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The following excerpt is from Mark Siebert‘s book The Franchisee Handbook: Everything You Need to Know About Buying a Franchise. Buy it now from Amazon | Barnes & Noble | Apple Books | IndieBound
While every item on the franchise disclosure document (FDD) is important, some may be more important to you than others. One of the big-ticket items you should be paying attention to is money: what you must put into the franchise and what you get in return.
It would be wonderful if there were a simple calculation to figure out your cost benefit, but there just isn’t. Unfortunately, because the FDD is such a complex document, many prospective franchisees try to simplify it, and nowhere is this more apparent than in the items dealing with fees and services (Items 5, 6, and 8).
Frequently, prospective franchisees will focus on either the franchise fee or the royalty and compare it to the competitors’. At a glance, the lowest fee seems the most attractive. Unfortunately, that’s the equivalent of going to a used car lot and buying the cheapest car you can find.
Related: Smart Tips for Successfully Navigating the Initial Franchisor-Franchisee Interview
Focus on royalties
It’s a huge mistake to make your investment decision based on the initial franchise fee alone. While you want a franchise fee that’s reasonable and competitive, it’s only one component of your total investment, and in most franchises, it represents a relatively small fraction of that investment.
For most franchisors, the initial fee isn’t a significant profit center. They have costs associated with marketing the franchise, franchise sales, legal documentation, training their franchisees, and providing them with initial support until they’re up and operating — all of which is theoretically covered by the franchise fee. So, while fees in the tens of thousands of dollars just to join the system may seem excessive, this isn’t where the franchisor makes its money.
Royalties should be much more important in your decision-making process. Let’s say you choose to pay a royalty that’s one percent higher than the fee of a comparable franchise offering. On sales of $500,000, that represents an additional $100,000 throughout a 20-year agreement.
But shopping based on royalty alone isn’t the answer, either. If you were to go to that same car lot and someone were to offer you a ten-year-old Chevy for $50,000, you’d think they were crazy. But if they offered you a brand-new Ferrari for that same price, you’d jump at it. The real question, then, is not price, but value.
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Understand the fees
At this point in your analysis, though, don’t try to assess the value. Just have a good understanding of the fees you’re likely to incur. In addition to the initial fee (found in Item 5), Item 6 of the FDD provides you with a table documenting all the fees the franchisor will collect from you. So, if the franchisor has a 5 percent royalty and a 1 percent technology fee, you’d pay a total of 6 percent. Go through this section closely to determine exactly what your commitments will be.
Also, be sure you understand how these fees are actually calculated. For example, while most franchisors charge franchise fees based on gross sales, some charge royalties based on gross profit (revenues minus the cost of goods sold). Some franchisors may have different definitions of “gross sales” — for example, excluding taxes or gift card revenues.
The one set of fees you may want to view differently as part of this analysis are your advertising fees, referral fees, or national accounts charges. Unlike most other fees, these fees are geared toward driving revenue to your busine