How to calculate a franchise fee isn't a question that has a straightforward answer. Business and economics experts refer to this process as both an art and a science because of the diverse, complex factors that play a role in the fee determination. Ideally, the established franchise fee will be fair to both the franchisor and franchisee.

What Is a Franchise Fee?

When you purchase a franchise, you become a business owner while benefiting from the goodwill the product or service has already established in the market. The franchise fee gives you the right to use the franchise name, logo, and branding for a specific time period.

You will also receive materials and training from the franchise company. They guarantee in the franchise agreement that another franchise will not open within a certain distance of your location.

What Factors Are Involved in Determining the Franchise Fee?

Some of the basic factors considered when establishing a fair franchise fee include:

  • The value of the trademarks and branding for the business in question
  • Costs associated with site selection
  • The extent of territory around your franchise that will be protected from competition
  • The cost associated with recruiting and selecting a franchisee
  • The cost of providing the initial training program
  • Franchise development costs
  • Advertising and marketing expenses
  • Marketing materials
  • Personnel hiring costs
  • Sales costs
  • The cost of providing on-site support
  • The potential profitability and return on investment (ROI) of the proposed franchise
  • The amount of gross profit the franchisor will net from the fee, often around 25 percent of the total fee amount or even higher

Although many businesses set a franchise fee based on the fees set by their competitors, this is not necessarily the most effective method of establishing this fee. That's because these fees can be dramatically different even within the same industry. The major source of revenue should come from the sale of products and services by franchisees and from royalty fees, not necessarily from initial franchise fees. Establishing a franchise fee that is too high can discourage good candidates.

Some companies even decide to set a low franchise fee to encourage new franchisees to buy into the business. Often, they plan to make up the "lost" money over time in royalty fees and sales profit from the franchise. However, setting the franchise fee too low may leave the franchisor short on funds that can be devoted to franchisee support and services, thus limiting the available profit franchise locations can earn.

Are Franchise Fees Tax-Deductible?

As part of your business start-up costs, franchise fees are subject to a partial tax deductions. Normally, a large percentage of these costs can be deducted after the business's first year in operation. Franchise fees, however, must be spread out (amortized) over 15 years or over the duration of the franchise agreement.

To determine the amortization amount, divide your franchise fee by the length of amortization. For example, if the franchise fee is $100,000 and the franchise agreement is longer than 15 years, divide the fee to get an annual deduction amount of $6,666.67.

You can also opt for monthly amortization. Divide your yearly amount by 12. With the example above, your monthly deduction amount would be $555.56.

Franchise fees should be recorded at full value in your business's financial books. It is also listed under the intangible assets section. The yearly or monthly amortization amount must also be recorded. This should be done the same way every time no matter what amortization schedule you decide to use.

Is Financial Performance Disclosed to Franchisees?

Prospective franchisees may be privy to some aspects of the parent company's financial performance. If the company in question is traded on mainstream stock markets, financial information is publicly available. The more franchises that exist, the easier it is to determine the overall profitability of the business.

When a business has many franchises, they may establish a flat franchise fee even though some locations are more profitable than others, rather than coming up with a new fee for every new franchise. In this way, the high-performing franchises supplement the cost of the additional support that tends to be required of franchise locations that earn less profit.

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