There are a number of financial aspects related to franchising which are sometimes confusing or plainly misunderstood.
Before entering into a franchise agreement, potential franchisees should know and understand the financial terms related to franchising some of which are listed below.
Advertising / Marketing Fee or Contribution
This is usually paid monthly by the franchisee to the franchisor for advertising and brand building expenditures. It is either a fixed amount, a percentage of the franchisee’s monthly sales or a combination of the two. It is paid in addition to the Management Services Fee.
This is also referred to as the initial or joining fee paid to the franchisor by the franchisee for the rights to use the franchisors intellectual property, training, initial support etc. This is usually included in the total investment.
Management Services Fee (Royalty Fee)
Franchisors require franchisees to pay an on-going fee, usually monthly which is calculated as a percentage of sales, a flat fee or a combination of the two. This payment is for the on-going use of the franchisor’s intellectual property and for the continuing services given by the franchisor for training, field services, etc.
Start-up or Establishment Cost
The total amount required to setup the franchise operation. This includes the franchise fee, along with other start-up expenses such as shop fittings, equipment, signage, business licenses and working capital.
The amount of money estimated for complete set up of a franchisee’s business, including the initial investment, the working capital, and subsequent additions to inventory and equipment deemed necessary for a fully operational franchise.
Unencumbered funds are viewed as available cash as opposed to equity when borrowing funds from a bank to buy a franchise. Most franchisors and banks require the franchisee to invest 50% of their own funds in cash into the business as they want to see the intent of the franchisee to take some risk by also investing in the business.
Unencumbered funds are necessary to buy a franchise, because if the franchisee borrows 100% of the funds, from a bank or other sources, the business will be over-geared. The franchisee will have to make huge repayments every month and it’s unlikely that a young business will be able to afford this.
Working capital is the amount of cash required to cover any cash shortfalls with the start-up and the initial few months while establishing the franchise. Initially, funds are needed to pay the first months’ rent and lease deposit, utility deposits, licences and incidental costs. As it takes time to build up a new franchise the first months are usually loss months, which need to be financed. The franchisees sustainability must also be taken into account.
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