What is a Royalty?
A royalty in franchising is similar to a payment made to authors or other celebrities to compensate them for a body of work, intellectual, or artistic property they have produced. In a franchise system, a royalty structure is the cash flow a franchisor sees from month to month, unlike the daily sales generated by a franchisee.
Many franchisees just starting out may have a difficult times understanding the importance of this monetary injection to the franchisor. The idea of paying a monthly “charge” to someone who hasn’t done anything to contribute to your day-to-day business can be bewildering. In fact, royalties have everything to do with your day-to-day business, regardless of the effort you have put in to keep your franchise operating.
When you bought your franchise, you paid an initial franchise fee. Now that your business is open, a percentage of your monthly sales must be contributed towards the franchisor as an ongoing fee to support the massive infrastructure that is the “system.” You can compare a royalty to a your property taxes: you may own the home but taxes have to be paid every year to support more than just the sidewalk in front of your home; your taxes help support the municipality as a whole.
How Do Royalties Support the Franchise System?
In a nutshell, royalties are the main source of income for a franchisor. They contribute towards such expenses as:
- the overhead costs of the head office such as rent and payroll
- they allow the franchisor to develop new products, services, and technological advances in how the franchises do business locally and internationally
- they allow the franchisor to move into new states, provinces, and countries to expand brand recognition.
A franchisor is not required to justify where and how the royalty payments are allocated. A franchisee may hate to pay them but from a franchisor’s standpoint, a franchisee’s success may not have been possible without the “brand” they invested in versus being an independent entrepreneur. There’s a price to pay for a successful franchise system — and that price is the royalty.
The Various Type of Royalty Structures
It is not uncommon for a franchisor to use a unique royalty structures that best serve the purposes of that system. For example, tutoring franchises may use a monthly “fee per student enroled” as the royalty. If a franchise has 100 students enroled that month and the fee per student enroled is $25, then that month’s royalty will be $2,500.
Percentage of Gross Sales
The most common royalty structure is the royalty payment based on a percentage of gross sales. The percentage can vary, but expect to see between 5% - 8% as the most common.
Percentage of Net Sales
Another version, less common, is the royalty payment based on a percentage of net sales. The percentages in this case may be higher because your net sales will naturally be lower than your gross sales, about 6% - 10% or more.
Flat Fee
Flat fee royalties are commonly seen in some home-based or service-based franchise systems. This royalty does not take into account any sales whatsoever; whether you make $1 or $10,000, your royalty will be the same each month. The franchisor is the ultimate benefactor here, second to the successful, cash-flow happy franchisee: a guaranteed revenue for the former and a bigger bottom line for the latter.
Royalties Are Not Negotiable: The Downside for Franchisees
What you must prepare for before you invest in a franchise is your understanding and acceptance of royalties. Unlike certain conditions in the franchise agreement, royalties are non-negotiable. On the other hand, they are not designed to sabotage your sales potential. Within the first 18-24, you will likely see your bottom line affected by these royalty payments because as your revenue increases, these payments will become justified.
In designing a royalty structure, franchisors have to be reasonable. Upon the advice of lawyers and accountants, royalties cannot be too extremely low or too extremely high. Any imbalance on this front will affect franchisee operations and in turn, the franchisor’s operations. If a franchisor’s royalty structure seems unreasonable high to you during your research, make sure you compare these figures to those of other systems. And always ask your franchisee interviewees how royalties have affected their businesses.
