Master franchising is the franchise structure of choice for most franchise systems expanding beyond their country of origin. A master franchise deal requires the setting of a number of fees and at two levels; (1) between master franchisor and master franchisee and (2) between the master franchisee and the unit franchisees in the target country.
Commonly, a master franchisee pays an initial franchise fee to acquire knowledge and expertise about the business model and to receive the right to develop the business in the new market, including the right to use and sub-license the use of the system’s trademarks. This fee represents a return on the original investments made by the franchisor to develop the business model and a recovery of direct costs incurred by the franchisor in sourcing and setting up the master franchisee. To make the expansion successful, there must be good value for all stakeholders.
Additionally, while the dollar amount of the fee is important, the structure of the fee arrangement is important too. For example, should the fee be a large upfront amount paid on signing or should part of the entire fee be linked to the performance of the master franchisee? Since upfront fees reduce risks for the franchisor and increase risk for the master franchisee, the structure of the fee affects the behaviour of both the franchisor and the master franchisee. Therefore, getting the fee and the structure associated with the fee right is critically important to the success of the international expansion.
Beyond the initial master franchise fee, a typical master franchise deal involves the setting of initial franchise fees and continuing royalty fees for the unit franchisees, as well as incidental fees for renewal and assignment at both the master and unit level. The division of the fees paid by the unit franchisees, between the master franchisor the master franchisee, also needs to be determined.
The Initial Master Franchise Fee
For the master franchisee investor, return on cash and capital appreciation are very important. However, anyone experienced in this area will tell you that the decision to invest in the franchise opportunity is often a decision made with a heavy emotional component; the investor likes/loves the concept, feels pride in importing a brand from another country and/or sees personal benefits in bringing opportunities to others in their country.
Unfortunately, other than the experience of those who have done a number of these deals, there is very little to no reliable statistical data about ‘market’ rates for fees in international franchise agreements. This is not surprising, given the number of potential and very diverse markets, franchise systems and industries which would need to be analysed.
These fees will be influenced by many factors, including the length of the term of the grant, the history of success of the franchise system, the amount of training and initial support to be provided by the franchisor and the level of additional investment required of the franchisee. Drawing analogies to other existing systems, with such franchise structures, can be helpful in deciding upon the amount to charge or pay, but it is best to relate the fee to the potential for profit and return on capital of both parties.
One of the most common mistakes made by master franchisors in this area is to set the fees too low. One way to alleviate this problem is to set a minimum amount and calculate the final fee based upon the performance of the franchisee, either by number of units opened or percentage of sales or some other basis that increases the front-end fee as the system is expanded within the territory. On the other hand, master franchisees often pay too much for such fees upfront, which can drain the master franchisee of much needed capital during the critical early stages of development of the territory. For the franchisee, the best approach is to fix the amount of the initial franchise fee, but have its payment dependent upon the number of franchises opened over an extended period of time.
Significant return
At a minimum, most franchisors would want to set the initial franchise fee to at least recover its costs for establishing the franchise in the foreign country. From that point forward the task becomes more complex. The franchisor may very well want to and be justified in adding to those costs a ‘goodwill’ value for the use of the brand name and/or an ‘opportunity’ value. The opportunity value, for want of a better definition, would be some value for the fact that the franchisee will be able to earn a significant return on its investment (if that is the case) simply by implementing the franchise expansion in the foreign country. This value will vary country to country depending upon the potential for development of the system in each country. A master franchisor will normally look to recoup its standard IRR (Internal Rate of Return) on any investment it would customarily make if it had decided not to use the capital to franchise in that market.
A master franchisee may also look at the time it takes to recoup the initial franchise fee in its evaluation of the offering. A two year payback is terrific and a five year payback is often acceptable. Some of the variables are the amount of the fee, the length of the term granted and the amount of additional investment required.
Who gets what?
Without a doubt, the most poorly-handled issue in master franchising is the division of the front-end franchisee fees and continuing royalty fees for the unit franchises in the territory, between the master franchisor and the master franchisee. These amounts are usually set by the master franchisor and are often the principal, if not only, source of profit for the master franchisee and the master franchisor in the target country. It is not unusual for the franchisor to base its decision on the allocation of these fees on its anticipated or desired return from the development of the system in the territory without serious or careful regard for how the master franchisee will finance the necessary development and support services for the unit franchisees. Mistakes with this issue will either ensure the demise of the master franchisee or reduce the quality and performance of the system in the territory.
For example, if the continuing royalty is set at 6% of gross revenue of unit franchisees and the franchisor decides it is entitled to 3%, when it costs 3% to do a proper job of developing and supporting the system in the territory, the master franchisee is faced with either making no profit on royalties or reducing the level of support to the unit franchisees. If, however, the franchisor keeps some of the responsibilities for administering the system, such as Internet management, training or supply chain management, the 50-50 split on royalties might work. The problem is even more apparent in the division of the initial unit franchise fees. Such fees are often, at best, compensatory to the master franchisee for the costs of properly setting up the unit franchisees. Therefore, where the master franchisee assumes all of the responsibility and expense for establishing the unit franchises, but the franchisor takes a percentage of the initial franchise fee, something has to be compromised. The point is that the responsibilities for the development and administration of the system should be decided first as between the franchisor and master franchisee. Then the division of the various fees should be based upon the costs of discharging those responsibilities and only after that should the parties divide up the remaining profits.
Unit economics
The starting point for any effort to establish fees in international franchise agreements should be the financial projections for the unit franchisees. If fees are set at levels that are too high for unit franchisees to be appropriately profitable, then the system will fail in that country and the franchisor may find itself enmeshed in litigation with the master franchisee or even unit franchisees. If fees are set too low, then the franchisor will be missing out on greater financial rewards for its efforts and the use of its valuable intellectual property.
Getting closer to the ‘sweet spot’ on fees for any particular country is solely dependent upon the amount and quality of the research done by the franchisor. And this means securing accurate information about every conceivable aspect of how the unit franchisees will be able to operate successfully in the foreign country. While the experience of the franchisor in its home country will be the logical starting point, it will be important to test all assumptions against the realities of the foreign jurisdiction, including cultural differences, labour costs, supply costs, buying habits, etc. Done thoroughly and correctly, this will inform the franchisor about the potential financial returns from the operation of the system in the foreign country, regardless of who plays the role of the franchisor.
From there, it is best for the franchisor to investigate what the full costs will be for a master franchisee to operate the franchise system in the foreign country. There are many variables which could make it a very different proposition than is the case in the home country; franchise sales commissions could be different, the time it takes to close deals might be longer, geography or infrastructure challenges might increase the cost of field supervision and the supply chain and labour costs might be higher.
Once these investigations are complete, and the financial model for unit franchisees, the master franchisee and the master franchisor are prepared (ideally with the help of local advisors, to take into account any local variables) the franchisor will have a picture of what fees are sustainable and, accordingly, what gross revenue might be available for division between the master franchisor and the master franchisee.
How the world really works
The chances of success in an international franchise expansion rise dramatically, when the franchisor takes the time to investigate the target country thoroughly and analyse the findings well. Nowhere in the process is this truer than in the determination of the fees to charge in an international master franchise agreement.
About the author
Edward (Ned) Levitt is a Certified Franchise Executive, a partner at Dickinson Wright LLP, Toronto, Canada, and provides legal services to Canadian and international clients on all aspects of Canadian franchise law
