The Federal Trade Commission (FTC), in Section 436.1(h) of the Franchise Rule, explains that a business qualifies as a “Franchise” (and is therefore subject to the specific regulations imposed on franchises) where three conditions are met:
The business grants a licensee the right to use its marks and other proprietary assets,
The business establishes and enforces brand standards that that licensee must uphold in order to be allowed to continue to use such proprietary assets, and
There is a financial relationship between the business and the licensee.
In most franchise systems, the “financial relationship” element is usually met in two ways: a one-time upfront payment (known as the “Initial Franchise Fee”), and an ongoing payment (known as the “Royalty Payment”). The Royalty Payment is normally paid monthly or quarterly and can be calculated in a few different ways.
WHY CHARGE ROYALTY FEES?
The typical financial relationship between a franchisee and a franchisor can be looked at similarly to that of a country club. 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.
In many of the most successful franchise systems, the amount paid by the franchisee as the Initial Franchise Fee will typically be enough to cover the franchisor’s expenses that are related to getting that franchisee up and running as a working, successful business. These expenses include training, advertising, and any costs related to securing or approving the location for that franchisee’s business, among other things.
Therefore, the Initial Fee is not where the franchisor is making their revenue. Instead, the ongoing Royalty Payments are how the franchisor makes its money, which it uses to support its franchisees and further build the business.
Generally, franchisees see their ongoing Royalty Payments as tied directly to the ongoing support that the franchisor is obligated to provide them. Though this may not always be contractually the case, it is essentially how most franchise systems work. 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 MUCH SHOULD A FRANCHISEE EXPECT TO PAY IN ROYALTY FEES?
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.
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.
The best franchisors will look into the unit economics that they expect from a franchisee’s business, including labor costs, product costs, rent, etc., and find a level that allows both the franchisee and the franchisor to make money. Many franchisees expect that their profit margin for their location will be equal to or more than what the franchisor is making off that location, but this is not always the case, particularly in poorly run franchise systems. In situations where it has been determined that operating a single location is simply not going to produce enough revenue for either the franchisee or franchisor (or both) to make a profit, some franchisors will require franchisees to purchase multiple locations, where the revenue pool can get large enough for the margins can become profitable.
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.