If you have some knowledge about franchising, then you probably know that franchisors collect a royalty fee from franchise owners. Every franchisee has a contractual obligation to pay a certain percentage of their sales to the franchise company over the terms of the franchise agreement. Although this payment is usually made weekly, it can also be paid monthly, quarterly, or even yearly. However, a lot of people are unsure of how royalty fees help the franchisor and franchisee make profits.
Royalties help keep franchisors in business since they make most of their income from this fee. The royalty allows the franchisor to earn money and expand the franchise network. In return for the royalty fees, the franchisor develops, maintains, and enhances the operating system of the business to give its franchise owners a competitive edge in the market. One of the top qualities of a franchise is that it comes with an operating system that mitigates the business risk for the franchisee. And this is one of the main differences between a franchise and a standalone business.
Types of Royalty Fees
Most franchisors calculate their royalty based on percentage. The fee can range from 1 to 40 % of the gross sales, but it usually ranges from 5 to 7.5 %. A percentage-based royalty fee can benefit new franchisees who are still in the early days of their business. This royalty structure provides both the franchisor and franchisee the motivation to make more over time.
Franchisors can also operate on a fixed-royalty model. In this case, the franchise owner pays a certain amount of money to the parent company on a regular basis, no matter the gross sales. Clearly, the benefits of this fee arrangement are the direct opposite of a percent-based structure and can benefit the franchisee more in the long run when they start getting bigger sales.
Item 6 of the franchise disclosure document (FDD) includes information about the franchise royalty fees. It is usually a fixed number and non-negotiable. Note that franchisees of the same parent company may have to pay different royalty fees. This can be due to the changes in the franchise agreement over time. For example, a franchisee may buy a franchise when the royalty fee is fixed at 6, and a couple of years later, the franchisor may decide to raise the rate to 7 % to cover improved services. This new rate will only apply to new franchisees, while the old franchisee will continue to pay the old rate until they want to renew the agreement.
Higher Royalties vs. Lower Royalties
Many prospective franchisees place too much importance on the franchise’s royalty fee. These set of people will research the top competitors in the franchise industry they are interested in, compare their royalties, and immediately decide that the franchise with the lowest royalty fee is the best one that will allow them to make more profits. No, this is not always the case. This approach is too simplistic and hardly results in an informed decision. It is best to see royalty as a line item expense just like other costs, such as real estate, labor, supplies, or marketing.
You need to do more research into a franchise system to know what the future holds for the franchise and how profitable it may be. It would be better to concentrate on the profits you will make in the end. At times, a franchise with higher royalty fees might be the better option for you due to the value of the business operating system and the strength of the franchise system as a whole.
Also, a franchise having low or zero royalty fees does not automatically mean you will have a better chance of success with it. Meanwhile, one of the biggest and most successful franchisors in the US charges a royalty fee of 40%. Yet, many of its franchisees are extremely successful. Although it’s crucial to know a franchise’s royalty structure, bear in mind that it’s just one of the factors that determine the business’s chances of success and profitability.
When investigating a franchise, make sure to put your basic knowledge of profit and loss economics into use. If the franchise brand can show that a higher royalty structure benefits everyone involved and makes the whole system (including franchise owners) more profitable, you should consider this a pro and not a con.
