Appeared in Franchise Canada Magazine May/ June 2008 as a Tutorial
Most franchises require the franchisee to pay a royalty for the right to use the franchisor’s trade-marks and operating system. It is the franchisor’s portion or share of the revenues for allowing you to use the system. The franchisee benefits from using the trade-marks and operating system to increase the value of their business assets and future income by being connected to an established brand. Customers are more receptive to products that are associated with a known brand and this in turn will generate revenue. Once you have found a new customer, the operating systems are in place to assist you in keeping them as repeat customers.
The franchisor uses the royalties to develop an infrastructure that provides ongoing support to the franchisees through;
- Consulting, sharing of best practices
- Arranging suppliers to capitalize on purchasing power
- Research and development
- Operational reviews and ensuring brand consistency
- Accounting systems
- Field support
- Initial training programs
- Ongoing training programs
For a franchise system to be successful royalties need to be both affordable for the franchisee and large enough for the franchisor to be able to fund the necessary support. Business models vary widely and as a result there is no standard royalty amount. Typically, royalties are paid monthly, calculated on the franchisee’s gross sales for the month and usually do not include legitimate refunds or taxes. Royalty amounts are not the same for every system and they can start at 3-4 percent and range as high as 10 percent or more. It is common to find royalties between 5-6 percent for retail franchises and 8-10 percent for service franchises.
There are numerous variations regarding royalty fees. Some franchisors charge escalating or declining percentages, based on different level of sales. Some franchisors do not charge a percentage of sales but instead charge a royalty based on a flat fee each month. Others may charge no royalty at all, but instead earn revenues through product sales.
A flat fee royalty is often used when it is difficult for the franchisor to monitor the franchisee’s monthly sales. This system may seem attractive to the franchisee but the downside is that there is no incentive for the franchisor to work with you to increase your sales. The franchisor is getting a flat fee each month no matter what level of support they provide. The advantage of a flat fee amount is that you know exactly what your franchise costs are going to be each month.
Revenues to the franchisor through product fees are typically used when the franchisee is distributing a product manufactured or distributed by the franchisor. Examples of a product based franchise are gas stations, automobile dealerships or soft-drink bottlers. Product franchising derives income from selling products wholesale to the franchisees, with a profit margin for the franchisor built into the wholesale pricing. The franchisee is required to purchase the product from the franchisor in the license agreement.
Royalties are not usually negotiable but instead are preset by the franchisor. There could be conflicts within the franchise system if one franchisee was paying 4 percent and another was paying 8 percent. For the most part royalty fees are constant and do not change. Exceptions to this would be if you were awarded a franchise when it was fairly new. When you are joining a franchise system at the early stages of growth you may be able to receive the benefits of lower royalties as the small franchise is starting out. As the franchise grows so should the operating systems and support. When you renew your franchise agreement you may be faced with an increase in your royalty fees. Remember that the franchisor has to make money or they will not be in business for long. Low royalty fees do not necessarily result in an advantage. Such low fees could result in the franchisor not being able to provide you with the level of support necessary to ensure the success of the system.
Most franchise agreements have a clause stating that failure to pay your royalties is considered a breach of your franchise agreement and could lead to the termination of the franchise agreement, as well as other damages.
The benefits to paying royalty fees will usually far outweigh the costs. A royalty is a cost of doing business as a franchise. It gives the franchisee the right to operate a business under a proven brand and business model. Always do your due diligence when looking at any franchise opportunity and talk to franchisees. Ask them the questions to ensure that the value for the royalties is there.