How to Determine Your Franchise Royalty Fee Structure
6 Tested Strategies to Consider
Franchisors tend to establish their royalty based upon a percentage of the franchisee's gross sales, and typically collect those fees on a weekly or monthly basis. More and more, franchisors are transferring the royalty payments via Electronic Funds Transfer, where the franchisee agrees to allow the franchisor to debit directly from their bank accounts.
However, there are many variations used by franchisors in structuring their royalties. These are some of the more common structures you will likely see:
Fixed Percentage of Gross Sales
It is the most common continuing royalty structure. The franchisee reports gross sales, after making certain approved adjustments (taxes, bad debts, returns, etc.). The royalty is calculated by applying the fixed percentage to the adjusted gross sales, traditionally on a monthly or sooner basis. It is often the simplest fee structure to administer, but might not always be the best method to ensure a proper balance for either the franchisor or the franchisee.
Variable Percentage of Gross Sales
Decreasing Percentage: This structure has the franchisee paying a lower percentage of gross sales as the total gross sales increase. It is favored by some franchisors who believe that reducing the percentage royalty on increasing sales is fairer to the franchisee, as it provides an additional reward for increased performance and still provides the franchisor with an acceptable rate of return. Some also feel that a decreasing percentage encourages franchisees to report total sales more accurately.
The basis of calculation can be accomplished in various ways, such as on monthly sales or adjusted for cumulative annual sales. For monthly sales, the franchisor establishes different royalty rates for various levels of monthly sales. As the monthly sales increase, the royalty rate goes down. The franchisee applies the royalty rate for all sales in that month. In subsequent months, the royalty rate will again be based upon the level of sales achieved.
For cumulative annual sales, the franchisee applies a decreasing royalty percentage based upon cumulative annual sales rather than individual monthly sales. The royalty report reflects the cumulative sales total, and as the franchisee exceeds the targeted sales, the royalty rate drops on future sales until the next sales target level is reached. Typical of this structure is that the lower percentage royalty is applied only to the sales above the prior limit.
Increasing Percentage: Some markets or locations are more likely than others to ensure a higher sales rate. A location with prime real estate in the middle of a well-populated town center may be more likely to do a higher sales volume than a rural location in a low-populated area (Note: this is not always the case!) The rationale to use a higher royalty rate as sales increase is to provide the franchisor with additional compensation for granting a market which it knows or expects to traditionally have superior performance.
While this structure is uncommon, it does create a way to charge more for a downtown New York City location franchise that a Fort Smith, Arkansas location franchise. An increasing percentage structure is one way that a few franchisors price franchise opportunities in locations or situations that are likely to have much different sales numbers.
Minimum Fee Structures
Minimum Royalty: There are certain situations or markets in which the franchisor wants to impose financial performance standards on a franchisee to be assured that they meet minimum performance standards. Some franchisors also want to earn a greater return than they may get from the franchisee in their earlier operations while the franchisor’s costs of providing its services are higher. Setting a minimum royalty in those situations is easier than some of the other strategies available to measure market penetration or performance by the franchisee.
When a minimum royalty structure is used, the franchisee will pay the higher of the fixed minimum royalty or the percentage royalty based on unit sales. Minimum royalties are frequently tied to periodic increases based upon CPI (consumer price index) adjustments or some other basis.
The problem with minimum royalties is that they likely will have a negative impact on the franchisee when they can least afford to pay the higher fee. Minimum royalties are triggered by lower sales at the franchise, which likely also means the franchisee is producing lower revenue for themselves.
Fixed Royalty: This royalty is a fixed fee that is not affected by unit sales. The franchisor is assured of a fixed dollar return each month, while the franchisee receives the full benefit from increased unit sales. The fixed royalty basis is similar to a commercial lease without any sales override. The fixed fee is typically adjusted periodically based upon a CPI or other basis.
As with minimum royalties, franchisees may be paying a higher royalty than they can afford at a certain time. The reason that this method is not frequently used is that it does not provide a proper return to the franchisor based on the higher volume the opportunity provided the franchisee.
Start-Up Period Adjustments
Franchisors recognize that during the initial period of operation, the franchisee may have higher costs in establishing their business and, at the same time, lower sales until they reach maturity. To assist their franchisees during this period, some franchisors will eliminate or reduce the royalty rate during the development period. The amount of royalty not collected is either treated as unearned or may be considered as a deferral or loan to be paid at a later date.
In some industries, like the hospitality industry, transaction-based fees are quite common. For example, in the hotel industry, the franchisee will pay a fee for each reservation booked through the central reservations system. You will find these types of a la carte fees common in franchisors that have central call centers or reservation centers.
Equally, franchisors may charge a fee based on extra services provided to the franchisee above what is required in the franchise agreement. Training is one common a la carte fee charged to franchisees based on the number of people they send through franchisor training.
No Royalty Fee
There are franchise systems that do not impose any fee but are still required to be considered a franchisor. It is common with systems based on a manufacturer or supplier that has established the franchise channel as a capture retail chain to sell their products. In these franchise systems, the franchisor earns its revenue exclusively from the sale of products to the franchisees and manufacturer or supplier that has established the franchise channel as a capture retail chain to sell their products.
In these franchise systems, the franchisor earns its revenue exclusively from the sale of products to the franchisees.
While the most common approach to franchising is the percentage royalty against top line sales, there are many variations that professionals consider based on industry norms or other factors. For example, with 7-Eleven royalties are based on the franchisee’s gross profits.
Determining the proper royalty structure is one of the most important decisions a franchisor needs to make when developing a franchise system. Unfortunately, many simply go with a percentage royalty on gross sales, and that structure may not be best for either them of for their franchisees. Take the time to develop a sound franchise strategy that includes the best royalty structure for your system.