Franchise Fees Upon Transfer – A Common Sense Approach
BY MICHAEL JORGENSEN, EXECUTIVE VICE CHAIRMAN, NCASEF
I recently watched a youTube video that someone had shared of the Australian Parliamentary Joint Committee On Corporations and Financial Services inquiry regarding the operation and effectiveness of the Franchising Code of Conduct. The Australian government is taking a hard look at the franchising model and the various regulations and methods of oversight currently in place. They have sought submissions and have heard testimony from many within the franchising sector, both franchisor and franchisees, as well as financial institutions and scholars.
I like to research, and find the submissions and testimonies very informative. Franchising is a wonderful business opportunity for many and has been for me, but like anything that goes unchecked, it can create issues where the strong can take advantage of the weak. you may not know Lord Acton, the late 19th century British historian, but you may have heard his well known quote, “Power tends to corrupt, and absolute power corrupts absolutely.” I applaud the Australian government for taking this approach and doing thorough research. I am confident that through this process they will implement changes that will improve the franchising model for all stakeholders. One can only hope that governments from around the world will follow their example.
Although my research could have lead me to write about many different items, one particular subject I felt compelled to write about is franchise fees upon transfer or sale. The reason this issue appeals to me is because it seems there is a lack of common sense in the way the fee is applied. I like to apply common sense. my high school history teacher, reverend Sanders, had many catch phrases, but my favorite was when he would say, “Thomas Paine, Common Sense…” which would prompt the class to repeat, “…is not so common.”
Another reason this topic appealed to me is because of the current change and direction in our system. It would be far easier for franchisees unhappy with the current changes and situation to move on if it were easier to walk away with a significant portion of either the investment they made or the equity they have built up over many years. I understand these are two different scenarios. I believe an example would help illustrate the issue at hand more effectively.
Joe Franchisee bought a brand new store for a $270,000 franchise fee two years ago. This store came with a ten-year agreement. Joe’s store is performing well; he opened strong and is seeing double-digit sales increases year-over-year. Joe’s mother and father live out of state and his father has become ill. Joe decides that he needs to move closer to his parents to help them and lists his store for sale, asking $270,000. The calculated franchise fee for the store is $275,000. The total that the incoming franchisee would have to pay in goodwill and franchise fee in this scenario would be $545,000.
Let’s assume Joe was able to get a buyer willing to pay the full price. he would re-coup nearly all of his initial investment plus whatever he was able to make in the two years he operated the store. I would argue that you would need to subtract the salary Joe would have made if employed elsewhere during this period from the calculation. 7-Eleven, on the other hand, received $545,000 in franchise fees and the new franchisee has paid double what Joe paid for the store just two years earlier.
I will get back to the rest of the example with some additional questions this raises, but I want to share an excerpt from the September 14, 2018 Australian Parliament Inquiry testimony by 7-Eleven and an exchange with 7-Eleven Australia CEO Angus mcKay, which also prompted me to choose this topic.
Mr. McKay: Senator, if I may: the vast majority of our stores sell on the open market, so these are transactions between franchisees. That’s our preferred method of transaction. What I would also highlight is that where we—
Acting Chair: Do you have a right of veto over that? If somebody wants to sell their franchise and they find somebody to purchase it, can you interrupt that process?
Mr. McKay: We only have a right of veto over the incoming franchisee, and that’s around whether they meet the standards that we expect within our network. We have no
right of veto over price. We play an important role in trying to make sure the price is fair, that we’re not seeing a store transaction that would put an unfair burden on an incoming franchisee. But our only right of veto is over the individual coming in.
Ms. Kearney: Do you receive an income or royalty for that sale?
Mr. McKay: We charge a franchise fee for the issuing of a further 10 years of franchising to the incoming franchisee, yes.
Ms. Kearney: And that’s over and above the purchase fee that they give to the outgoing franchisee?
Mr. McKay: It is.
Acting Chair: And what scale are we talking about in terms of dollar value there, Mr McKay?
Mr. McKay: Depending on the size of the store, circa $100,000 to $300,000. That would be a broad range.
Acting Chair: So it’s a fairly significant amount of money.
Mr. McKay: It is, and that fee is effectively the IP that we then license to the incoming franchisee to operate that store for the 10 years, so the use of the 7-Eleven trademark and all the things that go with that.
Joe Franchisee only used two years of a ten-year agreement. had Joe remained a franchisee for the remainder of his term 7-Eleven would not have seen any franchise fees for this store during this period. What happens if the incoming franchisee cannot make the income they expected to make based on paying over $545,000 for the store? Could they now try to sell the store for $545,000 with 7-Eleven charging another $275,000 franchise fee? If there were an interested franchisee they would be asked to pay over $820,000!
Looking at the information provided in the FDDs over the years, franchise fees have grown significantly since 2001, when they were approximately $18.3 million. They reached a high of approximately $87.2 million in 2012 and have stayed consistently above $70 million each year. According to the most recent FDD in 2017, franchise fees were approximately $77.48 million. It is important to note that during this time period 7-Eleven also grew from 5,115 stores—3,173 (62 percent) of which were franchised in 2001—to 8,030 stores (Sunoco’s not included), 7,162(89.2 percent) of which were franchised at the end of 2017.
Common sense would indicate that the best way to handle the franchise fee in the event of a transfer or goodwill sale would be to either prorate the fee charged to the incoming franchisee based on the time used of the existing franchisee’s contract, or rebate the selling franchisee the prorated portion of the franchise fee collected based on time still remaining on their existing contract. There would also need to be considerations for administrative costs incurred due to the transfer.
This would solve a number of issues. It would provide an acceptable path for those wishing to exit the system to recoup a measured portion of their initial investment or equity, and ensure that incoming franchisees are not overburdened with debt. Unfortunately, franchise fees have become a large part of the budget for 7-Eleven. A change such as this will absolutely have a financial impact short-term, but will make for a much healthier system long-term. It would also be a step in the right direction to making common
sense more common.