Franchise Royalty Fees : Percentage Versus Fixed?

Franchise Royalty Fees

At the end of last week I paid a visit to the National Franchise Exhibition at the NEC in Birmingham (UK). As always, it was a great opportunity to meet with and chat to other franchisors, a chance to see which new franchise brands are emerging into the market and to listen to a number of speakers on a variety of topics of interest to both franchisors and franchisees.

One key thing that always strikes me when talking to other franchisors is the variance in approach to franchise royalty fees (sometimes called franchise management fees or service fees). This is the regular fee paid by franchisee to franchisor, most commonly paid each month and often representing a percentage of turnover or gross profit.

The franchise royalty fee not only provides a regular source of income for the franchise brand, but it also covers the “running costs” of providing support services to that particular franchise branch. From the franchisee’s point of view the royalty fee can end up being often the most significant monthly outgoing from the business. For this reason it’s something that both franchisor and franchisee need to give very careful consideration to at the outset. Any emerging franchisor putting together their franchise package needs to ensure that their approach to the franchise royalty fee will not only cover their costs and be attractive to potential franchisees, but  that their fee structure will also allow the franchise business to grow financially and make a profit. The franchisee considering buying into a franchise opportunity will need to very carefully analyze the facts and figures, ensuring that the franchise royalty fee is taken into account when drawing up business plans, financial forecasts and looking at both best and worst case scenarios!

There are two main approaches to the calculation/administration of franchise royalty fees :

  • Percentage of turnover or gross profit over a fixed period, for example a month or a quarter. The average or typical starting royalty percentage in a franchise is 5 to 6 percent of volume, but these fees can range from a small fraction of 1 to 50 percent or more of revenue, depending on the franchise and industry
  • A fixed sum royalty fee

There are also some franchise brands that do not charge a regular royalty fee per se, but require franchisees to buy all products and services from them at a markup and generating their income that way.

There are advantages and disadvantages to either royalty fee approach, depending on the perspective of the party.

When looking at a percentage model, most franchisors are likely to favor a percentage of sales/turnover. This is because monitoring the franchisee’s accounts regularly to make sure that fee calculations are correct is an onerous task in the first place – made more complicated and time consuming if the relevant fee relates to gross profit and so involves analysis of costs as well as just simple sales.  However a fee calculated on a sales basis rather than gross profit can be disadvantageous to the franchisee – what if the costs of the enterprise prove higher than anticipated?

Whether on turnover or gross profit, the benefit to the franchisor of calculating franchise fees on a fixed percentage basis is that as the franchise branch grows and becomes more successful and sales/gross profit increases, so the amount payable in royalties to the franchisor increases. There is an obvious argument however that this can cause franchisees to become disgruntled – the harder they work the more they see the amount that they end up paying to the franchisor increasing! This can result in unmotivated and disengaged franchisees, which is of course exactly what any franchisor will want to avoid. So what can be a solution to this scenario?

One common way of tackling this issue is to place a cap i.e an upper limit on the amount of royalty fees paid by the franchisee. So the franchisee pays a percentage of turnover up to a certain amount, and once the upper threshold is reached the monthly figure is capped and remains fixed, going no higher. If the franchisee’s turnover continues to increase, he/she can be safe in the knowledge that the royalty fees will remain at the capped level.

Another more creative approach is to use a Decreasing Percentage Model. Using that model, the franchisor charges their franchisees a percentage of up to a certain level of turnover or gross profit.  Once the franchise branch’s turnover/profits reaches and exceeds that level, the percentage figure actually drops. At this level the franchisor should be confident that the franchise fee is financially sustainable and profitable for them, and importantly it provides a positive incentive for franchisees to continue to increase their turnover.

In comparison to the above percentage based models, a fixed sum royalty fee is exactly what it says on the tin! The same amount is paid by the franchisee to the franchisor each month, irrespective of sales or profit figures. This can be advantageous to both parties in that it provides certainty in terms of financial and business planning, and from the franchisor’s perspective the administration involved is kept to a minimum. However in a fixed fee model, the payment will still need to be paid by the franchisee even in lean times when the business is not turning over or selling a huge amount. A fixed royalty fee is likely to be the most profitable option for the franchisor when the franchisee is just starting out and sales/profits are low, but not as the franchisee begins to achieve success.

Ultimately, there are no guidelines for franchise brands to follow when deciding on their approach to franchise royalty frees, and certainly no right or wrong way to do it. A good franchisor will consider a variety of factors including which fee structure will appeal most to their target franchisee before determining their fee structure. And for a franchisee considering a franchise opportunity, it’s vital to weigh up the pros and cons of every scenario carefully – bearing in mind that low franchise royalty fees aren’t always a good thing and could mean that the brand will end up with insufficient money coming in to help it to grow, prosper and innovate!