If you are thinking about buying a franchise, you are probably familiar with the main costs involved. You will need to pay an initial franchise fee when you sign the franchise agreement, and you will need to pay monthly (or weekly) royalties and advertising fees based on your gross revenue. But are there “hidden” costs you should be aware of as well?
While the initial franchise fee, royalty fee and advertising fund contribution are three of the main costs involved with buying and owning a franchise, franchisees can incur numerous additional costs—and we’re not talking about the normal costs involved with running an independent business. Franchisors may impose a variety of other fees, and purchasing restrictions and other terms can further increase the costs of franchise ownership.
7 Examples of “Hidden” Costs Franchisees Will Often Incur
So, what are the other costs you need to be aware of when buying a franchise? Here are seven examples of “hidden” costs that can make it difficult (if not impossible) to build a profitable franchised business:
1. “Additional Expenses” in the Initial Investment Estimate
When reviewing the Franchise Disclosure Document (FDD), most prospective franchisees spend a decent amount of time focused on Item 5. This is the Item where the franchisor is required to disclose its estimated initial investment for getting a franchised outlet up and running.
But, when reviewing the Item 5 table, many prospective franchisees gloss over one of the most important line items. This is the “Additional Expenses” row just above the total. This nebulous line item is intended to cover a variety of expenses—and these expenses (along with all of the other costs listed in Item 5) can vary widely based on a prospective franchisee’s geographic location and other factors. So, while the Item 5 table is a starting point for determining your total initial investment, you should not rely on the franchisor’s estimates exclusively. If you do, you could be in for a shock when you discover how much it really costs to open for business.
2. Renewal Fees
When you buy a franchise, the initial franchise fee isn’t the only lump sum you’ll need to pay to your franchisor. If you want to keep your franchise beyond the initial term (which could be just two or three years), you’ll need to pay a renewal fee as well.
For some franchisees, the time of renewal is just about when their businesses start to turn profitable. But, many other franchise owners are still struggling to find a way to pay themselves at this stage. As a result, needing to shell out another $10,000 or $15,000 (or more) just to stay in business can be a tough pill to swallow.
3. Transfer Fees
If you are like many prospective franchisees, one of your goals may be to build a profitable business under a trustworthy brand that you can sell. While this is a possibility, it also comes with a hefty price tag. Franchisors know that selling a franchise usually means getting a nice payday, and they use their franchise agreements to make sure they get a piece of the action. Transfer fees are usually in the five figures as well. While this may be a drop in the bucket for some well-heeled franchisees, for smaller single-unit owners, it can represent a significant chunk of the profit they earn (or would have earned) from selling.
4. Costs for Purchasing from Designated Suppliers
Along with these one-time “hidden” costs, franchisees may find themselves obligated to pay various unexpected ongoing costs as well. For example, many franchisors require their franchisees to purchase equipment, supplies and inventory from designated suppliers. Since these designated suppliers know they are going to get franchisees’ business, they don’t necessarily have to compete with the prices franchisees could pay on the open market.
While most designated suppliers won’t gouge franchisees, buying from a designated supplier does often mean paying a premium. As a result, when buying a franchise, it is important to find out if the franchisor has designated suppliers—and, if so, to factor these suppliers’ pricing into your pro forma.
5. Costs for Purchasing from the Franchisor
In many cases, franchisees will also be required to purchase certain items from their franchisors—and franchisors will typically mark these up as well. For example, many franchisors serve as the sole source for branded items. While you could end up paying a reasonable price for branded items (or other mandatory purchases), it is equally possible that you could end up paying far more than you would pay an independent vendor.
6. Costs for Mandatory “Upgrades”
All franchisors reserve the right to make changes to their systems over time, and when they make these “upgrades,” their franchisees are required to comply. Not only that, but franchisees must comply at their own expense.
While some system “upgrades” may be relatively inexpensive—and may even enhance franchisees’ profitability—others can require substantial capital investments. If you are required to make an upgrade that you can’t afford, you may need to take out a loan or increase your line of credit in order to keep your franchise.
7. Liquidated Damages (or “Lost Future Royalties”)
Finally, many franchise agreements include provisions for liquidated damages. Also known as “liquidated damages,” these are fees that franchisees have to pay after losing their franchise due to early termination. Depending on the timing involved (among other factors), liquidated damages can present significant and long-term financial burdens for franchisees who were unable to build a successful business—and who are likely facing other liabilities as well.
Discuss Your Franchise Opportunity with Attorney Jeffrey M. Goldstein
This list is by no means exclusive. Owning a franchise entails several costs, and when buying a franchise, it is imperative to make sure you are aware of all of the costs involved. To discuss your franchise opportunity with attorney Jeffrey M. Goldstein (and to learn about our flat-fee franchise business review options), please call 202-293-3947 or contact us online today.
