The cost of operating a fast food franchise business is increasing.

• The decision by McDonald's to increase franchise royalty fees for the first time in many years shows how the economic landscape is shifting for entrepreneurs who partner with major corporations.
• Few franchise companies have the brand value of McDonald's, which was operating at below-industry norms for fees, making it an opportune time for them to raise their fees.
• As inflation decreases, the cost of franchising may increase due to rising technology expenses and wage pressures in the job market.

McDonald's raising royalty fees for the first time in nearly three decades does not mean that franchisees across corporate brands will experience an increase in their cost of doing business. However, it highlights the importance for business owners to stay updated on changes in the franchise business model. The economics of being in the franchise business may continue to increase due to various factors, including industry regulation and the cost of technological adaptation.

The change from 4% to 5% in royalty fees at McDonald's, starting January 1, affects franchisees in the US and Canada who are adding new restaurants, company-owned restaurants, relocated restaurants, and other scenarios involving the franchisor, but not existing franchisees. This adjustment brings McDonald's more in line with other restaurant franchises, many of whom already charge royalty fees in the 5% to 6% range, according to Kenny Rose, CEO of FranShares.

The royalty fees for franchise businesses outside of fast food can reach up to 12% or more, as stated by the International Franchise Professionals Group, a membership-based organization.

Here’s what franchisees need to know about the changing landscape:

Royalty fees could continue to rise

Some franchisors may increase royalty fees, following McDonald's lead, if they are below industry standards, according to Keith Miller, a principal at Franchisee Advocacy Consulting and spokesperson for the American Association of Franchisees and Dealers, a trade association.

The McDonald's increase in royalties is in line with the industry average, as stated by the International Franchise Association. Over the past 30 years, 62% of quick-service restaurant brands have adjusted their royalties by an average of 1.3%, according to their data.

The royalty fees charged by Wendy's, Burger King, and Subway range from 4% to 8% of gross sales, as disclosed on their websites.

McDonald's brand offers significant value to franchisors in their competition against corporate rivals.

Robert Branca Jr., who owns several Dunkin' franchises and serves on both the Coalition of Franchisee Associations and the International Franchise Association boards, stated that franchisors compete against each other for quality franchisees. He added that McDonald's, being a well-known brand, has the power to negotiate for a higher royalty fee compared to lesser-known brands.

Not all McDonald's franchisees were content with the new fee structure.

Despite record revenue for McDonald's Corporation, a group of franchisee-owners noted that their restaurants are generating less cash flow today than in 2010. The owners' group advised that reinvestment decisions should be reconsidered as they will not provide a historic return and urged every owner-franchisee to focus on protecting their business, employees, and family.

Franchisees can anticipate one of their highest cash flow years in 2023, according to McDonald's.

Other franchise business costs will inevitably increase

According to Matt Haller, CEO of the IFA, initial franchise fees and royalty rates have remained consistent with the rate of inflation over the past five years.

The cost of opening new business units increased significantly due to inflation in 2022, according to the IFA. The cost of investing in a franchising unit increased by as much as 30% when combined with higher interest costs. In the service industry, there was a compound annual growth rate of 4% to 5% in initial franchise fees from 2019 to 2023.

Franchise fees will inevitably increase due to inflation and rapid technological advancements. These fees encompass royalty fees, marketing assessments, reservation fees, and guest loyalty program fees.

"Things change, and staying relevant to your consumer is crucial for staying in business," Branca said, implying that some costs may need to increase mid-contract.

He gave an example of mobile apps, digital ordering, and electronic menu boards, which may not have been as relevant if a franchise agreement was signed several years ago.

Franchisees and potential franchisees should understand that raising fees can result in increased sales and profits for their businesses, such as marketing investments that attract more customers. However, it's important to note that this is not always the case, and there is a complex relationship between costs and business opportunity that cannot be ignored.

Franchise disclosures are being scrutinized, including by the FTC

A Franchise Disclosure Document is typically the initial source of information for a potential franchisee considering an investment in a franchise business.

Branca is part of a committee that aims to streamline the FDD's information, which is a document that outlines costs and expenses for prospective franchisees. The current format, which can span hundreds of pages, is outdated and difficult to comprehend, according to Branca. The committee's objective is to update the disclosures to make them more accessible and user-friendly for franchisees.

The FDD (Form DD-1) is a document that provides information about the financial health of a company. It includes information about the company's revenue, expenses, assets, liabilities, and equity. However, it may not disclose all expenses that a potential investor should be aware of. Some expenses that may not be disclosed in the FDD include legal fees, accounting fees, and other professional fees. Additionally, the FDD may not disclose any potential risks or challenges that the company may face in the future. It is important for potential investors to carefully review the FDD and consult with a financial advisor before making any investment decisions.

What is the potential income and risks associated with starting a business, and how can I exit the enterprise if it's not successful?

Improved disclosure can help brand growth and franchisee profitability, according to Haller.

The review by the Federal Trade Commission of the Franchise Rule it enforces has prompted an industry effort to address concerns about the franchise relationship. Earlier this year, the FTC sought public comment on its concerns about the effectiveness of the Franchise Rule.

Elizabeth Wilkins, Director of the FTC's Office of Policy Planning, stated in a release that the promise of franchise agreements as drivers of economic advancement and employment opportunities is not being fully fulfilled in certain situations.

The FTC is considering amending the rule, and has received more than 5,500 comments from various sources, including the IFA and major brands such as Marriott, Hilton, Yum! Brands, and McDonald's franchisees. According to previous CNBC reporting, an FTC proposal for these amendments may be released by the end of the year.

Pending changes in federal labor law could upend franchise economics

The National Labor Relations Board is expected to finalize its proposed rule on joint-employer status this month, which is also worth watching.

Franchisors could face higher employment costs under the proposed rules, which classify franchisees as employees or co-employers, potentially disrupting the franchise model, according to Haller.

He stated that if it remains, it may cause franchisors to adopt a corporate approach rather than a franchising strategy.

An analysis by Oxford Economics, commissioned by the IFA, suggests that franchisors may cut or eliminate many of the services they usually offer to franchisees, including training, uniforms, tools and equipment, and customer service standards, and transfer the costs to franchisees.

The Oxford Economics report suggests that the model could also move in the opposite direction, with a change in the law leading to even greater control over individual franchise locations as franchisors strive to avoid potential violations, fines, and litigation. This would likely increase the franchisor's management expenses, such as "more audits, new departments, additional technologies, and the presence of a franchisor's employee on site." As a result, franchisees should anticipate that some of these expenses will be passed on, potentially reducing their return on investment.

Franchise owners should take an active role and organize

Franchise owners should stay informed about their franchisor's fee and policy changes to prepare for potential cost increases and regulatory changes.

According to John Motta, chairman of the Coalition of Franchisee Associations, franchisees should organize among peers to defend their interests and business models. He recommends that franchisees get involved in their franchisor's advisory council if one exists to gain a "sense of what's ahead."

If there is no council, it could be beneficial to establish one to facilitate communication with the franchisor, according to Motta, who owns 32 Dunkin's across New Hampshire and Virginia.