How to Structure Franchise Royalty Fees

Royalty fees — the fees franchisees pay franchisors in exchange for the business model — are the lifeblood of the franchising world. However, there are many variations used by franchisors when it comes to structuring those royalties. 

Here are some tips to make sure you are structuring your royalty fees correctly.

Focus on Franchisee Success vs. Profit

If a franchise fee is the cost of admittance for a franchise opportunity, then the royalty fee is kind of like the monthly membership fee. Instead of “chasing fees” or looking at this membership fee as an opportunity for profit, franchisors should focus on making sure franchisees are getting the value they deserve. 

“The beauty of the franchise industry is that it is a true win-win situation — if the franchisee is successful and has more revenue, then the franchisor collects more royalties,” said Corey Elias, founder of franchise brokerage Franchise Captain. “In structuring a royalty fee, a franchisor must make sure to keep the success of the franchisees always in mind. They need to take into account the true value they are providing.”

Royalty payments are generally how franchisors pay for all corporate and franchise-related expenses. For example, all franchisee support initiatives and administrative costs are funded from royalty payments. In addition, the franchisor’s expansion and franchise development efforts are also funded through royalties. While this may lead some franchisors to think they need to focus on becoming royalty sufficient as fast as possible, Elias notes this should not be the primary concern.

“The key is not focusing as much on becoming royalty sufficient, and focusing more on making sure every franchisee brought into the system is reaching their goals,” Elias said. “If and when that happens, royalty sufficiency will surely follow. Overall, if a franchise system creates very successful franchisees, the royalties will cover everything.”

Calculating Royalty Fees

By focusing first and foremost on franchisee success and nurturing a healthy system, franchisors can determine which royalty fee structure will work best for their organization.

“To launch a franchise system successfully, franchisors need to have an in-depth plan for a royalty fee infrastructure at the onset,” said Elias. 

Here a few of the options franchisors can choose from when creating a royalty fee structure.

Fixed Percentage of the Gross Sales

The most common royalty fee structure is based on a fixed percentage of the gross sales — the royalty is calculated by applying the fixed percentage to the adjusted gross sales, traditionally on a monthly or sooner basis. Typically, the franchisee takes home 91-95% of their gross sales with the rest going to the franchisor. This is often the simplest method, but may not be the best choice for either the franchisor or the franchisee depending on the amount of revenue generated, the market potential and more.

Variable Percentage of Gross Sales

Another popular method is to determine royalties based on a variable percentage of gross sales. That means franchisees pay either a decreasing percentage or an increasing percentage of their gross sales over time. 

The decreasing percentage method works best for motivating first-time franchise owners who may be bringing a brand to a new area — the more they bring in in monthly sales, the less they have to pay the franchisor in royalties. This method is primed for helping franchisees build capital and encouraging multi-unit growth. 

“For emerging franchise brands, the flow of royalties will be slower in the beginning and the expenses will be high to market and grow the brand, so a proper plan needs to be put in place to account for this,” said Elias.

On the other hand, basing the royalty fee off of an increasing percentage of gross sales is ideal for franchisees who may be bringing a brand to a high-potential market such as big cities or for those who have been awarded prime real estate. An increasing percentage structure allows franchisors to efficiently price franchise opportunities in locations or situations that are likely to generate higher sales. 

Fixed or Minimum Royalty Fee

Some franchisors opt for a fixed royalty fee that is not determined by fluctuating unit sales. The franchisor is guaranteed a fixed dollar return each month, while the franchisee reaps the full rewards of increased unit sales. Some franchisors require a minimum royalty payment for each period, whether by a percentage or by a set dollar amount. These methods are uncommon as they often result in franchisees paying a royalty fee before they can afford it. 

Be Creative

While these are the most common methods for determining royalty fees, there are various ways franchisors can tweak them to work best for their specific industry or business model. For example, 7-Eleven royalties are based on the franchisee’s gross profits instead of gross sales. Other franchisors make a habit of eliminating or reducing royalty fees altogether until a new franchisee reaches maturity. Each franchise system is unique, and franchisors shouldn’t just go with a simple gross sales percentage method just because it is the most common.

“The equation of how many franchisees need to pay what percent of royalties to achieve a franchisor’s growth goals will be complex and completely different based on the brand,” said Elias. “The franchisor needs to invest in a great franchise accountant to help them run these figures.”

By understanding the options and resources out there, franchisors can create the perfect royalty fee structure for their particular concept, position franchise owners for success and scale the brand.