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What is a franchise?

What is a franchise?

Congratulations on your first step towards exploring franchising further and perhaps embarking with optimism and enthusiasm a new entrepreneurship mindset to partner with exceptional businesses and brands from across the world. We are happy to help you find the most suitable and best matched franchise investment opportunity. There is an ever-growing interest in Ireland for many international franchisors to partner with Irish entrepreneurs that believe in their proven and profitable business models. In the UK alone, there are more than 800 franchise brands active. In Ireland, we are at above 300 (end of 2018) so this number is set to increase substantially over the next decade. To help you get started, we have listed a number of things below. Did you know, for example, that about 80% of an average shopping street is a franchise?

We would like to give you a number of considerations before you plan an meeting or a call with a franchisor. There are a number of questions that we believe you should first answer before you proceed to best prepare.

Franchise literally means freedom

A franchise is a way of doing business where you, as a franchise entrepreneur, enter into an agreement with the owner of a trade name (the franchisor) that gives you the right to exploit a business with that trade name against payment. This is typical in most countries, when you often see a high percentage of an average shopping street or shopping mall consisting of franchised businesses.

The French word franchise (freedom) has ended up in English, and is derived from franc (free).

Recent research has shown that the chances of success of starting entrepreneurs in a franchise context (especially with more experienced franchisors) are around 90% and that a partnership in a franchise context achieves on average better turnover results than with non-cooperating independent entrepreneurs.

Typical Franchise Cost Breakdown

How much does a franchise cost? The answer to this question is not so simple because every franchise has its own financial requirements, so the costs to start a franchise are different for every franchise company. In most cases, you will be required to pay a franchise fee, all build-out costs for your location (including furniture, fixtures, and equipment), professional fees, contractor fees, signage, and inventory. The franchisor does not contribute to any of these costs. You must also make sure you have enough working capital not just to open your business, but to stay in business until the business is self-supporting.

Franchise Fee

Every franchise company will require you to pay an initial franchise fee. Most franchise fees are between €10,000 and €50,000. In some cases, you may see franchise fees less than €10,000. These franchises with lower franchise fees are usually home-based or mobile franchises. The franchise fee usually covers the cost of training (not including travel expenses - see below), support and site selection. The items or benefits that are included in a franchise fee are different for every company. In some cases, the franchise fee is just an upfront licensing fee for the rights to use the franchise name. Be sure to investigate exactly what you are getting in return for the franchise fee.

Legal and Accounting Fees

Anyone considering buying a franchise should consult with a qualified Franchise Lawyer. Your franchise lawyer will help you review the Franchise Disclosure Document's as well as the franchise agreement. There is no one set fee to review these documents. It is safe to say that you should budget anywhere between €1,200 and €5,000 to pay to a franchise lawyer. The amount of time you spend with your lawyer will determine the overall price.

It's important you start your record-keeping right from the start, so you should also work with a qualified accountant. Your franchisor may provide you with software or a chart of accounts, and your accountant will help you set up your books and records. Your account can also help you determine how much working capital you will require.

Working Capital

Working capital is the amount of day-by-day cash available to a business. Depending on the type of business, it is important that the working capital cover a particular length of time, ranging from as little as two or three months to as much as two to three years until the business is in full swing.

The franchisor typically provides an estimate of the amount that is needed, but you should do your own thorough research to make sure your calculation is based on your market rather than the system average, which may not be accurate for your location.

Build-Out Costs

Build-out costs vary wildly between franchises. Once you have decided on a franchise finish finding a location (the franchisor will need to approve the location), you will determine an estimate from the franchisor of your overall build-out costs. This will include all furniture, fixtures, equipment, and signage. Other considerations include professional fees for civil and architectural drawings, zoning compliance, contractor fees, decor packages, security, deposits and insurance, and landscaping. If you decide to buy a home-based franchise, there are no build-out costs involved. You may have other costs for software applications or computers, but sometimes these items are included in the franchise fee.

Supplies

All new businesses require you to have the proper supplies to run your business. Whether it is a food franchise that offers plastic utensils (small wares) to its customers or a service-based franchise that goes through a lot of office supplies, every franchise needs the proper supplies in order to do business. Your franchisor should be able to give you an accurate list or estimate of what is needed to open your franchise. Inventory If you are buying a retail franchise or any other franchise where you are selling a specific product, you must stock up on inventory. Once again, every franchise is different and has different requirements. You may be required to buy between €20,000 and €150,000 worth of inventory.

Travel and Living Expenses While Training

Franchisors will routinely provide training to the franchisee and, more often than not, at least one other employee besides yourself will be required to attend and successfully complete the training.

Although the training itself should be covered by the franchise fee, the franchisee is usually responsible for the training-related associated travel and living expenses. With some franchisors, training can last only a few days or one or two weeks, but in some more complex franchise systems, the training may extend for many months, with classroom training followed by online webinars or classes.

 

Franchise Royalties or Managed Service Fee (MSF) Payments

A business typically qualifies as a “Franchise” where three conditions are met:

  • The business grants a licensee the right to use its marks and other proprietary assets;
  • The business establishes and enforces brand standards that that licensee must uphold in order to be allowed to continue to use such proprietary assets; and
  • There is a financial relationship between the business and the licensee.

In most franchise systems, the “financial relationship” element is usually met in two ways: a one-time upfront payment (known as the “Initial Franchise Fee”), and an ongoing payment (known as the “Royalty Payment”). The Royalty Payment is normally paid monthly or quarterly and can be calculated in a few different ways.

The Purpose of Royalty Fees

The typical financial relationship between a franchisee and a franchisor can be looked at similarly to that of say a tennis or golf club. While the initial franchise fee can be seen as the upfront cost to join as a “member” of the franchise system, the Royalty Payments can be seen as the ongoing “membership fees” required to remain that membership. These payments are collected by the franchisor to fund the franchisor entity’s actions, which include both corporate and franchise-related expenses.

In many of the most successful franchise systems, the amount paid by the franchisee as the Initial Franchise Fee will typically be enough to cover the franchisor’s expenses that are related to getting that franchise up and running as a working, successful business. These expenses include training, advertising, and any costs related to securing or approving the location for that franchisee’s business, among other things.

Therefore, the Initial Fee is not where the franchisor is making his revenue. Instead, the ongoing Royalty Payments are how the franchisor makes its money, which it uses to support its franchisees and further build the business.

Generally, franchisees see their ongoing Royalty Payments as tied directly to the ongoing support that the franchisor is obligated to provide them. Though this may not always be contractually the case, it is essentially how most franchise systems work. Generally, all the support provided by the franchisor through its field consultants, marketing plans, business strategies, etc., are funded through the Royalty Payments provided by the franchisees. Additionally, all the administrative costs of running the franchisor’s headquarters and staff are funded from the royalty payments. Lastly, the franchisor’s efforts to further expand and develop the brand through recruiting and bringing in new franchisees to the system is funded by royalties.

How Much a Franchisee Should Expect to Pay

There are a number of ways that franchisors establish what their ongoing royalty fee will be. The most common is a percentage of the Gross Sales that the franchisee earns. Typically this ranges from between five and nine percent.

So, essentially, the franchise is taking in 91-95% of their gross sales with the rest going to the franchisor. Gross sales are the amount of revenues from the sale of services, goods, and any other products or merchandise by the franchise and is not reduced by any discounts given to employees or family members, taxes, or returns/credits/allowances/adjustments.

In most franchise systems this percentage is fixed, but it can also be an increasing or decreasing percentage depending on the level of sales. Some franchisors require a minimum royalty payment for each period, whether by a percentage or by a set Euro amount. There are also franchisors that determine the royalty amount as a set Euro amount based on different sales thresholds. Further, some franchisors don’t require any ongoing royalty payment at all.

The most successful franchisors will take great care in determining what their required royalty payments will be, whereas some franchisors will just use whatever their competitors are requiring, or just pick a number with little to no basis for it. Ideally, the franchisor will set the royalty amount at a level that will allow the franchisee to take home a healthy enough profit, after all expenses, such that the business will be able to succeed both initially and ongoing. The best franchisors will look into the unit economics that they expect from a franchisee’s business, including labor costs, product costs, rent, etc., and find a level that allows both the franchisee and the franchisor to make money. Many franchisees expect that their profit margin for their location will be equal to or more than what the franchisor is making off that location, but this is not always the case, particularly in poorly run franchise systems. In situations where it has been determined that operating a single location is simply not going to produce enough revenue for either the franchisee or franchisor (or both) to make a profit, some franchisors will require franchisees to purchase multiple locations, where the revenue pool can get large enough for the margins can become profitable.

Different industries and revenue models lead those industries to specific strategies for setting royalty amounts. There is no one way that is required, so franchisors can get as creative as they’d like.

 

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