Franchise Costs: Initial Fee, Royalties and Total Investment Explained
Short answer: Franchise costs have three layers: the initial franchise fee disclosed in FDD Item 5, ongoing fees such as royalties and marketing fund contributions disclosed in Item 6, and the estimated initial investment in Item 7, which adds real estate, build-out, equipment, inventory and working capital to the fee.
Franchise costs are the payments and investments a franchisee makes to open and run a franchised business. They are disclosed in three FDD Items that the FTC’s Consumer’s Guide groups as initial and ongoing costs: Item 5, Item 6 and Item 7. Reading the three together gives the real price of a franchise, which is always higher than the franchise fee alone.
What are the three layers of franchise cost?
The three layers of franchise cost are the initial franchise fee, the ongoing fees and the total initial investment.
| Cost layer | FDD Item | Paid to | When |
|---|---|---|---|
| Initial franchise fee | Item 5 | Franchisor | At signing, sometimes in installments |
| Ongoing fees (royalty, marketing fund, technology, training) | Item 6 | Franchisor or affiliates | Weekly, monthly or per event |
| Estimated initial investment | Item 7 | Franchisor, landlord, suppliers, contractors | Before opening and during the first months |
What does the initial franchise fee pay for?
The initial franchise fee pays for the right to join the system and the franchisor’s pre-opening services, typically training, site guidance and opening support. Item 5 discloses the amount, how it is calculated if it varies, and whether any part is refundable.
What ongoing fees does a franchisee pay?
A franchisee pays ongoing fees listed in Item 6, usually a royalty, a contribution to a brand marketing fund, and often technology, renewal, transfer or additional training fees. Item 6 shows each fee’s amount or formula, due date and remarks, such as minimum royalties that apply even in a slow month.
Ongoing fees decide long-term profitability. A low franchise fee paired with high ongoing fees can cost more over the term of the agreement than the reverse.
What does Item 7 include in the initial investment?
Item 7 includes every expense category needed to open and operate during an initial period, shown as a low-to-high range. Typical lines are the initial franchise fee, real estate and lease deposits, build-out or leasehold improvements, furniture and equipment, signage, opening inventory, opening marketing, insurance, licenses and permits, professional fees, and additional funds (working capital).
The range in Item 7 is an estimate. Local rents, construction prices and the time it takes to reach break-even move a real budget toward the high end or beyond it.
How do you compare franchise costs between brands?
To compare franchise costs between brands, put Item 5, Item 6 and Item 7 for each brand in one table, use the high end of Item 7 as the planning figure, convert ongoing fees into an annual amount at a realistic sales level, and check Item 19 (if provided) for the sales levels existing units reach.
Then ask current franchisees from Item 20 whether their actual opening cost landed inside the Item 7 range. Their answers show how far real costs moved from the estimate, and they are part of the 8-step franchise selection process.
What do franchise costs look like from the franchisor’s side?
From the franchisor’s side, franchise costs are the fee structure: the initial fee, royalty and marketing fund rates that a business owner sets when franchising a business. Those fees must cover the franchisor’s support costs while leaving franchisees a viable margin, which is why fee design is a step of its own in the guide to franchising your business.
Frequently asked questions
Is the franchise fee the total cost of a franchise?
No. The initial franchise fee in FDD Item 5 is one line of the estimated initial investment in Item 7, which also includes the location, build-out, equipment, inventory, opening marketing and working capital.
How are franchise royalties calculated?
Franchise royalties are usually calculated as a percentage of gross sales or as a fixed periodic fee. FDD Item 6 states the formula, when it is due and whether a minimum royalty applies.
What is working capital in a franchise budget?
Working capital is the cash needed to cover operating losses and expenses until the business supports itself. Item 7 includes an additional funds line that estimates it for an initial period stated by the franchisor.
Related guides
Sources
This guide is general information, not legal, tax or investment advice. Franchise laws change and apply differently to each business. Review any franchise decision with a franchise attorney and an accountant.