The business of taking charge

The golden rule of franchising, we are told, is that franchisors should not make a significant profit without justification from selling franchises. By the same token, they are not expected to make a loss either. This adage usually refers to the sale of franchises to new franchisees for a new territory/site. But what is perceived to be best practice where the franchisor is granting a franchise to someone who is buying a business from an existing (departing) franchisee?

To find an answer to this question, we need to go back to the golden rule. The received wisdom is that a franchisor should charge by way of an initial franchise fee only such sum as is sufficient to cover the franchisor's costs of enfranchising the purchaser. These costs vary from one franchise business to another, but there is a common thread that runs through most franchise systems in terms of the initial obligations of the franchisor towards a new franchisee. Principally these are selection; training; dealing with the legal formalities of entering into the franchise agreement; leasing agreements for premises and/or vehicles; computer systems etc; training the franchisee; helping the franchisee to set up in business (including recruiting employees); fitting out of the premises; helping with the initial advertising, marketing and promotions to launch the new franchised business. All these things cost money and a franchisor can legitimately seek to recover the costs from the new franchisee by means of an initial franchise fee.

However, to what extent does the same apply in circumstances where a new franchisee is buying an existing franchised business? For many years it has always been considered unethical for a franchisor to charge a full initial franchise fee to such a franchisee, because to do so would mean that the franchisor would be making a significant profit on the grant of a franchise. This is because some of the services referred to previously would not be provided by a franchisor. There are, however, a number of these and other services that a franchisor will usually provide and it needs to be paid for. In particular, the franchisor will have spent time interviewing and checking out the prospective franchisee, training the prospective franchisee, helping him/her to acquire the premises or vehicles from which they will be trading and in many cases assisting the new franchisee with his/her application for a loan from a bank. However, there are other services, such as site selection, helping to recruit staff (these will probably be taken over by the new franchisee) and launching the business, which will not be provided.

As a franchisor and a franchise solicitor in private practice, it has been my experience that there is an additional cost to franchisors that is often overlooked. Franchisors invariably get involved (albeit reluctantly) in the deal between the departing franchisee and the new franchisee and once a deal has been done, in helping with the handover of the franchised business, not to mention, in some cases, helping to lick the business into shape, which the outgoing franchisee may have run down. Generally, as soon as a seller has done a deal with his/her purchaser, there is a tendency for the seller to lose interest and commitment to the business being sold.

How does one quantify such a fee, bearing in mind ethical franchising and best practice? The answer seems to be for the franchisor to charge a fee for the services that in the franchisor's experience it knows the new franchisee will require. These services should be costed and a proper charge made.

Two problems arise. First, if this cost is not quantified at the outset, a franchisor will find it difficult to sell franchises as franchisees would be advised against signing an agreement that requires the franchisee to pay these costs in the future without any idea as to what they might be. Second, putting a figure on such costs at the outset could cost the franchisor dear if it has miscalculated or if, indeed, the true costs have risen beyond those anticipated by the franchisor at the time of signing the franchise document. Both of these points can be overcome if the franchisor states in a franchise agreement that a fee will be payable if a franchised business changes hands and that such a fee is expressed to be a percentage of the franchisor's then current initial franchise fee. This enables the franchisor to keep pace with inflation while at the same time giving some comfort to a new franchisee that there is a cap on the amount to be charged.

Who should pay such a fee? The outgoing franchisee or the new franchisee? It matters not much to the franchisor, who pays the fee so long as the fee has been paid and it is common practice for the obligation to pay to be visited upon the outgoing franchisee. As the new franchisee is the person who is going to benefit from the services for which this payment is made, the new franchisee will usually find that such a fee has been taken into account in determining the purchase price.

Finally, in deciding what the percentage should be, ethical franchisors usually look at their current practice and their current initial franchise fee. They then ask themselves what percentage of their current initial franchise fee relates to services that the franchisor does not expect to provide a purchaser from an outgoing franchisee and reduces the initial franchise fee figure accordingly. To this is added a percentage for services that a franchisor expects to provide upon the sale of a franchise business that would not be provided on the sale of a new franchise, such as helping the outgoing franchisee to do the deal, helping with the transfer of the business etc. Whatever the percentage the franchisor arrives at will at best be general, whether it is 40, 45 or 50 per cent of the current initial fee. It will not be accurate; any more than setting the initial franchise fee cannot be accurate as to the true cost to a franchisor. Different transactions will carry different costs, but by and large an experienced franchisor will have a good idea of what percentage it can safely charge to recover the costs of the services which it will be expected to provide to a new franchisee who purchases a business from an outgoing franchisee.

What is being suggested here, and what best practice requires, is not that either the outgoing or the incoming franchisee should pay for the franchise twice, but that the franchisor can legitimately expect to be paid the costs incurred by it in providing the necessary services. Without such provision, franchisees should not be surprised if their franchisors take less interest in their proposed sale than they should.