New York Franchise Law Blog : Franchise Lawyer & Attorney Charles N. Internicola, Providing National Representation of Franchisees and Franchisors

For the "start-up franchisor" (and even established franchisors) determining the appropriate franchise fee and royalty structure for your franchise system is a critical task that will have long standing implications.  The fee structure that you establish will serve as the primary source of revenue for your franchise system and will represent one of the most significant "expenses and obligations" on the part of your franchisees.  Set the fees to high and you risk franchisee and, ultimately, franchise system failure.  Set the fees too low and you risk "franchise system" failure resulting from your inability (as the franchisor) to properly support, develop and expand your system. 

The process of establishing your franchise fee and royalty structure should not be based on a rigid formula or a formula that simply duplicates the fees charged by your "perceived" competitors. Rather, your franchise fee and royalty structure should reflect the unique characteristics of your business, the sophistication of your existing business systems, the strength of your trademarks and your future obligations to maintain, develop and refine your franchise system and the rights of your franchisees.

When establishing these fees, some of the critical factors/principals that you should be considering, include: 

• The Initial Franchise Fee Should Reflect the Value of Your Existing System(s). In many respects the initial upfront franchise fee that you will charge to your franchisees should reflect the value of the existing "system(s)" that you have already established.  Higher franchise fees are usually predicated on valuable, well established and tested "systems" and intellectual property assets.  In making this assessment, consider:

(a)  The legal strength of your trademarks and their USPTO registration status;

(b)  The strength and recognition of your trademarks and trade dress by consumers in the marketplace;

(c)  The competitive advantage(s) that will be afforded to your franchisees by your "established" business systems, products and services, including unique products and sources of supply.

•  The Initial Franchise Fee Should Reflect Your Initial Training Obligations. The initial training of your franchisees will play a significant factor in the development of your franchise system and the success of your franchisees.   Your initial franchise fee should reflect and give consideration to the initial training obligations that you will be undertaking as you add each franchisee.  Your franchise fee must be sufficient to ensure that you possess the necessary financial resources and systems to properly train your franchisees.

• Your Royalty Structure Should Reflect Your Business and be Geared toward Franchisee Success. The relationship between franchisor and franchisee is one of interdependence.  That is, to be a truly successful franchisor, you need successful franchisees.  When structuring the ongoing royalty obligations of your franchisees, consider:

(a)  Successful franchise systems require successful franchisees, so ensure that the ongoing royalty rate reflects the economics of your individual franchise units and does not inhibit franchisee "profitability";

(b)  Royalties must be sufficient to support and pay the expenses associated with your current and ongoing efforts and obligations to continuously refine, develop, recreate and protect the core components of your franchise system.  As a franchisor you will possess some serious and necessary obligations respecting the continued development and refinement of your franchise system.  this is a serious obligation and your royalty structure must be sufficient to properly fund these activities;

(c) Your royalty structure should reflect your business.  Although the typical or predominant royalty structure is based on a fixed percentage of gross sales, start-up (and even current) franchisors should consider possible alternatives that may  better reflect the "unit economics" of their franchisees.

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In certain "franchise sales settings" franchisees are sometimes led to believe that modifications cannot be legally made to their franchise agreement.  That is, to induce a franchisee to sign the franchise agreement - without the benefit of any negotiations or review by a franchise attorney - the franchisee is led to believe that the franchise agreement is a "standard agreement" (signed by everyone) and that legally the franchisor is not allowed to make any changes.  The implication: you might as well just sign the agreement and not waste time or money since "we can't change the franchise agreement even if we wanted to".  

Sadly this misstatement / "myth" leads to a false sense of security and sometimes some big mistakes by prospective franchisees.  To be clear:

• Franchise agreements are negotiable;
• It is not illegal for a franchisor to modify its franchise agreement; and
• It is extremely common for franchisees to negotiate certain aspects of the franchise agreement.

Understanding these facts keep in mind that the extent to which a franchisor may be willing to negotiate the terms of its agreement varies depending on the negotiating power of the parties - one major factor includes the financial resources of the franchisee.  Also, certain core provisions of a franchise agreement - such as the royalty rate, methods of operation and use of proprietary products - usually are not and should not be subject to change.  

Some of the critically important franchise agreement terms that you should be evaluating and potentially negotiating, include:

• Scope of your protected territory;
• Grace periods regarding the commencement of royalty obligations;
• Liquidated damages and liability for early termination;
• Renewal rights;
• Transfer rights; 
• Cure periods for alleged defaults; and
• Potential "rights of first refusal".

Depending on your circumstances and concerns there are many other issues that, as a prospective franchisee, you should be considering.  However, it is critical that, as a prospective franchisee, you recognize that you have the "right" to negotiate the terms of your franchise agreement.  This "right" must be taken seriously.

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