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Dec, 07 2010

Why you pay what you pay

The franchise fee, though a stipulate amount that a franchisee has to pay to the franchisor in lieu to his services, needs lot of deliberation for an educated and well-informed business decision.

THE franchise fee is a sort of a security deposit in lieu of the franchisee's commitment. A one-time payment, it is non-refundable in most of the cases and is a way of raising capital from expansion. Though many believe it's not fair to charge one-time payment, as the franchise fee is included in both initial capex and set-up cost of the franchise unit. It increases the cost of acquiring and setting up the franchise unit. This cost is significant while taking up master franchisee contracts, especially for international brands, in which the franchisee fee is a major element of the acquiring cost.

Notably, the franchise fee is in addition to the accruals realised from new store sales. Service tax of 10.5 per cent is applicable on the franchise fee. This is an additional burden on the franchisees though most franchisors believe that it's all the more important to charge tax.

What decides the amount to be charged?

Incidentally, there is no empirical formula to calculate the franchise fee that a brand should charge from his franchisees. Typically, the thumb rule follows, bigger the brand, higher the fee. Since brand equity is difficult to be defined in a quantitative equation, the franchisees seldom have any negotiation capacity, for how much is too much. In business like food and beverages, where lot of hand-holding is required to replicate the original model, the franchise fee applicable is higher (Rs 7-15 lakh) for fine dining formats. So, the fee will vary, depending on the format. For instance, say a coffee shop charges Rs 3 lakh for a 500 sq.ft sized format. Now, if they have another model with much less franchise fee of about Rs 1.5 lakh, they would offer a 300 sq.ft format. Retail franchisors deliberately keep the fee much less than their peers, owing to the relatively high set-up cost, which the businesses seek. Brand equity as well success of the model are major enablers in deciding the franchise fee chargeable. It is not unfamiliar that established and well-known brands charge franchise fee running into crores.

Competition as well as peer pressure can lead to lowering of the franchise fee, as has been witnessed in the education sector. While brand owners compete with one other in order to tie up with the best investor (in terms of capital as well as commitment), the investor also gets the advantage of having so many brands to choose from. Hence, competitive lowering down of the franchise fee can be anticipated. Though in the same breath do remember, with the increase in the number of brands, the hierarchy of good or bad brands is bound to get more rigid. Hence, a relatively better brand should charge a premium on its  services and hence, a higher franchise fee.

A fresh change

Lately, a fresh trend has been witnessed in terms of the franchise fee with some franchisors taking up a more variable approach, i.e., instead of a fixed fee at the time of commencement of the contract, they split the amount into periodic payment. This is a comfortable approach for the franchisee, as the initial cost is reduced. However, it makes the franchisor's situation riskier, as the fee is then subject to the performance of the unit. Internationally, this is an established practice, the initial percentage is decided and accrual from a said period, say quarterly or half-yearly, is credited from the franchisee as per the said rate. But franchising happens a little differently in India as compared to the western markets. With the brand owner risking his brand equity as well as cost of opportunity while expanding through franchising, he must do some undercutting of the risk involved. The franchise fee is an indispensable component of the contract and the investor, indeed, is recommended to read between the lines while evaluating his prospective investments.

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