Franchises – What’s the cost of cloning success? The Initial Franchise Fee

As an alternative to starting a business from scratch, the beautiful thing about buying a franchise is that the franchise is a proven business model which can be readily replicated by virtue of strong brands, tight marketing, purchasing power and a franchisor who well and truly knows the ropes.  As an established brand, consumer search costs are low with a franchise and significant goodwill already exists.

Too easy. 

However, like many beautiful things, a franchised business costs money.  From a franchisor’s perspective, the costs need to be carefully fixed to ensure that the franchise model will be a viable and profitable model for expansion of the
franchisor’s brand and profits.  From a potential franchisee’s perspective, the costs need to be carefully scrutinised to assess precisely what the franchisor is providing.

Costs can be neatly analysed in the categories of initial payments and ongoing payments.  Here we review the initial payment.

The Initial Franchise Fee – What’s it worth? …Worth scratching the surface

 

Although the Initial Franchise Fee may have the flavour of a one-off initial fee, this can comprise a number of beasts and reflect a multitude of factors.  This may represent:

  • an upfront licensing fee to operate a business under the franchisor’s name or on the franchisor’s premises;
  • set-up costs, in particular training, site selection, site development, consultation on equipment, staff recruitment, assistance with and promotion of the business launch; and / or
  • to a certain extent, recovery of costs incurred by the franchisor in developing the franchise.

The precise nature of the fee is important as this may have significant tax implications for a new franchisee as to whether they are entitled to an income tax deduction in respect of franchise fee paid.  The fee may be of a capital or revenue nature and may or may not be tax deductible.  In order to be entitled to claim an income tax deduction, it may be that an expense be incurred in gaining or producing assessable income or be necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.  Conversely, where the expense is of a capital nature, it may be that no deduction will be allowed.  Therefore, close scrutiny of the Initial Franchise Fee is warranted from this perspective.

The amount of the Initial Franchise Fee can vary enormously depending on factors such as the strength and recognition of the brand, the length of the franchise contract and the extent of the franchisor’s involvement in setting up the business.
A potential franchisor should carefully consider the figures and what is being provided in order to assess whether entering into the franchise agreement is more advantageous than starting a business from scratch under their own brand and developing their own business system.

Although not typically expressed as an Initial Franchise Fee, the franchise arrangement may include an upfront franchise deposit that may or may not be non-refundable depending on certain factors.

Any Initial Franchising Fee will be included in a contract or other commercial documentation. Because the requirements are rigorous and comprehensive, both a franchisor and potential franchisee should seek legal advice on whether this
complies with the Franchising Code of Conduct, including minimum business conduct and disclosure requirements under the Franchising Code.

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