How Essential Are Royalty Fees for a Franchisor

The royalty fee is an ongoing payment that a franchisee pays to the franchisor. The terms of the payment are usually determined in the contract between the two parties; however, it is common for the royalty fees to be paid weekly, monthly or quarterly and is typically a percentage of the gross sales earned by the Franchisee. So why is it that the franchisors charge this continuing expense and why is it so important to them?

Franchises owners understand the importance of the royalty fee; however, those who are new franchising usually have a hard time understanding its significance and how it could be benefiting them. Let us explain.

Royalty fees are also called the management service fee and for a good reason, because it is essential for both parties. For royalties, it is not uncommon to be the only source of income for a franchisor, which they rely on for the growth and sustenance of the system.

It is essential to understand that the process of putting together all the necessary components so that franchisees can seamlessly start a business requires a lot of time, money and dedication on the franchisors’ part. These mechanisms may include training franchisees, maintaining an operating business, establishing trademarks and logos, establishing business best practices, which means that franchisees have the benefit of having a lot of the work already done for them.

Compared to starting their own business and establishing a brand from scratch, starting a new Franchise UK means franchisees have access to tried and tested systems, training, the goodwill of the brand, brand recognition and vendors that have all been created by the franchisor to help the Franchisee succeed.

Recent data shows that the franchising business model is far more successful compared to the other; this is in part due to the management services provided by the franchisor. Many franchisors also offer on-going support to the franchisees in the form of training and follow-ups, which means the franchisors are equally invested in the long-term success of their franchisees and the royalty fees serve as a compensation for the effort and money invested by the franchisors.

Having all these systems, practices and training at their disposal means that franchises have a reduced business risk and a structural advantage that improves their chances of success significantly.

Kinds of Royalties

As discussed earlier, the most common types of royalty fees include the percentage based and the fixed royalty. As a beginner in the world of franchising, you must understand the different kinds of royalty fees and how it benefits you as a Franchisee and the Franchisor:

  • Percentage-Based Royalty Fee

Percentage-based royalty fees are the most common even in coffee franchises, food franchises UK and home-based franchises due to the benefits it offers to both parties. In the UK, the average is about 6 to 8 percent of the gross sales; however, the range could be around zero all the way up to 20 percent.

The fee could vary from one contract to another between the franchisor and the franchisees. A percentage based royalty fee encourages both parties to make efforts to increase the volume of sales. Additionally, this type of ongoing service fee is more favorable for franchisees that are starting the business and are not able to pay a fixed amount fee, which could be more than they can afford in the initial stages.

The percentage-based royalty structure can be further subdivided into the following types:

Increasing Percentage

Usually found in agreements made with franchises located in busy locating with a higher likelihood of success. In the increasing percentage royalty structure, the percentage of royalty increases with time or other factors such as sales. This model benefits the franchisor more than the Franchisee as it targets franchises in a location with high traffic and better sales.

Among the percentage structure types, the fixed percentage model is the most prevalent of them all because it benefits both parties. The percentage remains constant irrespective of the volume of sales or the location of the franchise.

Decreasing Percentage

In contrast to the increasing percentage model, in the decreasing percentage structure the percentage the franchisee pays less as the volume of sales increases. This model motivates franchisees to increase the volume of sales so they can retain a more significant portion of the profits.

  • Fixed Royalty Fee

The fixed royalty fee is not as common as the percentage model, which could be due to its shortcomings because it does not take into consideration the amount of sales the Franchisee it making. The Franchisee is required to pay a fixed service fee to the franchisor.

For some franchisors paying a fixed amount at the beginning of the business can be a challenge; however, this model is more beneficial for the Franchisee in the long run as their sales grow. Because of paying a fixed amount, franchisees can rake in bigger profits once their franchise business starts to take off.

Fixed Minimum Royalty Fee

The fixed minimum royalty fee structure can be considered a type of the fixed royalty structure as it is a minimum fixed amount that franchisee must pay to the Franchisors. This model can be used simultaneously with another model such as the fixed percentage in the royalty agreement.

This, however, may not be beneficial for the Franchisee as it means that they will have to pay the franchisor a fixed minimum amount along with another type of royalty even when their franchise is doing poorly.

Transaction-Based Royalty Fee

In this type of fee structure, the royalty is charged on every sales transaction made by the Franchisee. Transaction-based royalty is more common in the hospitality franchising industry.

High Vs Low Royalty Fees

There is a common misconception among franchisees looking to start their first franchise business that lower royalty fees mean more profits for them to keep. On the contrary, higher royalties could mean that the Franchisee will have access to better business systems and lower business risk.

The onus lies on the franchisees to do their due diligence and conduct thorough research about the franchising opportunity, the advantages it provides and the profitability before arriving in a conclusion.

A reliable and reputable franchisor will be meticulous about defining the right royalty fee structure or percentage that is favourable for both parties. They will take into consideration their needs, the needs of the business as well as the need of the Franchisee to make a reasonable profit.