After our last blog post we received some questions about franchise royalties. It is certainly an area that you should be deeply aware of when you are deciding between franchise opportunities. Today’s post is a general overview of Royalties, what you get for their payment and what you can expect in return. We’ll also work through an example.
First, what is the definition of a royalty? A royalty is the payment a franchisee makes to the franchisor for them to use their concept in an effort to generate for revenue and profit.
Why Are You Paying This Month after Month?
Let’s look at some questions about royalties. First, why do we have a royalty? What’s it going to get you? What you’re doing is you’re buying the intellectual property of the concept, the brand recognition of that concept, and the systems and support that you will use to manage that business. For that you’re going to make a commitment. That commitment is a financial pledge you make over the term of your agreement. A royalty is a fixed percentage of the revenues that you make and you will personally guarantee that back to the franchisor.
Most Royalties Work This Way
Lets say, your franchised store makes $2 million dollars in annual gross revenue and your base royalty rate is 7%.
$2,000,000 x 0.07 = $140,000 / year
You’d owe $140,000 a year in royalties to the Franchisor. Now, most royalties are due on a monthly basis. Based on the Point of Sale (POS) system and other networked systems that communicate directly with the franchisor, that amount is usually debited automatically every month.
Be very aware that the royalty is taken from the gross, not from the net. Also understand that while you can push back on some things in your franchise agreement, you will almost certainly be unable to get a franchisor to budge on his royalty rate. If they change the rate for you, they’d open a Pandora’s Box with the other franchisees, and they’d be required to disclose it in future publications of the FDD.
So why did I just work through an example with annual numbers instead of monthly numbers?
Annual gross revenue is the metric that you’ll be provided with in the concept’s Franchise Disclosure Document. You can find this information in Item 19. So if you’re researching how much in real dollars that franchisor will make off your store, you can use the FDD, and the royalty rate to calculate that amount.
What Do You Get?
What do we get as a return on this commitment? You get the following items.
1) Research and Development.
R&D is the work that was done and will continue to be done on the recipes that support the menu and allow you to cost and price out that menu.
2) Procurement of Goods and Services.
Buying things in bulk allows the Franchisor to leverage the size of their organization to assure that you’re getting the best price for commodities from a safe source.
3) Operational Systems and Support
These systems allow you to manage the business successfully on an ongoing basis.
4) Marketing Programs
Ongoing marketing programs make sure that the concept and the franchise stay relevant.