Franchising is one of the best and most profitable business models in existence. Entrepreneurs can buy into an established brand with a great customer base while franchisors can take advantage of a steady revenue stream and rapid expansion. It should come as no surprise that this revolutionary approach to business generates billions each year for the American economy and now comprises over 750,000 unique franchises.
Before you can begin your own franchise journey, it’s important to be as informed as possible. This includes learning a few franchise terms along the way. By the end of this article, you’ll be knowledgeable on royalty fees, how to decipher a franchise disclosure document, what comprises a franchise agreement, and how a franchise discovery day works. With this information in mind, you will be able to discern the best franchise opportunity and start your path to success – the franchise way.
What is a Royalty Fee?
A royalty fee is an ongoing fee that is typically paid each week, month, or on an annual basis by the franchisee to the franchisor.
The royalty fee is generally calculated as a percentage of gross revenue for the given time period, although it may simply be a fixed amount as well. The royalty fee essentially boils down to the price of doing business with the franchisor. If you want to continue using the franchisor’s brand and gain access to valuable training, technology, and the like, make sure to pay your royalty fee.
The royalty fee, essentially a tax that all franchisees must pay, goes towards new innovations within the company, training, administration costs, salaries, and many more costs that national brands accrue. The royalty fee also goes towards advertising costs and product innovations that ensure the franchise stays ahead of the game. Without a steady stream of royalty fees, the franchise would cease to operate. The industry standard for royalty fees lies somewhere between 5-7 percent.
As we’ve mentioned, a majority of royalty fees are calculated as a percentage of gross revenue for a given time period. Gross revenue refers to the amount of sales generated during a given time period before cost is calculated. This type of royalty provides an incentive for the franchisor to invest time and energy into the franchisee. After all, the more revenue a franchisee generates, the larger royalty fee the franchisor will receive.
Fixed Royalty Fee vs. Minimum Royalty Fee
There are two key franchise terms when it comes to royalty fees. A fixed royalty fee entails that franchisees will pay the same fee regardless how the franchise performs. In some situations, franchisors may lower a royalty fee percentage if a franchisee has performed beyond expectations. But a fixed royalty fee means you will pay the same amount each pay period.
A minimum royalty fee is a way for the franchisor to hedge their bet. Many franchisors add this clause into the franchise agreement to ensure they receive an acceptable royalty fee each month. For instance, a franchisor may require the greater sum between a five percent monthly royalty fee based off of gross revenue or a $400 monthly fee. If five percent of the franchisee’s gross revenue is $150, they will be required to pay the $400 monthly fee.
What is a Franchise Disclosure Document?
Another key franchise term that you will come across time and again is the Franchise Disclosure Document (FDD). The FDD serves two main functions: it protects the prospective franchisee against any hidden aspects of the business and it protects the franchisor from misleading claims or false allegations.
The FDD also provides prospective franchisees with a detailed analysis of 23 distinct features of the franchise including various fees, executives, pending lawsuits, and restrictions. The Federal Trade Commission enacted the FTC Rule in 1978 as a way to make the franchise procurement process more transparent. The FTC rule requires franchisors to file an annual FDD with the most up to date information on their franchise.
The FDD must be provided to the franchisee at least two weeks before a franchise sale can be completed. The FDD is the most important document in the franchise buying process, so make sure to read through the FDD with a lawyer before officially choosing to purchase a franchise.
What is a Franchise Agreement?
The Franchise Agreement is a legally binding contract that outlines the exact terms of the franchise relationship between the franchisee and franchisor.
It’s important to note that franchise agreements are legally binding at the state level but not at the federal level. Franchise agreements include certain restrictions, obligations, trademark use, fees, and much more. Franchisees are granted restricted and non-transferable use of the brand’s trademark. The franchise agreement will also detail the exact territory that the franchisee can operate in.
Furthermore, the franchise agreement will include exactly how the franchisee will be trained and what advertising provisions will be made. Finally, the franchise agreement will state certain fees, when the franchise agreement will begin, what information is confidential, certain accounting records that must be kept, and that the franchisee must acquire insurance and cover all costs to ensure the franchisor is protected from all damages. The franchisor also retains the right to terminate said agreement if the franchisee does not comply with any or all of these stipulations.
What is a Franchise Discovery Day?
A franchise discovery day refers to a personal meeting between the prospective franchisee and the franchisor.
This meeting typically takes place at a corporate office or regional office that represents the franchisor. The franchise discovery day is only reserved for the most serious prospective franchisees and usually only done after a thorough background and credit check. Although the exact details of a franchise discovery day vary from company to company there are generally a few similarities that franchisees can find at each.
Prospective franchisees may sit through a group presentation about the franchise’s history, mission, goods, or services – what makes them stand out! Prospective franchisees will also have one-on-one meetings with executives and may even have the chance to interview current franchisees. By the end of your franchise discovery day, you should have a much clearer picture of the franchise, how it operates, and where you fit into that structure.
After your franchise discovery day, it’s important to discuss your impression of the franchise with a legal professional as well as any questions you had answered. Remember, a franchise discovery day is equally important for the franchise as it is to you, so make a good first impression!
So, Now You Know Some Key Franchise Terms!
Franchising is one of the most well-known and widespread business models in use across the nation. Yet, there are numerous aspects of franchising that many entrepreneurs are unsure about. With these key franchise terms in mind, you can stay ahead of the game and feel confident that you know all there is to buying your first franchise.