When a franchise is bought, there is typically an upfront fixed fee that is paid in a lump sum to the franchisor. This fee essentially covers the set-up, the initial services provided by the franchisor, the value of the intellectual property and the costs associated with training and support.
But when joining or selling a franchise, it is important to remember that this investment comes with a variety of components. One initial payment does not secure the right to operate the franchise with no further contributions.
Though the Franchise Agreement will determine the specific amounts to be paid, an agreement to purchase a franchise usually includes some form of ongoing payments for the continuous use of the intellectual property and brand of the franchise.
These ongoing payments are called royalties.
What Are Royalties?
Unlike upfront payments, royalties are paid on an ongoing basis for the continuous use of something. For instance, an author might receive royalties for every sale of one of their books.
For franchisees, royalties typically cover head office expenses (this could include administration, advertising, and technical support) as well as being paid for the franchise business idea and brand.
The brand recognition of something like McDonald’s is almost impossible to create. But when you buy a McDonald’s franchise, you get this brand recognition instantly. This helps to generate an immediate increase in sales that come directly from this recognition.
Franchise royalties are in place to cover things like this recognition.
Why Are Franchise Royalties Important?
Although at first glance it appears franchise royalties solely benefit the franchisor’s brand and business, this is not entirely true. Royalties are crucial to the success of the franchise business, and therefore of the individual franchise of the franchisee. If the overall business fails or declines, it is likely that the individual franchise will follow.
Most franchisors will reinvest a significant portion of the royalties they earn into the maintenance and development of the brand. This could come in the form of:
- New and attractive products
- Development and maintenance of technology
- Day-to-day management of the business
- Retaining of key staff
- Extensive advertising campaigns
Ultimately, much of what the royalties are spent on benefits the franchisee. However, this is not to say that franchise royalties should always be large. The calculation of these royalties is an important part of the process and helps to fairly balance the business relationship between franchisee and franchisor.
How Are Franchise Royalties Calculated?
As you might expect, these fees differ according to the franchise in question. Each franchise royalty will be tailored to what the specific business has to offer.
In this context, understanding what a fair royalty is requires an extensive review of the franchise agreement. However, as a rough estimate, the most common method will require a franchisee to pay between 4% and 8% of their gross sales each month. This is the key difference between normal royalties and franchise royalties.
For a franchisee, the royalties they pay are commonly tied to their performance in sales. An agreement favourable to the franchisee could potentially calculate this percentage based on the net sales of the franchise. Put simply, this would be the sales minus the expenses incurred. This provides a greater level of protection to a franchisee.
Franchise royalties are typically calculated on a monthly or quarterly basis, although an annual calculation might be suitable for certain franchises.
Other Types Of Franchising Royalties
There are a myriad of other ways to calculate the franchise royalty.
A franchise agreement might include a period of leniency or ‘adjustment’ at the beginning of the franchisee’s operation that requires a lesser payment. For instance, there might be a reduced royalty of 4% for the first 4 months, moving to 8% after that period.
There might be a fixed royalty fee that is not affected by unit sales, and provides the franchisor with a set income every period. For example, the franchise agreement might charge $10,000 per month for the use of the franchisor’s intellectual property.
Another version of this fixed fee that can be paired with monthly royalty calculation is a minimum royalty. This stipulates that a franchisee will pay the higher of the fixed minimum royalty or the monthly percentage royalty. It’s important to note that this method is sometimes seen as unfair on the franchisee as it is commonly imposed when they themselves are struggling.
Variable Percentage Of Gross Sales
The royalty might also be calculated through a variable percentage of gross sales. For instance, a franchise might pay a lower percentage of gross sales as the total gross increases, or alternatively, pay a higher percentage as the sales increase. The former might be used to encourage franchisee performance and provide a fairer system to the franchisee. The latter is used sparingly when the franchise in question is in a prime location with relatively superior performance. For instance, franchises in busy shopping centres or in the centre of town might use this fee structure.
Lastly, depending on the specific franchise, a transaction-based royalty might be suitable. For example, the franchisee of a hotel chain might pay an amount for each booked reservation. However, this is quite clearly unsuitable for something like a fast-food franchise.
All of these are contingent upon the terms included in the franchise agreement and of the nature of the franchise.
The Key Aspect Of Franchising Royalties
Having a proper understanding of the business you are buying or selling is crucial to the type of franchise royalties that will be paid.
Buying or selling a franchise in a way that does not provide profit to you personally is not a good investment. The franchise royalty should therefore keep potential profit in mind. If a franchisor agrees to provide extensive training, administrative support and ongoing legal assistance for an insufficient franchise royalty, they might find themselves incurring a significant financial detriment.
In a similar vein, if a franchisee agrees to pay an exorbitant franchise royalty that obtains little assistance in return, there may be issues with paying this fee.
Both the franchisee and the franchisor want the franchise and their business relationship to be successful. If it thrives, the franchisor will collect regular royalties whilst the franchisee will enjoy the success of the franchise.
It might be tempting for a franchisor to safeguard their own interests by requiring large royalties. However, to ensure the success of the franchise and thereby the payment of royalties, a franchisor should determine the fee to be paid in a way which allows the franchisee to earn a sufficient amount of revenue after deducting the expenses associated with the franchise.
As explored above, there are numerous ways to do this, but it all depends on the type of industry and nature of the franchise.
Laws around franchising can be quite dense, and it is an area of law that requires expert legal help. We have a number of resources to guide you in various stages of the franchising process, such as:
- Selling A Franchise
- What To Do At The End Of A Franchise
- Legal Documents You Need For Franchising
- Franchise Agreements
- What Fees The Franchisee Has To Pay
- Terminating A Franchise Agreement
- What To Do With A Bad Franchisee
- Franchisees’ Legal Obligations
- Franchise Grant Process
It is crucial to have a lawyer review your franchise agreement and the terms around royalties. Doing so would assist in providing for the future profit of the business relationship between the two parties.
If you are thinking about buying or selling a franchise, reach out to our team for a free, no-obligations chat about franchise royalties at email@example.com or on 1800 730 61.
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