By Georgina Scott
Royalties are an indispensable aspect of a franchise business. However, deciding on a suitable royalty rate can be difficult! Oftentimes, it is a delicate balancing act between two significant risks: undervaluing your brand or franchisees paying an unreasonable amount.
So what are royalties?
Royalties are the fees paid by a franchisee to the franchisor for the ongoing use of their brand and intellectual property. This payment can occur on a monthly or annual basis, depending on the agreement between the two parties. Oftentimes, the amount charged is a percentage of turnover or gross profit. Deciding on a rate can, however, be a difficult task.
The importance of choosing an appropriate rate
When deciding on a royalty rate, you must balance the needs of the franchisee with that of the franchisor. Royalties, also known as franchise management fees or service fees, provide a source of income for franchisors and a way for the franchisor to cover the cost of support services provided to that specific branch, as well as their broader business expenses. A franchisor needs to propose a rate that is attractive to prospective franchisees to ensure they are attracting and maintaining the best talent. However, a substantial royalty payment would also allow the franchisor to develop new products and services for the market, expand their marketing activities and grow the brand into different locations.
From the franchisee’s perspective, royalty fees can be their biggest monthly cost. If the rate is too large, this may prove difficult to manage during economic downturns, such as what was seen during the height of the global pandemic. Moreover, the rate needs to allow the franchisee to grow their branch and deliver a healthy profit. So how do you calculate an appropriate royalty fee?
Different approaches to royalty rates
There are two main approaches to the administration of royalty fees.
Firstly, the rate may be set as a percentage of turnover or gross profit over a set period. This period may be monthly, quarterly, or annually. For example, a franchisor may charge 5% of the gross sales revenue. Notably, the size of this percentage is highly variable and dependent on both the franchise and industry. The advantage of this approach for franchisors is the fact that as the business grows, so too does their royalty income. However, this approach does have the potential to frustrate franchisees given they ultimately have to pay more for doing a good job at growing their business. A great compromise is the setting of a cap on the amount of royalty fees the franchisee could be required to pay. Once this upper limit is hit, the franchisee has some reassurance that their royalty fees will not continue to grow!
The second approach is a fixed royalty rate. This fee does not change depending on the success, or lack thereof, of the business. In some respects, this approach can be beneficial for both parties by providing more assurance when it comes to business and financial planning. However, for franchisors this approach may prove less favourable as their fees will not increase as the business grows, and for franchisees this fixed rate may prove burdensome when the market is struggling.
If the past two years have taught us anything, it is that it is always wise to consider both the best and worst case scenarios when setting a royalty fee, regardless of whether you are using a percentage model or fixed rate. Unfortunately, it is not always smooth sailing when running a business, and it is in the interest of both parties to remain profitable during downturn periods.
To sum up, there is no perfect was to structure your royalty fees. Different approaches have different benefits and drawbacks. It is always necessary to consider the needs of your individual business, and to plan for both the best and worst case outcomes.
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