A King’s Ransom

How to tell if a franchise is a good deal or the price tag is crazy talk.

A King’s Ransom

South Africa enjoys a number of franchise exhibitions like the IFE and BOFE that expose prospective franchisees to a number of opportunities. Some concepts have entry-level price tags of less than R500 000, while others creep into eye-watering territory of between R2 million and R5 million.

While some concepts are deserving of their high price, there is an old saying that beauty is in the eye of the beholder. Value, in some cases, comes down to personal perception.

Value is often brought up by prospective franchisees who commonly ask, “Is the price right?” or “Is the franchise too expensive?” or “How do I know what the true costs are in a franchise?”

These questions cut to the heart of one of the key factors in making a decision about a franchise business: Whether or not the fees and costs that must be paid to a franchise are fair, reasonable and appropriate.

How do I know what the true costs are?

You have a big advantage with a franchise because the franchisor is required to disclose all fees and costs in the franchise disclosure document prior to purchase. If they don’t, that’s a warning sign. Some of the most typical costs and fees paid to the franchisor include:

  • Initial franchise fees. Many franchise companies require a new franchisee to pay a one-time initial fee to become a franchisee. This fee can be as low as a few hundred rand or as high as a few hundred thousand rand. Check to see whether this is included in the lump sum.
  • Royalties or ongoing franchise fees. Franchisees usually pay an ongoing franchise fee or royalty. This fee is normally expressed as a percentage of monthly turnover but can also be a fixed periodic amount such as R250 regardless of revenue. In some industries like education and training, there’s a set fee for each new student enrolled too. The average or typical royalty percentage in a franchise is 5% to 6%, but this can range from brand to brand.
  • Marketing fees. Franchises often require participation in a common advertising or marketing fund. This fund is frequently a national programme that includes media ordinarily out of the budget of individual business owners, but it can also have a regional or local market focus. As with royalty fees, this can be a fixed contribution but is more often a percentage of revenue in the 1% to 4% range.
  • Required purchases of products or services. Some franchisors require that a franchisee purchase certain required products or services, either from the franchisor or from affiliated entities of the franchise company. The thing to watch for in this situation is whether the pricing is competitive or not.
  • Refurbs. Most brands undergo a revamp every five to seven years at the cost of the franchisee. Make sure your franchisor is clear about the frequency and extent of revamps as franchisees are required to foot the bill for fitting out their stores.

Is it worth the cost?

While the disclosure document will let you know what these costs and fees are, whether these costs are reasonable is more difficult to answer because it involves a perception of value.

The secret to answering this question is to focus on the global picture of the opportunity from your perspective rather than the details of any specific fee or cost.

As an example, let’s suppose we’re comparing two franchise opportunities, A and B. The total investment required for each is an identical R1,2 million including initial franchise fee and all other costs. We determine from our investigation that the typical franchisee in A is making an average profit, after all expenses, of R160 000 per year in their business, whereas the typical franchisee in B is making an average profit after all expenses of R4 million per year.

In examining the disclosure documents for the two opportunities, we further learn A has an initial franchise fee of R8 000, a royalty fee of 1% and no other costs. Franchise B has an initial franchise fee of R800 000, a royalty fee of 25%, a marketing fee of 10% and further requires the franchisee to purchase required supplies for their business at what we’ve determined is a 1 000% mark-up – well above competitive rates for comparable supplies.

Which is the better opportunity?

Which delivers better value to the franchisee? Which is more fair and reasonable in relation to the fees and costs that they charge?

In this example, most people would identify B as a far better opportunity, in spite of the fact that its fees and costs are dramatically higher than A. This is because, from the franchisee’s perspective, it offers a much greater return.

The fees and costs that go to the franchise company are what they are. The true test of value is what goes to the franchisee.

That said, there’s one caveat that every prospective franchisee must be aware of. Occasionally, franchises have average returns far outside the range that would be considered normal for a business to produce. These situations are rare, and they typically don’t last for long because extraordinary returns tend to attract a huge number of competitors very rapidly.

If you see an opportunity that looks like B in the example above, you should be wary about how long these types of returns might last. If the business follows form, it will soon attract competitors and experience pricing pressures that will bring the margins way down.

Option B is not going to look very good with these extraordinary costs and fees if the revenue starts a rapid downturn.

How to calculate reasonable business proceeds

A standard formula for calculating a reasonable distribution of business proceeds is one-third of the average pre-tax profit margin (before any franchisor fees or costs or any franchisee compensation) goes to the company and two-thirds to the franchisee.

If, for example, the net margin is 21%, then the total of all royalty and other fees should be no more than about 7%. This formula may or may not seem fair to you, but you will find that many of the most successful franchise opportunities seem to stay very close to this formula.

You should never enter into a franchise agreement if you don’t feel the fees and costs you’re required to pay the franchise company are fair and reasonable. Rather than focusing specifically on what is going to the franchise company, though, make sure your focus is on what is coming to you, and then you’ll know if you’re paying the ’right price.‘

Jeff Elgin
About the Author
Jeff Elgin has developed a consulting system that matches pre-screened, high-quality prospective franchisees with the franchise opportunities that best fit their personal profile.

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