What is the Royalty Fee and Why is it Necessary?

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what is royalty

The world of franchise costs can be confusing for first time franchise owners. So, today we intend to demystify the royalty fee – what it is and why it’s necessary.


If you’ve spent some time browsing franchise opportunities, you’ll have already noticed how much their investment levels vary. One area that differs significantly is the royalty fee – how much it is and how it’s paid. So you feel confident comparing franchises and finding one that’s perfect for you and your budget, read on to find out all you need to know about the royalty fee.

What is it?

A royalty fee is an ongoing payment that franchisees make to franchisors after buying into a franchise.

Essentially, the royalty fee is like an ongoing membership charge to remain part of the franchise. This is separate to the upfront franchise fee that is an initial one-off payment made to become a member of the franchise. When you’re buying into a franchise, you’ll be informed of what the regular royalty fee will be and how it is calculated.

What does it go towards?

As well as the fees funding the support and ongoing training that franchisees and their teams receive, the administrative costs of the business and new franchisee recruitment are paid for through existing franchisee royalty fees. The fee also goes towards ongoing adverting and promotions; updates to operating manuals; and the franchisor’s sale of goods and services to the franchisee’s business. Royalty fees are what make the franchise system work.


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Why is it necessary?

In essence, the ongoing royalty fees are how the franchisor makes money – although much of the money is reinvested into the business to support franchisees and to encourage the growth and development of the brand.

When do you pay it?

The royalty fee is generally paid on a monthly or quarterly basis and is usually calculated as a percentage of gross sales. There are, however, more methods of calculating franchise royalty fees:

Gross sales

The most common way to work out the royalty fee is as a percentage of the gross sales (the profit generated from the sale of services, goods and any other products or merchandise) that the franchisee earns. This type of royalty provides an incentive for the franchisor to support the franchisee’s growth, as they’ll receive more money the higher the franchisee’s profit is. They usually come in one of three forms:

  • Fixed percentage. In this case, the royalty fee percentage is fixed so that franchisees know how much they must pay to the franchisor on a monthly or quarterly basis. This is the easiest royalty structure to calculate and is therefore widely used.
     
  • Increasing percentage. This type of agreement allows the franchisor to vary the percentage that a franchisee pays in royalty fees based on several factors. The most significant factor to determine this amount is the location of the franchise. In essence, applying an increasing percentage model enables franchisors to charge a higher royalty rate to franchisees who wish to trade in a busy – and therefore more lucrative – area.
     
  • Decreasing percentage. This royalty model benefits franchisees that work hard to build their business and are more profitable as a result. If the franchisee is selling more, the franchisor rewards them by applying a lower royalty percentage. This acts as an incentive for ambitious franchisees to make more money.

Fixed royalty

A fixed royalty fee does exactly what it says on the tin. A franchisee pays the same amount in regular royalty fees regardless of how the franchise is performing. Whilst this gives franchisors reassurance that they can expect the same payment every month, it may be less attractive for franchisees who must pay a fixed fee even in quiet periods.

Minimum royalty

This acts as a safety net for franchisors and tends to be implemented alongside the percentage royalty model. If a franchisee doesn’t achieve the gross sales needed for the percentage to be high enough, the minimum amount would be applied. Like the fixed royalty method, this removes risk for franchisors, who can guarantee a certain regular payment, but isn’t quite so appealing for franchisees.

No fee

Believe it or not, there are many franchise investment opportunities that require no ongoing royalty payments at all. Be mindful, though, that certain conditions may be added to the franchise agreement in a non-royalty fee arrangement. This could include the requirement to purchase products from the franchisor or their agreed supplier on a regular basis. This enables the franchisor to still generate an income in the absence of royalty payments.


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How do I know the amount I’m paying is fair?

Conscientious franchisors will spend a lot of time and effort determining the right percentage to set their royalty fee at. Preferably, the franchisor will factor in that the franchisee needs to take home a reasonable profit after expenses. But it’s important to maintain a balance. The fee also needs to cover all ongoing expenses necessary for the franchise to flourish, and so it needs to be realistic.

It’s in the best interests of the franchisor to decide on an amount that enables both parties to make a healthy profit from the franchise. If the franchisee’s profit margin is too low, then quality franchisees will not be able to be recruited and retained. Equally, if the royalty is not set high enough, investment back into the business will be inadequate. In either situation, both franchisor and franchisee lose out.

Something to bear in mind

There are no specific guidelines for franchisors to follow regarding the setting of royalty fees, so some innovative strategies can be used to determine the amount. Some franchisors may just apply the percentage that their competitors have set, whereas others may pluck a number out of thin air. To avoid buying into a franchise with unrealistic fees and charges, ensure that you consult an experienced financial advisor before signing the franchise agreement.

If you’ve enjoyed this, check our other article ‘What is the Marketing Fee and Why is it Necessary?’.
 

 

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