Is new franchisor's lack of royalty a red flag?

Sean, great question!

First let me say that I know nothing about David Bradley Chocolatier (DBC) other than that which is contained in your post and readily available on their website.  It would appear as though they might be considered a ‘Product Franchise’.

As you may be aware, franchising began with ‘Product Franchising’ and the Singer Sewing Center way back in 1858.  It was not until the mid 1900’s that men like Howard Johnson and Ray Kroc began to introduce ‘Business Format Franchises’ which is what most people think of when they hear the term franchising.  There have been and continue to be many successful Product Franchise concepts, with Auto Dealerships, Beverage Distribution, and Tire Stores dominating the classification.  Product Franchising operates much like a distributorship, in that the franchisee purchases trademarked goods from the franchisor and then sales those goods at retail.

With all of that said, YES, this approach does in fact work, SOMETIMES!  One of the cautionary aspects of a “New” Product Franchise is that all too often they pop up quickly in response to a FAD.  And as we all know those things which ‘get hot quick’ often ‘burn up quick’.  Chocolate certainly is not a FAD.  People have been consuming it for more than 4,000 years.  Hershey, Nestle, and Ghiradelli have all made names for themselves in feeding our appetite for this sweet confection, however most of us on an everyday basis are not indulging in gourmet, hand dipped chocolate treats at a cost of $23 + per pound.

A ‘Red Flag’ is anything which causes us to ask additional questions.  The product purchase/lack of royalty was a ‘Red Flag’ to you.  Obviously, you would want your franchisor to have the cash flow and profitability needed to continue to refine, improve, develop and expand the concept.  One must ask “will they be able to achieve that from the price that they charge franchisees for product”.  The next question is, “after paying a price for product that covers the costs associated with production and then inflated to cover the cost associated with supporting the franchise system will you still be able to sale the product at a price and in quantities which will allow you to make a profit?

DBC may be the next McDonalds, or Subway, but as I see it, based on very limited information there are some real concerns. 

• You’re basically dealing in one product, EXPENSIVE CANDY! 
• You’ll have little or no control over the price you must pay for product.
• The concept would suffer during economic down turns.
• DBC aggressively markets its product online through its website, through fund-raising activities, and through affiliate programs.    As a franchisee will you receive revenue from these activities if and when the customer is in your territory?
• DBC although having been in business since 1978, it has no track record in franchising.  It should also be noted that the first 23 years of being in business they operated under the name Sophisticated Chocolates.

I checked out the California Department of Corporations website to see if perhaps I could locate a UFOC.  They do not appear to be registered in CA, not surprising being that they are new and based on the east coast.  If this is something you’re seriously considering, you’ll be able to gleam a great deal of information from their UFOC upon receipt.

From all that I’ve read their candy is delicious.  It certainly looks yummy on their website.  So in the event that you become a franchisee send me a sample.  I love chocolate, but I’m not likely to pay $23 dollars a pound when a Whitman’s Sampler at Wal-Mart makes my sweet tooth happy and only lightens my wallet by about 5 bucks.

Keep us posted as you learn more about David Bradley Chocolatier, and if I can be of any additional help do not hesitate to ask Dear Franny, here at Blue Maumau.

Franny

P.S.  If you are simply interested in a franchise involving candy, you may want to take a look at Candy Bouquet a proven low cost franchise concept that offers a variety of profit centers.

Dear Franny,

Mr. Hicks and Mr. Kelly both bring up interesting points. I have always wondered why a franchise model without royalties could not work.

Who cares if a franchiser's revenues come from royalties or from product sales if the product can be priced competitively? I know it goes against traditional franchise wisdom. E.g. In a healthy franchise system, royalties pay for ongoing franchiser operational costs and franchise fees pay for franchiser developmental costs. It's generally seen as dangerous if royalties cannot buoy up a franchise system's operational costs. Generally Accepted Accounting Principles want the seller to offset a given revenue stream with the matched expense. But that can be done through product mark-ups as well.

What if a franchiser was able to make significant innovations by dropping the cost of their goods compared to the competition? Or what if their products were a premium item with high mark-ups to more easily cushion margins through the sale of its product without it cutting into the competitiveness of its franchisee?

You might argue that innovations in cost cutting will eventually be whittled down to nothing as the competition catches up in say, year ten of the franchisee agreement. You might also argue that there is an increased risk that margins for premium goods will become tight as through time premium items can become a commodity. But some premium goods are highly unlikely to become commodities and can more readily absorb small franchise mark-ups, e.g. diamonds, gourmet chocolates, 6' roses, vintage wine, etc.

Regards,
Unconventional

Franny (Jim?):

If my identity wasn't clear, I apologize.  I tried to make it clear with the blog post reference, but guess that didn't do it.  I also thought "Franny" was Don, who knows me.  There's no "set-up" or any hidden intention behind the question other than stimulating conversation about an (somewhat) unconventional approach from the standard royalty. 

I don't have a lot of experience with franchise systems that derive most of their revenue from product mark-up, so I'm interested in hearing if there are upsides, or franchises where that approach works well. 

A couple of concerns come to mind from a franchisee standpoint.  The first:  is there an agreement that regulates how much the franchisor marks up the product?  Can the franchisor change that price at its discretion?  I recall franchisees of a certain ice cream company suing the franchisor years ago, claiming they could buy the ice cream cheaper in the supermarket, at full retail price, than was charged by the franchisor.

Another concern is that, in my experience, product markup is a very hot issue with franchisees.  (Quiznos, UPS Store and others are in litigation over it.)  Even though royalties are off the gross sales, not profit, they're clear and upfront.  Markup of required purchases can be shrouded in a bit more mystery, and create suspicion.  I had one client go out of business because the franchisees resented the product markup.  Then again, I think Dippin' Dots does pretty well with it.

Again, Jim, sorry if this was the wrong place to post this question.

Sean Kelly
President
IdeaFarm
seankelly@ideafarm.net

Franchisors that supply products or goods to their franchisees are commonly called Product Format Franchises where the franchisor granted the franchisee the right to a product or service and the use of an established trademark, but gave very limited operational support.  The Franchise Agreement may provide for the supply of products through a nominated (could be the franchisor) supplier/distributor, and set guidelines for the acceptable standards of products to be used in the franchisee's business. Should the suppliers nominated not be able to supply the nominated product, a franchisee would normally have the ability to seek other suppliers, provided that the goods meet the standards set. 

"Old fashioned" franchise thinking was that a Franchisor could obtain an income from product supply.  As that is more transparent and could provide an opportunity for abuse by interfering with end prices and their structure, most Franchisors now adopt only a service fee or royalty income which is commonly referred to as Business Format Franchising.

Read more at my Let's Talk Franchising blog. 

Jim Coen
Franchise Perfection
877-469-3002
jim@franchiseperfection.com
www.franchiseperfetion.com