This blog previously discussed the common ways a franchisor makes money.  As we noted, almost all franchisors charge the following fees:

• An initial franchise fee;
• A periodic (weekly or monthly) royalty;
• A development fee or territory fee; and
• A periodic advertising fee.

We also began discussing less-common ways a franchisor makes money.  The first of these was charging “Buildout Fees”: fees for developing a franchisee’s site.  The second was “Rental Fees”: fees for developing a turnkey business and leasing it to the franchisee.

A third way is selling products and services to franchisees.  The franchisor may choose to be the sole supplier of products and services, or it may be one of several suppliers.  The franchisor is most likely to be the sole source of supply if the product or service contains confidential information or trade secrets.

To sell products and services to franchisees, the franchisor would:

1. Form an affiliated company (the “Supply Company”) to sell the products and services;
2. Have the Supply Company develop a supply chain;
3. Have the Supply Company actually sell the products and services; and
4. Have the Supply Company administer the supply chain, the sale of products and services, and the collection of revenues.

Forming a separate company allows the franchisor to:

1. Protect its other companies from liability;
2. Pledge or sell equity in the Supply Company without affecting its other companies;
3. Tailor its business expenses for tax purposes; and
4. Calculate a markup that would be reasonable to charge for products and services.

Although there is no cap on the markup the Supply Company may charge:

1. The markup must be reasonable. It must be low enough that: (i) the franchisee may still make a fair rate of return on its franchised business; (ii) the markup does not place undue strain on the franchisor-franchisee relationship; and (iii) the markup does not breach the implied covenant of good faith and fair dealing present in all contracts.
2. The franchisor must disclose in its Franchise Disclosure Document the amounts the Supply Company receives.

Selling products and services is beneficial to the franchisor because it allows the franchisor to: (i) maintain its quality standards; (ii) protect its proprietary information; and (iii) estimate the amount of the franchisee’s sales.

A franchisor will usually negotiate prices with suppliers.  Purchasing products and services from the franchisor allows the franchisee to obtain the benefit of bulk purchase arrangements.

One well-known franchisor I represent earns over 35% of its revenue from the sale of branded merchandise through its franchised and company-owned restaurants.  Another charges no initial franchise fee and no royalty: almost all of the franchisor’s revenues are derived from the sale of inventory to franchisees.  Although this franchisor’s structure is unusual, it is highly effective in its market.