Choosing a Franchise: How Base Fees and Royalties Relate to the Value of the Franchise

In recent years, entrepreneurs and "corporate dropouts" or former executives (Fortune 1991) have turned to franchising as an attractive alternative to traditional forms of organization. Franchises such as fast food chains, quick oil change operations, and business support companies (e.g., mail and printing services) have experienced phenomenal growth: an estimated 28,000 new franchise outlets were sold in 1991, compared to 13,960 sold in 1986 (Fortune 1991). There are over 370,000 franchise outlets in the United States, accounting for between $200 billion (Bond 1989) and $700 billion (Fortune 1991) in annual sales. This growth in franchising has occurred despite the restriction of freedom and financial costs incurred in entering franchise arrangements. Unlike independent entrepreneurs, franchisees must run their businesses as stipulated by the franchisor. Franchise contracts specify the products sold, retail quality standards, prices, and hours of operation. Contracts also specify a starting date, the length of franchise agreements, renewal periods, and termination clauses. More importantly, franchisees do not keep all locally generated profits: they agree to pay franchisors a base fee and ongoing royalties on sales. Contract terms vary greatly, but base fees typically range from $15,000-$40,000 and output royalty payments vary from 3 to 9 percent of gross sales. "How-to-franchise" resources suggest that the primary reason for this tremendous growth in franchising as an organizational form is that franchisees gain valuable advice, assistance, and a "proven formula" for running a business that increases their chance of success (Bond 1989, Norback and Norback 1982). Entrepreneurs (franchisees) purchase the right to use a franchisor's brand name and are provided with an array of support services that assure the value of the franchise. Contracted services typically include startup assistance such as site selection, lease negotiations, and field training, as well as ongoing services such as central data processing, inventory control, and field operations evaluation (Bond 1989). In sum, entrepreneurs entering into franchise agreements incur substantial restrictions and financial costs. The franchising literature and the rapid proliferation of fast food chains, quick oil change outlets, and similar businesses suggest that the value of the franchise and contracted services are commensurate with fees and royalties charged. We test this notion by examining whether franchisees receive good value for their required fees. RESEARCH OBJECTIVES Our objective is to assist potential franchisees in determining the value of franchises. We test the proposition that base fees and royalties are positively related and increase with the value of the franchise. We examine whether base fees and royalties demanded by franchisors vary with factors used by potential franchisees as indicators of the value of the franchise (age, growth, and market representation of the franchise operation), and whether they vary with contracted services. In previous studies, researchers have analyzed attitudes about franchising (Knight 1986, Withane 1991), master franchising (Justis and Judd 1986), and perceived advantages of franchising (Peterson and Dant 1990), but they have not empirically addressed how base fees and royalties vary or whether they are related to the value of the franchise. We begin to fill this void in determining the value of franchises. There are two contributions of our analysis. First, we examine whether franchisees receive good value for their base fees and royalties. If base fees and royalties vary with the value of both the franchise brand name and contracted services, we argue that franchisees receive value commensurate with fees and royalties charged. Second, we examine the usefulness of information provided to potential franchisees in databases such as the Sourcebook of Franchise Opportunities, 1989 (Bond 1989) for choosing a franchisor. …