In addition to charging an upfront franchise fee, franchises also charge ongoing royalties. If you’re looking at investing in a franchise, it’s time to start getting comfortable with the idea of paying both.
A royalty fee is an ongoing fee that a franchisee pays to the franchisor. This fee is usually paid weekly, monthly, or quarterly, and is typically calculated as a percentage of gross sales.
Unlike a franchise fee, the royalty is meant to be a profit center for franchisors and is payment to use the franchisors brand and IP. It also covers the costs of ongoing training, support/coaching for your business, and innovation.
While you may be paying anywhere from 3% to as much as 25% of your revenue to the franchisor, you also have the experts right there to help your business grow. You won’t need to personally direct and invest in research and development campaigns for new products, marketing approaches, or sales tactics.
The franchisor uses its own funds to test any innovations in your business, then rolls out a market tested system to the franchisees. At least that’s what they should be doing. Some franchises are certainly better than others when it comes to keeping their brand and business model current, and you can uncover this in your research of a franchise prior to investing.
If you’ve looked into franchising, you may have noticed some royalties are 3%, while others are higher. Why is that? Well, there can be a number of justifications for a royalty based on the quality of ongoing support that they offer you, but I’ve found a correlation between the type of business and the royalty rate.
Service businesses that do not sell actual products or require their franchisees to carry significant amounts of inventory typically have higher royalty rates. Why? The margins are typically better in these businesses so there’s more room for both you and the franchisor to put food on the table.
Franchises in the food and beverage space typically have a lower royalty rate because the margins are thin, but also because the franchisor is typically making money from the supply chain. For example, they buy potatoes at $.10 per pound and sell them to you for $.20 per pound. They’re making more money from potatoes than from your royalty so they’re willing to offer a lower rate.
It’s important to keep in mind that you actually want your franchisor to make money. You need them growing brand awareness, innovating, and reinvesting in the growth of the brand. They need your royalty payment to do that. Always remember that the incentives are designed to be well aligned in franchising i.e. the franchisor is only successful from a healthy royalty stream, and a healthy royalty stream is only developed if they have successful franchisees. Especially since franchisors really want multi-unit franchisees and you will most likely not open additional units if the business doesn't make economic sense to do so.
There’s typically no negotiation on the royalty fee and there’s really no such thing as a “fair” royalty. After all, would you rather pay 10% with a great return on your investment or 5% to a weaker concept just because you get to keep more of your revenue? In other words, the royalty should be evaluated in the context of your overall return on investment. If you’re excited about the ROI, you’ll probably just have to bite the bullet on the royalty, whatever it may be.