Royalty Fees Are Expensive, Or Are They?
Franchisees tend to complain about paying an ongoing royalty fee or that it is too high, one may not really understand the underlying value or the main purpose of the royalty fees.
Back-Up a Minute – Let’s Look at Why the Royalty Fee Even Exists
When you are purchasing a franchise, you pay:
- The initial fee,
- Setup costs and
- An ongoing fee as well.
In return for the payment of the initial fee, the franchisee is granted access to the franchisor’s intellectual property and is then entitled to receive assistance in setting up the business and receive initial training. Beyond that, there must be ongoing support, training and supervision.
No amount of upfront fee could sustain ongoing support indefinitely because the cost of performing this service will be sizable and needs to be recovered. It is only fair, therefore, that the franchisee has to pay an ongoing fee.
A Royalty Fee Will Help Franchisees Succeed and It May Just Save The Business
You are buying a business model that has been proven successful, so there is a fairly good chance for you to succeed vs setting up your own independent business. Franchisees are in a fortunate position where they don’t have to be concerned as much about business strategy and how to make the brand or business successful, the franchisor has already developed (and will continue developing) the roadmap to make the business successful. This roadmap is the primary reason why franchisees succeed.
What Is In It For The Franchisee?
Royalty fees go towards the maintenance and support of the franchise network. Here are some examples:
- Access to a franchise operating and business systems: the franchisor has spent years developing and perfecting the systems and model before selling it to franchisees. The franchisor is responsible to continuously develop and improve these systems for the franchisees
- Ongoing use of the brand name and intellectual property
- Ongoing training: Training occurs continuously in most franchises
- Ongoing support on-site and off-site: Field Service Consultants/Area managers providing ongoing support and visits. The support team travels to franchisees to reinforce training, review financial performance, assist with benchmarking, mentors the franchisee, ensures quality and standard compliance, etc.
- Communication and advice
- Procurement and Marketing
Royalty or Management Service Fee, What Is the Difference?
Some people describe this fee as a royalty, but this is a misleading name. Royalty payments are linked to “passive performance”. For example, a singer will receive royalties from CD sales for as long as the CD remains on the shelves. Once the song has been recorded, the singer has done his/her part and apart from the occasional personal appearance or other PR exercise, is not required to do anything more.
In contrast, a franchisor operating a business format franchise will, in addition to allowing the franchisee to use the intellectual property, provide intensive ongoing support. For this reason, the term “management services fee” (MSF) seems more appropriate.
But for the purpose of this article let us stick to royalty fees.
How Does A Franchisor Determine The Royalty Fee?
The royalty fee tends to vary widely depending on the industry and even from one franchise opportunity to the next and is influenced by several factoring including:
- The level of ongoing support
- Typical sales levels and
- Gross profit percentages that can be achieved by a franchisee
Calculation of Royalty Fees
1. Percentage of franchisee sales
In practice, the royalty should be calculated as a percentage of the franchisee’s sales as this is a fair method that reflects the business potential of the area and takes the franchisee’s development into account. When royalty is a percentage of sales this is seen as an incentive for the franchisor to maximise franchisee performance. This should be reassuring to as a franchisee, knowing the franchisor is motivated to provide the highest level of ongoing assistance and support. Generally, the percentage is between 1-7% and but in some instances, it could be higher.
2. Fixed fee
Some franchisors require a fixed royalty fee. Fixed fees are set up front with an annual increase to compensate for inflation.
The reasoning for this is to take away the need to monitor franchisee performance. Reputable franchisors are generally against charging fixed royalty fees for support, and these are the reasons why:
- There is no real financial incentive for the franchisor to support the franchisee or the brand
- This implies that the franchisor is simply sitting back and waiting for his monthly “royalty cheques” to arrive
- During the first few months of operating the business the franchisee needs the most support possible and sales might be low. At this point the fees might not be affordable to your business.
The Better I Do The More I Need To Give To The Franchisor
The royalty fee is often perceived as penalising a franchisee that is performing well, and seen as a demotivating factor but that isn’t the case, the franchisor is assisting the franchisee, providing ongoing support and brand development that enables a franchisee to do better and grow the business. If you are getting value for money, the actual figure should not be a concern for you as a franchisee.
In practice, unless both the franchisor and the franchisee have a realistic chance to profit from the relationship in the long term, it will not be a success. It follows that the upfront fee should be reasonable and, even more importantly, the royalty should be set to ensure that the franchisor can afford to offer support and make a fair profit without crippling the financial viability of the franchisee’s business.