DETERMINING FEES AND OTHER PRICING ISSUES

« ...continued from page 1

METHODS OF DETERMINING ROYALTY FEE STRUCTURE
Most often franchisors establish their royalty based upon a percentage of the franchisees gross sales. While it is often the simplest fee structure to administer and explain to the franchisees, it is not always the best method to ensure the best balance for either the franchisor or the franchisee.

There are many variations used by franchisors. Some of the more common fee structures include:

FIXED PERCENTAGE OF GROSS SALES
This is the most common fee structure. The franchisee reports gross sales, after making certain approved adjustments (taxes, bad debts, returns, etc.). The royalty is calculated by applying the fixed percentage to the adjusted gross sales.

VARIABLE PERCENTAGE OF GROSS SALES

DECREASING PERCENTAGE - MONTHLY SALES
This structure is used by some franchisors in the belief that reducing the percentage royalty on increasing sales is fairer to the franchisee as it provides additional reward for superior performance and still provides the franchisor with an acceptable rate of return. Some also feel that the decreasing percentage encourages franchisees to report total sales more accurately.

The franchisor establishes different royalty rates for various levels of monthly sales. As the monthly sale increase, the royalty rate goes down. The franchisee applies the royalty rate for all sales in the month. In subsequent months, the royalty rate will again be based upon the level of sales achieved.

DECREASING PERCENTAGE - CUMULATIVE SALES
This royalty structure is similar to above. except the franchisee applies a lowering royalty percentage based upon cumulative annual sales rather than individual monthly sales. The royalty report reflects cumulative sales total, and as the franchisee exceeds the target, the royalty rate drops on future sales until the next sales target is reached.

INCREASING PERCENTAGE - MONTHLY SALES
All locations and markets are not created equally. The rational for the use of an increasing percentage is to provide the franchisor with additional compensation for granting a market which has superior performance.
5.2d INCREASING PERCENTAGE - CUMULATIVE SALES
This royalty structure is similar to above. The franchisee applies a higher royalty percentage based upon cumulative annual sales.

MINIMUM FEE STRUCTURES

MINIMUM ROYALTY
The franchisor grants a market with the expectation that the units performance will meet certain minimum expectations. To provide the franchisor with a minimum level of return on the market, regardless of the sales at the location, a minimum fixed royalty is established.

In those periods in which the royalty as a percentage of sales does not meet the minimum royalty, the franchisee remits a minimum royalty fee. Minimum royalty fees are typically adjusted periodically based upon a CPI or other basis.

CUMULATIVE AVERAGE
Similar to the minimum royalty above, except the franchisees may pay their royalty based upon a rolling average of sales.
Sales in periods which exceed the minimum requirements, may be averaged with sales in periods which did not meet minimum requirements. This method reduces the negative impact felt by franchisees who are required to pay a minimum fee. The periods which may be averaged are typically limited to three months.

FIXED ROYALTY
The royalty is a fixed fee and is not affected by unit sales. The franchisor is assured of a fixed dollar return each month, while the franchisee receives the full benefit from increased unit sales. The fixed royalty basis is similar to a commercial lease without any sales override. The fixed fee is typically adjusted periodically based upon a CPI or other basis.

START UP PERIOD ADJUSTMENTS
Franchisors recognize that during the initial period of operation, the franchisee may have higher costs in establishing their business and at the same time, lower sales until they reach maturity. To assist their franchisees during this period, some franchisors will eliminate or reduce the royalty rate during the development period. The amount of royalty not collected is either treated as unearned or may be considered as a deferral or loan to be paid at a latter date.

TRANSACTION BASED
Franchisees are charged a fix fee based upon number of units sold, transactions closed, rooms rented, bottles shipped, etc.

NO ROYALTY FEE
In franchise systems in which the franchisor earns income from the sale of merchandise or services to its franchisees, the markup on these sales and services is earned in lieu of royalty.

ESTABLISHING RETAIL ADVERTISING AND MARKETING FEES
Regardless of the structure a franchisor chooses to administer and expend franchisee marketing contributions, they must be certain that the amount of promotional dollars available is adequate for the purpose. They also must be assured that the level of advertising contribution required of the franchisee is affordable. Just as with other continuing fees, the marketing contributions by franchisees must be balanced.

Franchisors that set fees at unrealistically low rates, in order to be competitive with other franchisors, will soon find that the lack of effective advertising programs will be viewed by the franchisees as a failure of the franchisor. Setting the fees at too high a rate will be unaffordable by the franchisee and will therefore create other problems.

And, just as with the evaluation of other continuing fees, all franchisees and markets are not equal. Unit sales, critical mass, population densities, local media costs and effective marketing methods and availability will vary.

Nor are all franchise systems equal. Large systems have national marketing alternatives which smaller systems do not. Franchisors that have effectively established critical mass have alternatives which other systems do not.

Therefore before establishing advertising and marketing fees, franchisors need to be aware of their retail and marketing positioning. Among a host of considerations they must take into account:

1. What are the effective retail advertising and marketing strategies available today.
2. What are the effective grand opening advertising and marketing strategies available.
3. What strategies are affordable for the system and markets today.
4. With responsible growth expectations, what will be the affordable marketing strategies in the future.
5. How to structure the advertising fees to ensure that the franchisor has the flexibility to meet future requirements.

RETAIL MARKETING EXPENDITURES

GRAND OPENING
The amount the franchisee is required to expend on Grand Opening marketing is usually stated in the franchise agreement. The methods for implementing the grand opening program will vary, from general guidelines established by the franchisor and provided to the franchisees for their implementation, to a program planned and implemented directly by the franchisor for the new franchisee.

Regardless of the approach taken , the general range of minimum costs for the grand opening program can be estimated by the franchisor.

While the minimum level of grand opening costs are specified in the franchise agreements, the franchisee always has the option to expend more. And in established markets, the grand opening campaign can often include support advertising from the other franchisees.

There are generally two methods franchisors utilize to manage the grand opening expenditures:

1. The franchisee pays for the cost of the program directly.
2. The franchisee contributes the required amount to a designated fund or cooperative.

In some franchise systems, in addition to the grand opening expenditure, the franchisee is required to make an additional contribution to a designated fund or cooperative. The purpose of this contribution is to effectively compensate existing franchisees in the market for developing the market prior to the franchisees entrance.

LOCAL MARKETING
Most franchisors have some requirement for franchisees to advertise locally. The amount required is often set as a fixed dollar amount, a minimum dollar expenditure vs a stated percentage of gross sales or simply as a percentage of sales.

Often franchisors will state the local marketing requirement as a range which can be adjusted over time. The reason for establishing the local marketing contribution as a range is to provide for future changes to the franchisor's local marketing strategy as well as to provide for changes in market dynamics and costs.

YELLOW PAGE ADVERTISING
The requirement to advertise in the franchisees local yellow pages is often specified separately.

The determination whether to credit the cost of the yellow page advertising to the franchisees minimum local marketing requirement, or to specify that it is in addition to the local marketing requirement varies among franchise systems.

LOCAL AND REGIONAL COOPERATIVE PROGRAMS
The use of advertising cooperatives by franchisors is growing. These are marketing funds which the franchisees typically have a greater level of control than they do over national fund contributions.

Even in franchise systems which have not established cooperatives, it is not uncommon for the franchisor to provide for the right of the system to establish the cooperatives in the future. In those situations, the local franchisees will be required to participate in the cooperative when they are established.

The amount of the franchises contribution to the cooperative is usually stated as a minimum vs a percentage of gross sales. In some systems the amount of fund contribution may be stated as a fixed dollar amount, typically with an annual CPI adjustment.

As with yellow page advertising the contribution can either be credited against the local minimum marketing requirement or as an additional expense for the franchisee.

NATIONAL FUND CONTRIBUTIONS
There are very few franchisors who have not established a provision in their franchise agreements for a national advertising fund.

As with other marketing expenditures, these can either be a fixed dollar amount (with annual CPI adjustments), minimum dollar amount vs a percentage of sales or simply as a percentage of sales.

Most franchisors attempt to spend their franchisee's fund contributions in their markets even when it is not provided for by the franchise agreements. The reasoning for providing the option to expend money outside of the contributing market are:

1. Strategic - Some markets may require more advertising expenditures than can be afforded by the local franchisees. It is in the systems interest to provide this additional support by taking money from other markets.
2. National and regional advertising requirements.

Some franchisors, even though not required by the franchise agreement, will manage the national funds, internally, on a market basis. They will treat advertising advances to markets, in excess of the markets contributions as inter-market loans.

SUPPLEMENTAL ADVERTISING CONTRIBUTIONS
Franchisors often specify minimum advertising weight by market. This is to ensure that marketing dollars are spent effectively.

In situations when the available fund balance does not enable advertising at this minimum weight franchisors may decide not to expend any of the fund balance until the minimum dollars are available in the local market.

In some systems, the franchisor may lend money, from their operating accounts to the fund or may contribute the money. In other system, the franchisor may give the franchisees the option to make supplemental contributions to provide for the additional dollars. In those systems, it is usually provided that when a majority of franchisees in the market agree to the supplemental contributions, the other franchisees are obligated to do so also.

FREQUENCY OF COLLECTION
Typically, royalties and advertising are collected on a weekly, bi-monthly or monthly basis, although there are still a few franchisors that collect their fees on an annual basis. The majority of franchisors, especially those whose franchisees have considerable capital invested in fixed assets, have elected a monthly basis.

Franchisors need to examine the cost benefit relationship of requiring frequent franchisee remittances vs. working capital benefits. While it is certainly feasible with electronic transfer to collect fees, even on a daily basis, the transaction costs can be prohibitive. Many franchisors who examine the cost of collecting fees on a frequent basis discover that the cost, both for the franchisee and the franchisor in administrative, banking, bookkeeping, lost management time and opportunity costs, make the cost of improved cash flow an illusionary benefit for the system.