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Cost Factors to Consider When Buying a Franchise

One of the quickest methods of starting your own business here in San Diego — becoming your own boss — is to buy a franchise. There are many advantages of buying a franchise including knowing that you are selling products or providing services from an established brand with an established and verifiable customer base. Franchises can be very profitable, but, profitability is often a function of costs. If you are thinking of buying a franchise, a good San Diego business lawyer can help. Here are a few cost factors to consider when buying a franchise.

San Diego Franchise Law: Initial Franchising Fee

If you are buying a “new” franchise, the franchisor will charge an initial franchising fee. Such fees are generally lump sum and can be quite substantial.

Purchase Price/Transfer Fee

If you are buying an already existing franchise (from either the franchisor or a franchisee), it goes without saying that you will have to pay a price for the business. Franchisors, however, have a legitimate interest in vetting new franchisees and in obtaining revenue. Thus, if you are buying from an existing franchisee, often there is a transfer fee that is required to be paid to the franchisor as part of the purchase. Franchisors justify these fees as necessary to offset their administrative costs in vetting and approving the new franchisee. These transfer fees are areas for potential negotiation between buyer and seller since a potential buyer will want to have the seller pay any transfer fees or receive a price reduction.

Annual Franchise Fees

In addition to the initial lump-sum franchise fee, in general, the franchisee must pay an annual franchise fee (or sometimes these are paid in monthly installments). These are generally flat fees and, therefore, not linked to annual revenues. These annual fees substantially reduce profitability for new franchises or if there is a “down” year.

Ongoing Royalty Fees

Sometimes the annual franchising fee is called a “royalty fee” or “royalty payment.” But, many times, the annual franchise fee is in addition to royalty payments. “Royalty payments” are payments made for the right to use the franchisor’s trademarks, copyrights, and trade secrets. With a fast food restaurant, for example, the name and the logo are trademarks owned by the parent franchisor. You cannot use the name and the logo without permission. A franchisee must pay royalties in exchange for permission to use the name and logo. Most often, royalties are based on a percentage of monthly or quarterly revenues. Sometimes, royalties are due without reference to revenue. Such a payment structure can significantly affect profitability.

Advertising Costs

Some franchisors pass through to the franchisees advertising costs. This allows the franchisor to increase its profitability, but correspondingly reduces the profitability of the franchise. The justification is that the advertising benefits the franchisee as much as the franchisor, so everyone involved should share the costs. Sometimes, national advertising is not included and franchisees are only charged in-part for regional and/or market-specific advertising. This is often considered more reasonable since a franchisee is only paying for advertising in-market. The big concern here is that, in general, the franchisee has no control over the advertising costs. This is another risk to profitability.

Must-Purchase Products and Sourcing Restrictions

Most franchisors require various products to be purchased from the franchisor or its affiliates. This is justified as a means of ensuring quality of product and uniformity. But this is also the main mechanism for generating revenue for the franchisor. However, almost without exception, the cost of the franchisor’s products will be higher than similar products bought on the open market. Again, this is part and parcel of franchising, but can significantly affect profitability. This also potentially restricts one of the main methods of “being your own boss.”

Product and Sales Restrictions

In a similar vein, franchisors will restrict what products you can sell. Again, this is part and parcel of franchising, but it can prevent you from testing other products and/or revenue streams without the permission of your franchisor. This is true also for geographic territory restrictions for franchises that are not site-specific.

Debt-Servicing

If you buy or start a franchise with lender financing, the other major cost factor to consider is the ongoing debt-servicing obligations. This is, of course, not specific to franchising but applies to all businesses. Minimizing debt obligations is often the key to profitability and long-term success.

Contact San Diego Corporate Law

For more information, contact franchise law attorney Michael Leonard, Esq. of San Diego Corporate Law by email or by calling (858) 483-9200. Mr. Leonard has the experience to review your franchise disclosure documents and agreements, help with the purchase (or sale) of a San Diego franchise and/or assist with any business-related matter. Mr. Leonard has been named a “Rising Star” four years running by SuperLawyers.com and “Best of the Bar” by the San Diego Business Journal.