Thursday, March 02, 2017

Should You Forgo the Initial Franchise Fee and Go with a Higher Royalty Instead?

In a recent discussion with a representative from a global food franchise, I was asked what I thought about the idea of not charging an initial franchise fee (IFF) and instead go for a higher royalty rate. My initial response was that they would buy themselves a higher revenue stream at the expense of the franchisees' profitability. On the other hand, the franchisor would have upfront costs that they would only recoup over time instead of receiving cash right away.
The thought stuck with me so I built a model to see what the numbers would look like.
  • Initial Investment:      $1 million
  • Initial Franchise Fee:  $50,000
  • Term:                          10 years
  • First year AUV:           $1.25 million dropping to $1.175 million in year 2, rising by 2% thereafter
  • EBITDA:                      25% constant
  • Royalty:                       5%

Under this scenario 1, the franchisor’s IFF and royalty revenues from that unit add up to $685,584 over the ten-year term of the agreement. Over the same period, the franchisee’s total EBITDA minus royalty will reach $2,542,338. This pattern follows a honeymoon period typical for a food concept.
Under scenario 2, after excluding the IFF the initial investment drops to $950,000. For simplicity’s sake, I applied the royalty rate that would drop the franchisee’s total EBITDA minus royalty amount by the same amount over ten years. In short, the franchisee roughly pays the $50,000 IFF in form of a higher royalty rate of 5.4% over the term of the franchise agreement.
The franchisees pays a lower initial investment but also makes less money over ten years due to the higher royalty payments which at the 5.4% rate somewhat compensate the franchisor for not having collected the IFF at the beginning of the term. He loses out on the profit margin from the start, the most crucial phase in a new business.

Is this Viable?
In my view, there are downsides for both parties because too many assumptions need to hold. First, the unit needs to be around for the entire term. Second, the unit’s margin cannot drop under 25% and third AUV needs to rise by 2% each year for ten years.
The franchisee pays a lower IFF, so that’s $50,000 less for the loan he needs to take out. But the running expenses go up, eating into his margin. On the other hand, at the increased 5.4% royalty rate, the franchisor gets basically compensated for foregoing the $50,000 at the beginning of the term. Yet, why would the franchisor wait for the cash for ten years when the early phase requires him to invest the most first into finding, training and initially supporting the new unit?
An additional increase of the royalty from 5% to 6% would provide a good cushion for the franchisor, increasing his revenues from the unit by over $77,000 more with no IFF revenue at the beginning. However, the franchisee loses over $127,000 over the ten year term. Even adding back the $50,000 IFF means he will be close to $80,000 short.
The only way this could make sense is if the franchisor exclusively partners with large corporate franchisees. Presumably these guys won’t need as much training after ten units so you can perhaps just have them open locations on auto pilot. Also, the franchisor won't incur expenses for finding new franchisees and making sure they are qualified. 
But even then, there are costs involved for the franchisor as for instance legal, site approval etc. And the same rule applies, the assumptions need to hold for ten years.


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