A royalty fee is an ongoing fee that the franchisee pays to the franchisor. This fee is usually paid monthly or quarterly, and is typically calculated as a percentage of gross sales.
Ongoing Membership Fees
While the Initial Franchise Fee can be seen as the upfront cost to join as a “member” of the franchise system, the royalty payments can be seen as the ongoing “membership fees” required to remain that membership. These payments are collected by the franchisor to fund the franchisor entity’s actions, which include both corporate and franchise-related expenses. The ongoing royalty payments are how the franchisor makes its money, which it uses to support its franchisees and further build the business.
Generally, all the support provided by the franchisor through its field consultants, marketing plans, business strategies, etc., are funded through the royalty payments provided by the franchisees. Additionally, all the administrative costs of running the franchisor’s headquarters and staff are funded from the royalty payments. Lastly, the franchisor’s efforts to further expand and develop the brand through recruiting and bringing in new franchisees to the system is funded by royalties.
How Royalty Fees are Calculated
There are a number of ways that franchisors establish what their ongoing royalty fee will be. The most common is a percentage of the Gross Sales that the franchisee earns. Typically this ranges from between five and nine percent. So, essentially, the franchisee is taking in 91-95% of their gross sales with the rest going to the franchisor. Gross Sales is the amount of revenues from the sale of services, goods, and any other products or merchandise by the franchisee, and is not reduced by any discounts given to employees or family members, taxes, or returns/credits/allowances/adjustments.
In most franchise systems this percentage is fixed, but it can be also be an increasing or decreasing percentage depending on the level of sales. Some franchisors require a minimum royalty payment for each period, whether by a percentage or by a set dollar amount. There are also franchisors that determine the royalty amount as a set dollar amount based on different sales thresholds. Further, some franchisors don’t require any ongoing royalty payment at all.
Properly Determining Royalty Payments
The most successful franchisors will take great care in determining what their required royalty payments will be, whereas some franchisors will just use whatever their competitors are requiring, or just pick a number with little to no basis for it. Ideally, the franchisor will set the royalty amount at a level that will allow the franchisee to take home a healthy enough profit, after all expenses, such that the business will be able to succeed both initially and ongoing.
Different industries and revenue models lead those industries to specific strategies for setting royalty amounts. There is no one way that is required, so franchisors can get as creative as they’d like.