Franchise Royalty Fees Explained
A royalty fee is not an upfront payment but rather a percentage of your business’s sales.
When a franchisee buys a franchise business, they will pay an initial franchise fee, and then continual royalty fees to run their business under the company name.
Royalty fees are charged to use the parent company’s trademark, logo, brand name, and other forms of intellectual property. It can also include training or technical support from the franchisor.
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Royalty fees are essential to understand when deciding whether or not it’s the right decision to buy a franchise. Here’s you will know all about them and why they’re essential in this handy guide.
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The Truth About Royalty Fees
Royalty fees are paid to the creator of the original work for its continual use. For example, when a company uses an author’s writing, it might pay royalty fees for each book sold. Music royalty fees are similar, though they’re based on album sales instead of book sales.
We can pay royalties in two ways: as a percentage of sales or advance against future sales. Also, it is usually paid on a monthly or quarterly basis, depending on the terms of the agreement.
Franchise fee vs. Royalty fees vs. Initial investment
A franchise fee is a one-time fee you pay when you sign your franchise agreement. It covers the initial investment in the franchise, as well as any contributions toward national advertising, training, and other services that may help your business start faster. A royalty fee is based on a percentage of sales, and it’s due regularly during your contract term.
Why Royalty Fees in Franchise are an Important Part of the Model
If you’re looking into opening a franchise, you know that you’ll have to pay upfront in most cases. Though we all know you have to pay up for franchising fees, are you aware of the other costs and expenses involved?
The franchise owner is the person who invests in getting the rights to market and sells an already existing brand. They can be an individual or corporations. On the other hand, a franchisor, or franchiser, is the person who owns an entire brand and offers its business model to franchisees.
There are three main types of franchising: manufacturing, distribution, and retail.
Franchise chains like McDonald’s and Dunkin’ Donuts are good examples of this. McDonald’s is a huge multi-national corporation, but they still get royalty fees from each location that a franchisee owns. This is why it’s so important to protect your intellectual property for your brand and business.
This is how franchising works. A company with a concept for a product or service will sell the rights to use that concept to someone else and then make money by charging royalties for every territory or location that opens up.
The royalty fee payment scheme can differ per company. Some companies as for a percentage of the sales while others ask for a fixed amount. Royalty fees in the franchise are usually monthly or quarterly payments that can be calculated differently depending on the franchisor’s requirements and agreed upon in the agreement.
Does Franchise owner Need to Pay Royalty Fees?
Yes, franchisees must pay a percentage of their revenue to the franchisor as a royalty fee monthly.
You see, your franchise agreement will include a clause that requires you to pay a certain percentage of your profits as royalties at a specific period. You need to read the entire FDD before signing the dotted lines carefully.
It is Fees for Running and Maintaining the Franchise
There are many expenditures to effectively manage the franchise business and stay a part of the franchise system once it is up and running. The continuing costs are included in Item 6 of the FDD under “Other Costs.” The royalty fee is the most frequent recurring cost in franchising.
The urge, why this question is being asked is because of the increase in franchising in the United States. Because of its popularity, it has caused the number of lawsuits to increase. It has led to many questions about what a franchisee needs to pay for.
Royalty Fees Vary
The way a franchisor charges for its services varies widely. Some franchisors charge a flat fee, some charge a percentage of sales, and others charge a percentage or flat fee plus a royalty on gross sales.
According to Entrepreneur, the initial investment to start a franchise can range from $50,000 to $500,000; this includes startup costs like signage and product samples and business equipment like computers and product display racks. It depends on the kind of franchise opportunities you want to buy. You also pay between 6% and 10% of your gross sales as ongoing royalties along with a franchise fee.
To find out whether a franchise company is charging you a royalty fee, ask for a copy of the franchise disclosure document. It specifically spells out what you’ll be required to pay the franchisor.
How to Calculate Royalty Fees in a Franchise
Royalty fees are one of the main factors determining franchisees’ profitability. A few options for franchisees to choose from when calculating royalty fees as per the franchisor’s set structure include:
- A flat rate.
- A percentage of sales.
- A percentage of gross profits.
- A percentage of net profits.
- Several others.
Fixed or Flat Rate Royalty Fee
There are two royalties systems used by franchisors: the tiered system and the percentage system. Under a tiered system, the royalty is set at a flat rate for all franchisees. For example, a franchisor might require a flat amount every month from its franchisees. Some franchisors opt for a fixed royalty fee not determined by fluctuating unit sales. In this case, the franchisor is guaranteed a fixed dollar return each month, while the franchisee reaps the total rewards of increased unit sales.
Fixed Percentage of the Gross Sales
The most popular royalty fee structure is based on a fixed percentage of the gross sales — the franchisee pays a certain amount of money of every dollar collected, after which they get to keep the rest for themselves. Typically, the franchisee takes home 90% or more of their gross sales, with the remaining 10% going to the franchisor. In this model, the franchisor collects a percentage of total sales, usually between 4-6% of gross sales.
Most franchise companies choose to use this option to give their franchisees freedom and flexibility, placing minimal control over every aspect of the business and preferring to leave it in their hands.
Varying Percentage of Gross Sales
The most attractive royalty fee structure is a variable percentage of the gross sales — this means that the royalty percentage varies with the level of gross sales achieved. A percentage-of-sales method is often used as part of a financial incentive package for new franchisees to help them build a sustainable business. The more the franchisee sells, the less they pay in royalties. It encourages franchisee investment in growing their business and building capital to open additional locations.
Percentage Of Net Profit
The three most common ways franchisors calculate royalties are on sales, profits, and a percentage of gross sales. However, a myriad of other formulas can also be used. For example, 7-Eleven pays royalty fees based on gross profit instead of gross sales, while one franchisor requires their franchisees to pay a royalty fee based on the wholesale price of the goods they sell.
Are Franchise Royalty Fees Negotiable?
While the royalty fee percentages vary across industries and business models, a few common denominators apply to most. The franchisor usually takes a more significant portion for the first few years of a franchisee’s business once it reaches maturity. Another common denominator is that franchisors tend to ease off on royalties after a specific time, usually about five years.
The Penalties For Not Paying Royalty Fees Can Be Harsh
Franchisors will often deduct royalties from the franchisee’s share of income instead of asking for a fixed-sum royalty fee upfront. But if you do not pay them regularly, they may terminate your franchise or hold you liable for other expenses.
It may be surprising for you to know that many franchise agreements don’t allow you to benefit from your franchise until you’ve paid all of your fees and royalties. This is because many franchisors consider not paying fees a breach of the agreement. This shouldn’t be an issue if you have the required liquid capital and net worth.
If you want to know more about royalty fees in the franchise, you can send us a question at Fransmart.