What’s up with that upfront fee?


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Initial and upfront franchise fee

Recently, the practises surrounding upfront fees paid by franchisees and the franchisor’s entitlement in this regard were in the news. This article features some of the best practices on paying upfront fees

What is an Upfront Fee?

This is a fixed amount, usually payable upon the signing of the franchise agreement, in exchange for the right to use the franchise’s name, logo and business systems. It is also referred to as a joining fee or initial fee.

Why is there an Upfront Fee?

There are 2 important reasons why franchisees need to pay an upfront fee:

  1. This fee assists the franchisor with the development of the franchise business; site selection; lease negotiation; business planning; securing finance; outlet design and build, staff recruitment and training as well as pre-launch marketing locally.
  2. This fee also is also remuneration to the franchisor for development of the concept (“the business know-how”) and to secure rights of operating the franchise in a territory.

What is a fair upfront fee?

  1. There are various considerations to decide what a fair upfront fee would be:
  2. Compare with what the market is charging (remember a franchisor is competing with other franchisors selling franchises)
  3. The capital invested as setup costs including the upfront fee should be recovered in profits by the franchisee within 3 to 4 years of buying the franchise. It is important to note that these profits are after the franchisee has drawn a market related salary.
  4. The upfront fee compensates the franchisor for the development cost of the franchise. Total development costs must be amortised over the projected total number of franchises planned.
  5. Actual direct costs as outlined above should be recouped.

Noteworthy points:

It is interesting to note that an upfront fee may be disproportionate, in that the fee may not be the same for all franchisees. The reason for this is that an outlet in a prime area will certainly be more profitable and provide greater returns than an outlet in a secondary area; therefore a prime area justifies a higher fee.

What constitutes unethical and unlawful practises when it comes to upfront fees?

Franchisors should not keep an upfront fee for a long period of time without awarding a territory and specific site in the territory. For example it could be considered unethical to delay awarding a site and territory as well as not communicating with the franchisee 5 or 6 months after receiving an upfront fee.

Franchisors are not supposed to use upfront fees as their main source of income (they should not be selling franchises to stay liquid or solvent).

The impact of the Consumer Protection Act (CPA)

Section 7(2) of the Consumer Protection Act No. 68 of 2008 (CPA) states that “a franchisee may cancel a franchise agreement without cost or penalty within 10 (ten) business days after signing such agreement, by giving written notice to the franchisor”

The impact that this has, is that an upfront fee paid into a trust would be completely refundable to a franchisee if the franchise agreement is cancelled within the cooling off period. A franchisee must not be penalized in any manner whatsoever (whether it is in any form of cost recovery or by imposing a penalty) in the event that the franchisee decides to cancel the franchise agreement within the cooling-off period as contemplated at clause 7(2) of the CPA.

However the situation would change if the franchisee decides to cancel the franchisee after the cooling off period.  An example of what could happen in such a scenario:

  1. An upfront fee of R150 000 is paid by the franchisee into the franchisor’s trust account
  2. The franchise agreement is signed and the cooling off period passes.
  3. The franchisor incurs costs of R40 000 to provide the franchisee assistance with a business plan, site selection and time spent helping the franchisee.
  4. The franchisee decides not to proceed and cancels the franchise agreement after the cooling off period
  5. The franchisor could keep R40 000 of the upfront fee paid and refunds the R110 000 balance to the franchisee.

Conclusion

There are very valid reasons for upfront fees being paid in franchised businesses and the franchisee should ensure they are negotiating with a reputable franchisor to ensure that these fees are managed in an ethical manner.

Input on the Consumer Protection Act provided by Maria D’Amico of D’Amico Incorporated.

If you have questions or comments on this article, email: melissa@franchisingplus.co.za