Franchise Tutorial 5: Intro to Royalties
receptive to products that are associated with a known brand and this in turn generates revenue. Once a franchisee has found a new customer, the operating systems are in place to assist franchisees keep them as repeat customers.
The franchisor uses royalties to develop an infrastructure that provides ongoing support to franchisees including:
- Consulting and sharing of best practices
- Arranging suppliers to capitalize on purchasing power
- Research and development
- Operational reviews and ensuring brand consistency
- Accounting systems
- Field support
- Initial training programs
- Ongoing training programs
For a franchise system to be successful, royalties need to be both affordable for the franchisee and large enough for the franchisor to be able to fund the necessary support. Business models vary widely and as a result there is no standard royalty amount. Typically, royalties are paid monthly, calculated on the franchisee's gross sales for the month and usually do not include legitimate refunds or taxes. Royalty amounts are not the same for every system and they can start at three to four percent and range as high as 10 percent or more. It is common to find royalties between five and six percent for retail franchises and eight to 10 percent for service franchises.
There are numerous variations regarding royalty fees. Some franchisors charge escalating or declining percentages based on different levels of sales. Some franchisors do not charge a percentage of sales but instead charge a royalty based on a flat fee each month. Others may charge no royalty at all, but instead earn revenues through product sales.
A flat fee royalty is often used when it is difficult for the franchisor to monitor the franchisee's monthly sales. This system may seem attractive to the franchisee but a potential downside is that there is no incentive for the franchisor to work with their franchisees to increase their sales. The franchisor receives a flat fee each month regardless of the level of support they provide. The advantage of a flat fee amount is that franchisees know exactly what their franchise costs will be each month.
Revenues to the franchisor through product fees are typically used when the franchisee is distributing a product manufactured or distributed by the franchisor. Examples of a product based franchise are gas stations, automobile dealerships or soft-drink bottlers. Product franchising derives income from selling products wholesale to the franchisees, with a profit margin for the franchisor built into the wholesale pricing. The franchisee is required by the licence agreement to purchase products from the franchisor.
Royalties are usually non-negotiable and are often preset by the franchisor. If one franchisee is paying four percent and another is paying eight percent, there could be potential conflicts within the franchise system. For the most part royalty fees are constant and do not change. Exceptions to this would be if a franchisee were awarded a franchise of a fairly new and emerging franchise system. When joining a franchise system at the early stages of growth, franchisees may receive the benefits of lower royalties as the emerging franchise system is starting out. As the franchise grows so should the operating systems and support. When renewing their franchise agreement, franchisees may then be faced with an increase to their royalty fees. However, one must remember that the franchisor must make money in order to remain in business and royalties is an important revenue stream for the franchisor.
Low royalty fees do not necessarily result in an advantage as low fees can result in the franchisor's inability to provide franchisees with the necessary level of support and ensure the success of the system.
Most franchise agreements have a clause stating that failure to pay royalties is a breach of the franchise agreement and may lead to the termination of the agreement. The franchisee may then also be liable for other damages.
The benefits of paying royalty fees often far outweigh the costs. A royalty is a cost of doing business as a franchise. It gives the franchisee the right to operate a business under a proven brand and business model. However, prospective franchisees must always do their due diligence when looking at any franchise opportunity. Speaking with current and past franchisees of the franchise system will help to ensure that the value for the royalties is there.
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Posted Date: January 2011