Does the franchisor earn income from the sale of merchandise and supplies to its franchisees? Are rebates from suppliers considered income to the franchisor or are they passed through to the franchisees as either reductions in their cost of goods or as contributions to their advertising funds?

When the franchisor can identify the cost of a specific event, transaction or service provided to a franchisee, they can then set user fees accordingly. The purpose of the user fees is to compensate the franchisor for specific services used by a franchisees on an as used basis.

Once the determination is made regarding the user fees, the balance of any revenue shortfall will typically be made up from the royalty fees collected.

BROAD BASED FEES
The purpose of the broad based fees are primarily to:

1. Compensate the franchisor for relinquishing their rights to a market for a defined period of time.
2. Compensate the franchisor for providing the franchisees with the services they require.

It may sound obvious, but the accumulation of all of the continuing fees collected from franchisees, both broad based and user, is the continuing franchisee revenue for the franchisor. While certain fees are more significant and occur with greater frequency, royalties being the primary example, it is the total of these revenue when compared to the total expenditures and required rate of return which is the important driver in establishing a fee structure.

Ultimately, by financially modeling the franchisee and franchisor, and identifying which fees will be user based and which will be included into general services, the rate of royalty can be calculated.