Should I care how my Franchisor makes it’s money?

How a Franchisor makes its money is really not as obvious as you may think and with the vast majority of Franchisors it is also not very transparent, even those affiliated to one of the Franchise associations. The best example I have heard quoted is McDonalds where it is claimed that they make more money out of their property than burgers! This is because McDonalds owns the vast majority of their real estate and makes a significant part of their income from leasing these properties to their Franchisees. Indeed the former McDonald’s CFO, Harry J Sonneborn, is even quoted as saying ‘we are not technically in the food business. We are in the real estate business. The only reason we sell fifteen-cent hamburgers is because they are the greatest producer of revenue, from which our tenants can pay us our rent’.

So is the question of how Franchisors make their money something Franchisees should concern themselves with?

Absolutely…. 100% ….because this has a direct impact on your purchasing options, costs and ultimately the profitability of your business. But it is not just how but also how much money the Franchisor makes that you need to know. In fact it is so critical that you need to know this BEFORE you sign your Franchise Agreement, be comfortable with what you have been told by the Franchisor (see my later blog titled ‘Due Diligence – the most critical step in any Franchisee journey’ which you can access here) and get the protection you need in writing, preferably in your franchise agreement or failing this, in a side letter.

One of the foundations of franchising, as a model, was the purchasing power that a Franchisor, with many Franchisees, has over a small standalone business.  Historically the Franchisor would pass such savings/benefits achieved onto its Franchisees which, in itself, was a good enough reason to sign up for a franchise. Sadly, as time has moved on and Franchises have changed hands, new owners have got greedy and started to take advantage of completely one sided Franchise Agreements which allows them to charge Franchisees what they want for the products and services.

Personally, I do not have an issue with any business making money but I strongly believe that it needs to be done in a transparent, honest and ethical way. Even the BFA‘s own ‘Guide to Best Practice in Ethical Franchising‘ says that ‘no Franchisor should have secret sources of income from the operation of the system by Franchisee, e.g. hidden commission, introduction fees or purchasing incentives (eg “kick-backs” or “back-handers”)’.

Franchisor income sources

Listed below are the broad categories of how I believe Franchisors make their money and some of the potential issues I see with them. Many Franchisees will be surprised 😮, others will be frustrated 😠 and a lot will be angry 😡 if they find out their Franchisor is adopting some of these practices unbeknown to them and in direct contravention of the BFA‘s ‘Guide to Best Practice in Ethical Franchising‘.

i. Upfront Franchise Fee

Understandably Franchisors charge an upfront franchise fee to cover training and the initial launch of the franchise although the amounts charged from one Franchise to another vary massively.

ii. Commission payments –  a.k.a. Management Service Fees, Royalties, Franchise Fees, Service Fees…

Based on my own research, the vast majority of Franchisors are completely transparent about the ongoing commissions that the Franchisee has to pay to the Franchisor, which is not surprising, as it’s a contractual commitment that cannot be hidden! What is not always clear to Franchisees is the impact these commissions have on the bottom line of a business.

A commission payment of 10% of sales (Not net profit!), which looks normal in the industry, does not sound like a huge amount but if you are making a 40% margin based on your average selling price, this commission payment to your Franchisor reduces your own margin by 25% (yes 25%) from 40% to 30%. Franchisors ask you to pay this commission upfront even though you may not get paid by your customer until much later. In this situation you are effectively providing the Franchisor with free working capital whilst you are having to fund your own working capital which may be out of savings or a loan.

iiia. Margin from sale of products to Franchisees – a.k.a. kick-backs or back-handers from suppliers but could also include supplier funding of events or supplier funding for capital investments.

Franchisors will always give the impression that they have the interests of the Franchisee at their heart but the reality can be very different, especially when the business is no longer owned and operated by its founder. The franchise prospectus and any marketing spiel will give the impression that you will benefit hugely from being part of a bigger network of Franchisees but they will invariably avoid talking about the pricing of products and services that you are contractually required to buy from them. It is imperative that any prospective Franchisee asks all the right questions in this area, which you can find in a later blog here titled ‘Due Diligence…Ignore it at your Peril’.

The reality is that Franchisors benefit from the purchasing power that they get when their network grows. This will result in either larger upfront discounts to the Franchisor or post event kickbacks or backhanders. The Franchisor can also use their power to get free products from the supplier that the Franchisor then ‘sells’ to the Franchisee as part of the initial franchise fee or maybe when setting up a retail space.

I have heard from some reliable sources that some Franchisors are secretly benefiting by as much as 50% margin on the prices they charge their Franchisees for their products (but this may be even higher in certain industries such as the retail / food sector) which results in some staggering profits when you are dealing with a Franchise network running into the 100’s, if not 1000’s.

What is even worse is that the Franchisor then charges their approx. 10% commission on top of this….the higher the sale price to the Franchisee, the higher their commission….!

iiib. Margin from manufacturing of and sale of product to Franchisee

Where the Franchisor is also the manufacturer of the product that you are selling (e.g. garage doors, kitchen worktops etc.), it is even more critical that you have a clear mechanism agreed with the Franchisor in terms of how they will price the product to you. It is imperative that your Franchise Agreement includes a clause around competitiveness where pricing to you is benchmarked in some way with the wholesale prices of competitors (which will not be easy as this sort of information is not readily available).

The same would apply when the Franchisor leases land they own to the Franchisee like the example from McDonalds mentioned above. The Franchisee needs to ensure that the costs of the lease are competitive with leases for a similar property in the same area. 

Where the Manufacturer/Franchisor also sells the same product through different channels (e.g. blinds) the Franchisee is exposed to some really fundamental risks as the manufacturer could end up selling the same product in different channels at prices lower than you are able to buy them from the Franchisor, resulting in a cannibalisation of the market. This exact scenario came up in recent years with Thorntons chocolates where a new MD decided to change their strategy from selling through high end stores operated by Franchisees to a pile it high sell it cheap strategy with large supermarket chains and garages. In the end Franchisees were being charged more for the product than they could buy in their local Wilko’s but there was absolutely nothing they could do about it and it resulted in the closure of the Franchisees business. 

“Last year, he was selling Easter eggs for £8 that he was buying from Thorntons for £5. At Wilko, that same egg was being sold for £3”

As an aside, I would really question why anyone would sign a Franchise Agreement with the Manufacturer of a product as opposed to just buying direct from them as a trade buyer without any contractual commitment? What if their product quality or service deteriorates or they start charging uncompetitive prices? Once you have signed a Franchise Agreement you are stuck with them however if you had just signed a trade agreement you would be able to move to another supplier.

iv. Margin from provision or sale of services to Franchisees e.g. Digital marketing, PPC, equipment maintenance, insurance etc.

Historically, I believe that Franchisors have not tried to make money out of the services (not much at least!) it has provided to Franchisees but I believe this has started to change in recent years.

Franchisors have spotted an opportunity to make money, either directly or indirectly, out of services such as digital marketing. For example a Franchisor may contract a digital marketing agency and recover these costs along with some margin from the Franchisees. This probably makes a lot of sense as long as the Franchisor is open about the margins they are making from the Franchisee as per the BFA ‘Guide to Best Practice in Ethical Franchising‘. An issue that I hear more and more from Franchisees is regarding the way Google or Bing PPC (Pay Per Click) are being dealt with. Franchisees are now being pressurised by their Franchisor into spending vast sums of money on PPC but the Franchisees are saying that they are not seeing the benefits from the investment and are questioning whether this money is actually being spent on PPC in their geographic area. Google and Bing provide a huge analytics capability to each of their customers to slice and dice their raw data. Franchisees should demand access to the raw data for their geographic area so that they can see directly what is being spent and the value this investment is bringing in terms of leads etc. There are many impressive free and paid for tools in the marketplace that can help with the analysis of the data.

Is PPC the new PPI scandal of the commercial world?

Separate from this, Franchisors are now looking for full end to end control of the supply chain because they do not always trust their Franchisees. In order to achieve this, they are mandating use of central book keeping and accounting services which are then charged to the Franchisee. This means that the Franchisor has full visibility of what is going on within the Franchisees own business. This really goes against the mantra that most Franchisors spout about regarding the ‘Freedom‘ you will achieve when becoming a Franchisee. My advice to anyone is to avoid any Franchise where services like this are mandated because this type of control will only be the tip of the iceberg.

Furthermore, the same principal of transparency around how, and how much, the Franchisor is making out of any contracted services to Franchisees should also apply.

v. Advertising levy a.k.a. National Marketing fee etc.

The concept behind a centrally managed advertising levy is very sound in that each Franchisee pays a % of their sales (typically 1-3%) as a contribution towards a fund that is used by the Franchisor to run national campaigns that are designed to benefit all Franchisees. This all works fine as long as the Franchisor uses the money as intended to the benefit of all Franchisees but it is also open to abuse where the funds are directed towards other activities to the benefit of the Franchisor. This issue has been highlighted by various recent court cases in the UK such as DWYER [Drain Doctor] V FREDBAR & ANOTHER, and other countries have brought in regulation to prevent this from happening, which is exactly what is now required in the UK franchise industry. The Franchisor should provide all Franchisees with a detailed breakdown of the way ‘their money’ has been spent along with the benefits delivered.

vi. Liquidated damages – Franchisors win when you are winning and win when you are losing

Not only do Franchisors win when you as a Franchisee are winning but a certain type of Franchisor, which I believe Sir Geoffrey Cox was referring to when he talked about ‘unscrupulous and dishonest franchises’, use liquidated damages as a means to win when you are losing. 

The Franchise Agreement will lay out the so called ‘liquidated damages’ you will have to pay to the Franchisor when your agreement is terminated, which will be dependent on how much time is remaining in the agreement. In plain English this could require you to pay to the Franchisor the commissions and other revenues (e.g. advertising) that they would have earned from you if you had stayed until the end of the agreement along with the Franchisors costs.

These liquidated damages, which can run into £millions, are designed to ensure that the Franchisor not only wins when you are doing well but also win when you fail and are now being incorporated into their business model. Where is the so called ‘partnership’, ‘family’, ‘shared risk’ ‘collaboration’ ‘trust’ etc. that so many Franchisors talk about in their marketing to potential Franchisees….?

I have also seen senior Franchise lawyers that are affiliated to the BFA talking about how valuable liquidated damages are to help keep Franchisees in line whenever there is a dispute: ‘Communication is key but must be underpinned by the franchise contract and liquidated damages clauses can be useful!’

In my view liquidated damages clauses are clearly being used as penalties in Franchise Agreements, which should be unenforceable in a court of law and even if they weren’t considered a penalty, they are completely unethical.

My very strong advice to any potential Franchisee is that if there is any mention of liquidated damages in a Franchise Agreement, just walk away, because the intentions behind its inclusion are very clear.

So what does the BFA say about payments to Franchisors?

The BFA are very clear in their very useful ‘Guide to Best Practice in Ethical Franchising‘, (which I only saw for the first time 12 months after I left my franchise, despite the BFA saying that it should be shared with potential franchisees prior to singing the Franchise Agreement!), that;

“As a general rule no Franchisor should have secret sources of income from the operation of the system by Franchisee, e.g. hidden commission, introduction fees or purchasing incentives (eg “kick-backs” or “back-handers”). These are in essence payments by Franchisees, since the benefits are retained by the Franchisor and not passed on to the Franchisees.

It is permitted for Franchisors to make a mark-up (or to obtain a commissions, fees or incentives) on products or services supplied to Franchisees, provided that:

• The existence of mark-ups (or commissions, fees or incentives) is made clear to Franchisees (even if the exact amount of it is variable and not disclosed);
• The Franchisor nevertheless ensures that the supply to Franchisees is on terms which are competitive. A franchise that is dependent on Franchisees paying uncompetitive prices for product or service will never be viable in the long term; and
• The benefit of the mark-ups, commissions, fees or incentives to the Franchisor do not compromise the objectivity and good faith of the advice they give to Franchisees as regards the operation of the system. In other words, the Franchisor must act in the best interests of Franchisees when recommending or requiring the use of a supplier. They must not require Franchisees to use a supplier who provides a lesser service, or at a higher price, purely because the Franchisor obtains a direct or indirect benefit.’

Whilst I believe these are great points, sadly this is only ADVISORY and Franchisors, even BFA affiliated ones, can chose to ignore it completely. In fact, I have yet to see a single Franchise Agreement that addresses these issues in the way that the BFA advises.

The Franchisor’s Margin Lever

Franchise Agreements that do not address these issues in a satisfactory way in effect give the Franchisor complete control over how much money they make which has the effect of limiting the margin available to the Franchisee. It’s akin to a lever that the Franchisor can pull at any moment in time to increase or decrease their margin.

Issues around pricing and sharing of margin within Franchises very rarely make their way into the public domain because of clauses written into Franchise Agreements that restrict Franchisees ability to work together with other Franchisees on any issue against a Franchisor (Collective bargaining) or talk negatively about any issue in public forums. One example that did make its way into the public domain is Domino’s (of pizza fame), which happens to be a publicly listed company and meant accounts were public, and Franchisees could see how much the Franchisor was making relative to the Franchisees. Following a standoff lasting a few years, and a change of CEO, the Franchisees successfully worked together to persuade the Franchisor to invest more in the business in return for faster store openings. The problem for Franchisees is that the vast majority of Franchises are privately owned and and therefore accounts are not public.

Another ongoing example of the imbalance of profitability between Franchisor and Franchisee that is in the public domain is the Post office (leaving aside the biggest miscarriage of justice in British corporate history), where the margin is clearly too much on the side of the Post Office which leaves Sub-Post Masters earning the equivalent of much less than the minimum wage for the hours worked.

“Our income is constantly eroded and I believe the Post Office are taking a massive proportion of the money that we generate.” – quote from a Sub-Post Master

The net affect of all of this is that the Franchisee is put in an impossible situation whereby they have to buy their products and services from the Franchisor at completely uncompetitive prices which massively compromises the bottom line of the Franchisee. 

The worst thing is that all of this is perfectly legal because there is absolutely no regulation in the U.K. to protect Franchisees, unlike in most other developed countries who have encountered these exact issues and decided to take action through regulation. Many of the same Franchisors that regulation has been put in place to restrict in other countries are also operating in the U.K.. Do we really think that these same Franchisors will be behaving differently in the U.K.? 

If your Franchisor is very open and transparent about any kick-backs, back-handers or commission payments from suppliers and have a ‘never knowingly undersold’ promise written into the Franchise Agreement, then kudos to them. If they don’t, I would be asking them lots of very difficult questions.

I would love to hear from any Franchisors that have followed the BFA advice in full because your actions need to be celebrated. Unfortunately most Franchisors are unwilling to share their Franchise Agreement template…..what have they got to hide?

The perfect business model for Private Equity companies

With Franchise Agreements like this that give so much ‘control’ to Franchisors over pricing of their products and services, and provide as close to a guaranteed income stream as you can find with very limited credit exposure, there is no surprise that Private Equity companies have been buying up a lot of the mature Franchises in the UK and overseas.

Subway is the latest established Franchisor to fall into the hands of Private Equity so watch this space to see how the relationship between Franchisor and Franchisee progresses…

In Summary….

Franchising is the perfect Business model from a Franchisor perspective with long term contracts, guaranteed income, very limited credit exposure and a very positive cash flow. Because of personal loan guarantees and liquidated damages clauses, they win when you are winning and win when you lose.

But would you ever sign a commercial agreement with a supplier that commits you to buying all of your product from them over the term of the contract without knowing the price they will be charging you? 

I have a sneaking suspicion that the answer to this question will be a resounding NO as it would be the equivalent of commercial suicide! 

So why would you sign a Franchise Agreement with a company that you have no previous relationship with, without knowing the price of the products and services you will be committing to buying?

If you still want to proceed with your franchise opportunity, you should;

1. Get confirmation in writing from the Franchisor how and how much money they, or their partners (Such as digital marketing agencies), are making out of the products and services they supply to its Franchisees
2. Get confirmation in writing from the Franchisor how they will ensure that the pricing of any products and services will continue to be competitive in the market place.
3. Get confirmation in writing that the Franchisor will be transparent about how any national marketing fund, that Franchisees are obligated to contribute into, is spent.
4. Ensure there is no liquidated damages clauses that are designed to be a penalty.

So…..Should I care how my Franchisor makes its money?

Hopefully I have demonstrated to any potential Franchisee the importance of focusing on your due diligence and asking all the right questions about the pricing of the products and services you will be contracted to buy from the Franchisor. The answers to these questions will be fundamental to the making or breaking of your business and with personal guarantees and draconian liquidated damages clauses, the consequences could be really dire for you and your family.

So there is no doubt in my mind that potential Franchisees, (and for that matter existing franchisees), should concern themselves greatly about how and how and much money the Franchisor makes and demand answers if this is not already transparent.  Without satisfactory answers and written commitments, potential Franchisees should walk away from the opportunity.

Time for Regulation

Ultimately it is very clear to me and many other current and past Franchisees that the Industry is conflicted in that they serve the needs of the Franchisors and it is only the U.K. government that can take the necessary action and introduce legally binding regulations to protect Franchisees from what Sir Geoffrey Cox called ‘unscrupulous and dishonest franchises‘.  Otherwise we will continue to see livelihoods, and in some cases lives ruined, which I am sure you will agree, is completely unacceptable.

My request to you…

My request to you is to share your own personal experiences with pricing and margins in the comments box below.

• Is your Franchisor upfront with its franchisees how it makes its money?
• Are you aware of any ‘secret’ commission payments, kick-backs or back-handers from suppliers?
• Do you get a detailed breakdown from your Franchisor of how your central advertising fund is being spent?
• Do you have any other experiences that current or prospective Franchisees would benefit hearing about?

If you are worried about posting your experiences publicly, please share them with me directly through the contact form or via the email link and I can assure you I will protect your anonymity.

Please share this blog with other Franchisees as well as anyone you know that may be thinking of investing in a franchise and ask them to subscribe here for future blogs.

It is worth re-iterating the point that I know there are many great Franchisors out there that act in good faith and are very passionate about making their franchisees’ business a success. Sadly, as with any issue in society, it is always a small minority of people that ruin it for the majority but as the consequences for Franchisees are so serious it is really important that we speak out and even more critical that regulation is introduced to protect them. The focus of this blog is on ‘The Perils of Franchising’ as there is little or no public information available about the real risks involved in investing in a franchise.

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Details about the author and his experience of being a Franchisee can be found here. Just to be clear, the authors’ views expressed in this blog are exactly that….his views, based on his personal experiences, by connecting with many current and past franchisees of many different Franchisors and through his own market research.

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