Is the Price Right? How to determine whether a franchise is a good deal or overpriced

There's an old saying that "beauty is in the eye of the beholder." It has been my experience that "value" is likewise defined by 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.

Let's start with the last question first. You have a big advantage with a franchise, because the franchisor is required to disclose all fees and costs in the Uniform Franchise Offering Circular (UFOC), which they must provide to you prior to any purchase. This document breaks out the information you need, and the franchisor is subject to legal liability if they don't make this disclosure accurate and complete.

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Some of the most typical costs and fees paid to the franchisor (or to direct affiliates of the franchisor) include:

• Initial Franchise Fees. Most franchise companies require a new franchisee to pay a one time initial fee to become a franchisee. This fee can be as low as $10,000 to $15,000 or as high as the sky--in some cases well over $100,000. The average or typical initial franchise fee for a single unit is about $20,000 or $35,000.
• Royalties or Ongoing Franchise Fees. Franchisees usually pay an ongoing franchise fee or royalty. This fee is normally expressed as a percentage of the gross revenue of the franchised business but can also be a fixed periodic amount such as $500 per month, regardless of revenue. The average or typical royalty percentage in a franchise is 5 to 6 percent of volume, but these fees can range from a small fraction of 1 to 50 percent or more of revenue, depending on the franchise.
• Marketing Fees. Franchises often require participation in a common advertising or marketing fund. This fund is frequently a national program, 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 percent range.
• Required Purchases of Products or Services. Some franchisors also 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.
• Other. There are no other typical or common fees or costs, so if you see anything else in a franchise disclosure, check it very carefully to make sure it's appropriate.

The UFOC will let you know what these costs and fees are. The other question about 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 $150,000, 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 $20,000 per year in their business, whereas the typical franchisee in B is making an average profit after all expenses of $500,000 per year.

In examining the UFOC documents for the two opportunities, we further learn A has an initial franchise fee of $1,000, a royalty fee of 1 percent and no other costs. Franchise B has an initial franchise fee of $100,000, a royalty fee of 25 percent, a marketing fee of 10 percent and further requires the franchisee to purchase required supplies for their business at what we've determined is a 1,000 percent markup--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. B is not going to look very good, with these extraordinary costs and fees, if the revenue starts a rapid downturn. This very dynamic has happened in the past 25 years of franchising in the video rental, diet center and bagel sectors--just to name a few well-known examples.

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 percent, then the total of all royalty and other fees should be no more than about 7 percent. 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."