Understanding the three most common types of franchise royalties
Tuesday, April 24, 2012/
When deciding to franchise a business, new franchisors often have little understanding of the different types of royalty options available to them.
Franchisors which form part of their network’s supply chain may even have the freedom to not charge royalties at all, and instead derive their income exclusively from mark-ups on goods or services supplied to franchisees.
Such mark-ups are not viewed as royalties for the purpose of this article, which examines the three basic royalty models: Fixed Dollar Amount, Fixed Transaction Amount and Fixed Percentage Method.
Royalty Model 1: The Fixed Dollar Amount
The Fixed Dollar Amount royalty is the simplest of all franchise royalty models. It is set as a specific amount of money (eg. $100 per week) paid on a regular basis irrespective of the franchisee’s business performance, or the levels of support provided by the franchisor.
This royalty model is particularly common among mobile service franchises as it requires no monitoring of franchisee performance, because whether or not the franchisee is enjoying high gross sales, the royalty remains unchanged.
Franchisors who use this royalty model typically collect it by debiting the franchisee’s bank account on a regular basis for the duration of the franchise agreement.
While this is the simplest type of royalty, it has both advantages and disadvantages for franchisees and franchisors.
As a proportion of a franchisee’s gross sales, the Fixed Dollar Amount royalty may be quite high until sales grow, but because the franchisor does not receive any increase in royalty if a franchisee increases their gross sales, the franchisor has no financial incentive to help the franchisee.
For franchisors, the lack of monitoring systems required to collect this type of royalty means that little, if any useful or timely business information will be provided by franchisees to develop network performance benchmarks.
Additionally, franchisor royalty income cannot be increased without granting more franchises, or indexing the royalty to allow for inflation (which is common, but accounts only for the net present value of money such that a $100 per week royalty this year might be $103.50 per week next year, allowing for inflation of 3.5%).
Royalty Model 2: The Fixed Transaction Amount
By far the rarest of the three basic royalty models is the Fixed Transaction Amount method.
Under this method, which has much in common with the Fixed Dollar Amount method, franchisees are obliged to pay a dollar value equivalent to a pre-determined number of sales transactions on a regular basis.
For example, the franchisor might determine that the royalty will be the equivalent value of 10 standard services or products sold by franchisees.
Furthermore, the franchisor recommends the price of the standard service or product, and applies the royalty accordingly, even if some franchisees charge a higher or lower price.
Again, no real monitoring of the franchisee’s business performance is required because both the franchisee and the franchisor understand that the royalty will be the same from one period to the next, and applied irrespective of the franchisee’s gross sales.
The number of services or products to which the Fixed Transaction Amount does not change, only the recommended price, which may increase annually or at more regular intervals, and at a rate greater than inflation due to market forces.
Consequently, this type of royalty provides greater scalability of income to the franchisor (compared to the Fixed Dollar Amount royalty) because the franchisor can either increase the recommended price, or recruit more franchisees to increase its royalty income.
Royalty Model 3: The Fixed Percentage Method
The third and most common form of royalty is the Fixed Percentage Method, where royalties are charged as a percentage of a franchisee’s gross sales.
Irrespective of the actual percentage amount (eg. 1%, 10% or greater), a graph of the royalty payable to the franchisor would appear the same as below for a new franchise. Initially the dollar value of the royalty is low as gross sales start to build, and then as gross sales increase, so too does the dollar value of the royalty.
The steepness of the curve initially will depend on the rate of growth of sales, and this growth rate will slow to a more sustainable level, as evidenced by the levelling of the curve.
This royalty model directly links the franchisor’s income to the franchisee’s sales performance, and therefore provides the franchisor with an incentive to assist franchisees to grow their sales, unlike the Fixed Dollar Amount and Fixed Transaction Amount royalty methods.
Because the Fixed Percentage Method provides a royalty model that incentivises the franchisor to grow franchisee sales, it also provides a scalable income to the franchisor that allows for greater reinvestment in support services provided to franchisees.
Under this royalty model, franchisors can increase their income by either recruiting more franchisees, or actively seeking to grow the sales of existing franchisees.
A downside to this model is that it requires much greater sophistication in franchisee monitoring in order to be effective. Best practise is to link franchisee point-of-sale systems with head office so that sales across the entire network, and in specific outlets, can be monitored live in real time. This also allows for royalties to be calculated by the franchisor based on the payment period, and levied immediately, rather than waiting for reports to be provided by franchisees.
The choice of royalty model is critical to the long-term success of both franchisor and franchisee, and should be determined after a detailed operational and financial analysis.
Unfortunately, franchisors who choose the wrong royalty model, or set the wrong amount, number of transactions or percentage, can later realise that their royalty income is insufficient to meet their operating costs.
Without a full assessment of the financial viability of the choice and size of royalty before franchising, franchisors may risk long-term cashflow and solvency issues, plus potential conflict with franchisees if support services cannot be sustained.
A comprehensive analysis should be done before franchising a business, and then a trial royalty applied to company-owned operations to determine the viability on both franchisee and franchisor ahead of launching franchise operations.
Jason Gehrke is the director of the Franchise Advisory Centre and has been involved in franchising for nearly 20 years at franchisee, franchisor and advisor level.
He advises both potential and existing franchisors and franchisees, and conducts franchise education programs throughout Australia, and publishes Franchise News & Events, a fortnightly email news bulletin on franchising issues and trends.