Fixed vs. Percent: Understanding Franchise Royalty Fees

Posted Oct 28, 2014 at 04:33pm By

Category: Franchise Experts

If you’re reading this article, chances are that you’ve been researching Franchises. By now, you should be familiar with a Franchise Disclosure Document or FDD. This is one of the most important documents detailing many of the costs associated with a particular franchise. This article will explore the benefits, and pitfalls, of the ongoing Franchise Royalty Fee. If you’re wondering what these fees are for, the best way to understand it would be to remember that the Franchise Fee is a one time, upfront payment to join the franchise system.  The royalty is an ongoing payment made in return for continued support over the length of the franchise relationship.

Fixed vs. Percentage Royalty F

These ongoing fees can be levied as a percent or fixed fee. The percent based approach is normally a percent of gross sales.  For example, if you have gross sales of $10,000 and the royalty is 6%, then the payment to the franchisor would be $600.  The payment would go up or down based on your gross sales volume.  On the other hand, a fixed royalty never changes.  If the fixed royalty is $1,000 per month then it remains constant whether your gross sales are $10,000 or $50,000 per month.  Over the years, many prospective franchisees have asked me which approach is better.  Although it is a rather straight forward question, as with many things, the answer can be more complex.

The percent based approach is by far the most popular – as you grow your business, so to do the royalty fees. In most cases the percent fees are smaller in the beginning stages as your business as sales are just starting to get off the ground. Many franchisees tend to prefer this approach as (1) it keeps their costs lower in the beginning where you tend to have lots of extra out-of-pocket costs, and (2) franchisees like the fact that the royalty is a variable line-item which only increases as they grow.

The idea behind the percentage is that the Franchisor and the Franchisee are ‘in it together’.  Both sides invest in the franchisee in the beginning and receive very little reward.  As the business grows, the extra work, coaching and support are rewarded with higher returns. In a few cases, some franchisors offer a diminishing percentage based on sales. Once you achieve a certain benchmark, your ongoing royalty percentage actually decreases, incentivizing the franchisee to grow their business even more.

The fixed-fee approach is not as common, however it may make more sense in the long run. Having a fixed, monthly fee can be more burdensome in the beginning, especially if you grow slowly; however, as the business grows, the relative cost of the royalty goes down.  This means that if you happen to be an above-average earner, then you would definitely benefit from this type of royalty structure; of course, the opposite applies if you are a subpar performer.

Ongoing fees are an integral part of the franchising system and exist to ensure that you receive ongoing support. As with all things franchising, the FDD is the best place to start. Items 5 and 6 in the FDD will clearly outline the fees that you might be subject to and provide you with details regarding the approach the franchisor uses.

One last thought regarding royalties.  I am often asked what is ‘normal’.  Is there a royalty that is too high?  The fact is that royalty is simply a line item expense.  In return for your royalty payment, you should have access to an infrastructural backbone that more than offsets the cost of the royalty.  The real question is profitability.  Would you prefer a franchise with 1% royalty, very little support and very little profit – or - a franchise that has a 30% royalty with lots of support and a strong bottom line profit? Keep your eye on the ball – profitability is what matters.

Only after conducting all of your due diligence, often with a Franchise Coach, will you be able to measure the value of the opportunity. At that point, the ongoing franchise royalty will either make sense or it won’t and you’ll know what to do!

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