Franchise dues:Right, but how wrong?

Franchise systems cannot survive without generating a significant level of ongoing income from franchisees. One-off franchise entry fees rarely tally to anywhere near the funds expended to develop a system, let alone to provide for its ongoing administration and support requirements, and obviously franchisors require a commercial return. Yet over time, the nature and level of royalties and other forms of dues can become a very sore point within systems.

I have, in fact, never encountered a franchise system in which some degree of resentment about the pre-agreed, regular payments to the franchisor doesn’t happen. It can range from mild irritation to full-scale spite, but most franchisees will experience at least a tinge of it at some point. Outcomes range from occasional, spur-of-the-moment tiffs that are silly and go away, to full-scale wars that have resulted in total system collapse and a world of grief for everyone involved.

It is never a problem when franchisees first enter a system because they have been told what they will be up for – often in excruciating detail – whether it’s a royalty on turnover, a flat monthly fee, a requirement to purchase marked-up product from the franchisor, or some other arrangement. But as time goes by and franchisees become used to their businesses and more confident in their roles, there is a tendency to start resenting that monthly cheque to the franchisor. Perhaps this is just human nature.

Roughly a million years ago, when Australian franchising was in swaddling clothes, my brother-in-law Roger Levey founded the Capt’n Snooze network on the back of a successful retail model, and he says that for the first year or more the relationships were great. But then some franchisees started doing exceptionally well and saying, “Hang on. But this is simple. How come we’re paying so much for something that turns out to be easy?” As a franchising pioneer, Roger could not have foreseen this attitude then, but he developed the kind of solution for which he became justifiably noted.

“Just before the agreement was signed, we would go out to lunch and be mates and excited because we were going to make a fortune together and as I picked up the bill I would ask them to agree to come back to the same place, same table, for lunch with me in exactly 12 months’ time. And I told them that by then they would be seeing themselves on the other side of a fence from me. They would protest this because everything was bathed in a glow of warmth and I would say, ‘No. You’re going to see it this way because by then you’ll think you have done it all yourself. Either we will get over it or we won’t’.” I would have dearly loved to have been a fly on the wall at some of those ‘reunions’, but Roger is still mates with most of these early guys, 25 years later. He realised that everyone in the system was in the one paddock, but that you cannot escape that there is a fence between franchisor and franchisee so you learn to live with that – and while the grass must be watered both sides of that fence, it’s the franchisor who invented the tap.

When does doubt set in?

There is no particular time period for the onset of doubt over dues. It is surprising how often franchisees who have worked successfully within a system for ages can – quite out of the blue – decide their ongoing dues to the franchisor are a rip-off. What was OK yesterday is a disgrace today. Same arrangement, same levels and standards of service – but now the fees stink. It’s so common that maybe franchisors should write it into their processes: ‘month

18 – fight over dues’.

One wonders why this is so. People understand that when they commit to a home loan they’re up for the payments until their responsibilities are discharged. The value of the home might plummet, neighbours from hell might move in next week, interest rates might rise at no fault of their own, but it’s accepted that there is no point in going to the bank and saying you think you ‘really should’ be paying less. You might choose to purchase an exotic new car that you think is ‘you’, but after some time, get tired of it. You get over the status reward, or perhaps you’re jaded by the thirst of the thing. There is no point at all in a whinge at the yard, or asking the place to subsidise your fuel. It’s not a warranty claim. It was your choice and if you want to do something about it you have to sell the car for whatever you can get.

This syndrome is more common in some franchise systems than others, but I was curious to know if it’s universal so I thought of the happiest network I know and phoned John O’Brien at PoolWerx. Understanding him to be forthright to a fault, I asked if he had copped any dissent over dues and his response was an incredulous: “What? Are you saying you have run into someone who doesn’t? The thing is you can do everything in your power to make sure applicants understand that you need money too, but it can be hard if they’re a lot more interested in the other stuff. Like what they will get for their marketing levy.” O’Brien’s understanding of ‘the way things are’ is echoed by another straight-shooter, Gary Shearer from SafetyQuip. I knew he had agonised over getting his system’s royalties arrangements fair and transparent because he wanted no landmines in the field. But he says he has found it quite hard to focus applicants’ attention on fees and certainly that is not because they are naïve; SafetyQuip is a complex business and you have to be a fairly serious player to get through the door. But Shearer says: “I find that they’re focused on the concept and set-up. Their accountant has told them the royalty arrangement is fine (because if anything, it’s too generous anyway) so that’s just not an issue. But it worries me a bit that they pay so little attention to being sure it’s absolutely fine with them too.”

On the subject of counting beans, I know that Glen Hickman’s Mr Rentals franchise is particularly attractive to accountants whether it’s for themselves, or their clients – and this, when the royalty (at 10 percent) sits above the mean. The reason the Mr Rentals royalty scrapes the double digits is because the model offers a high average level of residual income from any sale and after a while, the business pretty much runs itself. Hickman says: “The end result is that the franchisee should be able to move away from the day-to-day, while our support and an employee or two of theirs feed them a comfortable regular income. If that is not worth 10 percent I don’t know what is. But occasionally we still have someone say, ‘But system blah only charges this’.”

One of the problems is indeed that a franchisee might compare Hickman’s 10 percent to, say, SafetyQuip’s 5.25 percent and say, “Can this be right?”

Spot the difference

It is, because the businesses bear no resemblance. A business charging royalties of 22 percent can actually represent a better deal than one charging two percent, dependent on a range of factors as long as your arm but including turnover, effort required, costs of running the business, sales of product versus service sales, and levels of franchisor service requirements. Some businesses like Rod

Douglas’s The Money Innovators do pretty much everything for their franchisees, freeing them to concentrate on sales and relationship management. This means an entirely different approach and dues that are going to be higher simply because the costs of franchisor service are so much higher. There is nothing usurious about it and as with any business endeavour, it’s bottom line reward that counts for both franchisee and franchisor.

The point here is that the best systems in the world are going to cop flak, not because they are out of order but because applicant franchisees do not seem to be focused at the outset on how the franchisor makes money from their ongoing activities, in return for what. And there seems to be an impression that most systems operate in much the same way, which they certainly do not. This can make uninformed comparisons misleading and, much more to the point, emotionally volatile tank traps.

Say I am paying royalties. My business is growing great guns, but what I notice is that my monthly cheque to the franchisor is getting bigger and bigger and I start saying, “Wow, this is getting a bit serious. It was alright when I was paying ‘x’ but now I am paying ‘y’. That’s an increase of ‘z’ percent, for exactly the same concept and much the same effort on the part of the franchisor. Can that actually be fair?”

So as franchisee I am musing over this when I run into Bill who is also a franchisee and I learn that he’s paying his franchisor a flat monthly fee that has nothing to do with his turnover. He can make a zillion dollars and still pay exactly the same every month, meaning he gets to keep every additional buck he generates. I raise this discovery over the kitchen table that night, my wife freaks out and suddenly we’re feeling pretty dirty about it. Yes I know I was exposed to all the figures and put my mark on the paper, but no one told me I would end up paying ‘y’ to these guys. And what happens if I keep working like a dog to build the business? They just get more and more.”

As a franchisee I am forgetting a couple of things. Like the concept isn’t mine and I did not have the experience and spent nothing and took no risk to prove it. I see only what works, and not what didn’t. I didn’t spend a cent on developing the system and so took none of the risk in doing that either. And I have forgotten the years when I started and paid next to nothing, yet got attention the equal of everyone else.

What sorts of dues?

It’s not rational but it doesn’t matter. Most of this issue is emotional. On the evidence, it would seem that franchise applicants need to put a lot more focus on whether or not they will remain comfortable with ongoing dues, to run a whole range of scenarios that ensure this, and to understand exactly why the franchisor’s dues arrangement is as it is.

Perhaps there is also an argument for a Roger Levey-style approach, wherein franchisors or their psychological assessment people explain that, however good any system is, there is a curve of franchisee disenchantment that seems to be a natural part of the process. However silly that might seem to applicants at the time, it is something for them to remember should doubts start to arise. I am not for a moment saying this should be compulsory, only that it might well prove to be wise.

Now let’s take a quick look at the most common fee arrangements.

Royalties are a percentage of turnover. At agreed periods, usually every month, you report your total sales and pay the franchisor whatever percentage of that amount is stated in the agreement. Royalties can range from two percent to more than 20 percent and while I believe the sector mean sits at six to seven percent, it would be facile to compare systems on the basis of whether they are over or under the mean. A business model that has a high component of product sales will generally involve a considerably lower royalty than one dependent on a large sales-of-services component. This is simply because in the first example, the franchisee is making a considerably lower net profit in proportion to turnover, as the cost of goods is a much bigger factor. It will also be impacted by the level of services it is necessary for the franchisor to provide for franchisees to efficiently operate, compete and grow their businesses. And more besides. One advantage of a royalty system is that in the early stages of their businesses, when turnover is low, franchisees are paying very little and this helps them to get on their feet. Another is that it provides the franchisor with revenue-generating incentive to help individual franchisees build their businesses as rapidly as possible. One disadvantage is that it is not exactly unknown for franchisees to under-report their turnover, threatening both franchisor income and the stability of the arrangement; however this is being overcome by increasing establishment of computerised point-of-sale systems linked directly to franchisor administration.

Flat fees are as simple as that. The agreement is to pay a set amount per month for the duration. The advantage to franchisees is strong incentive to get their heads above water fast and that any income growth above a break-even point (that factors in the fee) is going to be theirs alone. An advantage to the franchisor is simplicity and the removal of any temptation by franchisees to under-report. One disadvantage to franchisees is that at the outset, when turnover is low, the fee is a fixed cost that can be difficult to meet. Another is that the franchisor has no financial incentive to help their businesses grow (other than as marketing bait to further continued franchise expansion). A disadvantage to the franchisor is that when territorial saturation is complete, no further growth in income is possible other than through cutting head office costs, which an entire network might challenge.

Margin-on-product involves an agreement by franchisees to source products essential to the conduct of their business through the franchisor – typically exclusively. Advantages to franchisees are that they are paying purchasing costs related only to what they sell or stock, and that the franchisor has an incentive to help grow their businesses, as more sales mean more income. The disadvantages of this system lie largely with transparency. Franchisees may become suspicious about what the franchisor is ‘really’ paying and whether the benefits of any bulk purchase or spot deal are being passed on. And franchisors may have suspicions that franchisees are sourcing stock outside network arrangements, which can be difficult to police. It becomes particularly difficult when franchisees find that, while taking every advantage of the brand and support, they can source stock similar to the franchisor’s at a much lower cost. These deals might well be one-off and product quality comparisons will inevitably be subjective, so a lot of emotional volatility can be involved.

Exceptions occur. For example, George Yammouni’s Mend-ABathroom is a margin-on-product system, but it is different in that the product is a world technological leader and exclusive to the system. Franchisee businesses are dependent on access to that product alone, so outside sourcing is not an issue. And the franchisor must ensure pricing, support and continued technological advancement (which maintains point of difference), build franchisees’ sales, and grow the value of their businesses, if franchisor revenue growth is to be maintained. Although it is a margin-on-product system, the fee structure remains transparent because it is based on unique intellectual property and there is no middleman or broad potential supplier base in the equation.

Some business models are unique and require unique arrangements and I have cited The Money Innovators as such a system. In terms of business method, its uniqueness lies in the fact that it does all of the franchisees’ work beyond sales and relationship management. The consequence is that customers pay the franchisor directly, and it is the franchisor who rebates to franchisees. Franchisee income is 50 percent of initial sales, up to 50 percent on further commissions flowing from those sales, and a program rewarding franchisees according to a variety of quantifiable performance criteria. It’s an unusual formula for an unusual business that makes absolute sense in the circumstance.

My guess is that around 50 percent of Australian franchise systems operate on a royalties basis, 30 percent are flat fee, and 20 percent are margin-on-product and ‘other’.

Good, better, best?

Bearing in mind that there will always be exceptions, is one approach generally better for franchisees and the health of the sector as a whole? Almost certainly. Argument is inevitable and this is a subject likely to become the pivot of a nasty controversy. However the way ahead is to push debate into the open. The Code and its provisions for disclosure have helped lead Australia to the world forefront, but even in Australia, franchisor/franchisee relationships remain a ‘delicate’ issue and it is clear that the whys and wherefores of ongoing dues are a very common cause of contention.

I do not believe that any party is necessarily ‘wrong’ and understand that there will always be exceptions to the rule; however, as it stands:

› Under provisions of the Code and for their own protection, franchisors disclose and endeavour to explain their ongoing fees arrangements to applicants.

› Franchise applicants have an enormous amount on their minds, generally are focused on the immediate ‘get throughs’, rather than the long-term and, despite the best endeavours of franchisors, might not be listening closely enough to what they are being told. Something has gone wrong when a straightforward ‘yes’ becomes a resentful ‘why?’.

› Among franchise applicants and franchisees, broad understanding of the different fee structures that operate and their reasons for being, do not appear to be well understood.

› In the franchising sector, strong communication and understanding are pivotal. A deal is a deal, but one element of the Code is that this is simplistic. Franchisors need to remember it is beholden upon them to ensure that the franchisee ‘understands’. This is shades of grey.

› You can lead a horse to water and see that it drinks, but when it stops, has it finished, and how could you tell? I read somewhere once that ‘the way things are’ have a habit of disguising themselves.

BIO (RETRIVE PIC FROM P.64 FRANCHISING MARCH/APRIL 2004)

Marketing strategist Graham Bauer has been a business development and franchise recruitment adviser to many of Australia’s leading franchise systems for the past 20 years and is a past executive of the Franchise Council of Australia in Queensland. He can be contacted on 0438 910 889.