Thinking about starting a franchise business?
There are tons of reasons why this can be a good idea:
Established brand name recognition. Business plans and ready-made systems.
Support and education to let you hit the ground running.
Marketing and advertising paid for by the franchisor.
A network community of peers
It’s basically a business-in-a-box. Except without… you know… an actual box.
This can be particularly great for businesses (like real estate brokerages!) that already have an established revenue stream, and are looking to diversify their revenue or expand without having to start from scratch. Again.
Most franchise agreements have some sort of initial buy-in that covers the type of things mentioned above – a “pay to play” if you will, called a franchise fee.
The idea is to set a franchisee up for success from day one without the need to reinvent the wheel. The more the franchisee succeeds, the more the franchisor can grow, and the more the franchisor succeeds, the better tools, systems, etc. they can offer to help their franchisees succeed.
It’s like a happy little success feedback loop.
Pretty straightforward, right?
Then there are royalty fees.
These are not the same as franchise fees, and they can be a bit more complicated.
Percentage vs. Flat-Fee Franchise
Royalties are fees paid by the franchisee on some sort of regular schedule – weekly, monthly, yearly, etc. as determined by their franchise agreement.
Traditionally, the most popular way to structure royalty fees is as a percentage of every dollar the franchisee makes in sales.
However, recent history has seen the rise of another option – the flat-fee franchise. This setup means the franchisee pays the same royalty fee every time) subject to modest annual adjustments), regardless of how much money they make.
Each of these setups have their potential pros and cons, so how do you know what’s right for your business?
Percentage-based franchise royalty model
According to International Franchise Professionals Group, “Typical franchise royalties range from 4% of your revenue to 12% or more based on the type of franchise business.”
For example, say your royalty fee percentage is 10%.
For the month of June you have gross sales of $50,000, so your June royalties owed would be $5000.
July brings a jump in gross sales to $82,000. You now owe $8200 in royalties. Ouch.
Businesses that have high revenues, like food franchises, can be subject to lower franchise fee percentages – the lower percentage can be balanced by sheer volume in sales.
But what about lower revenue businesses?
They can be subject to higher royalty percentage rates since their gross sales are lower. Service businesses can also be subject to higher royalty percentages since they don’t have to carry warehouses full of inventory.
To make things potentially more confusing…
These royalty fee percentages can also vary.
Some can be set up as a tiered structure, where the percentage depends on the growth of the franchisee’s business or if they hit certain revenue targets. Even the age of the business can factor into royalty percentages.
The potential advantages to percentage-based royalties are:
- They can be much lower when a business is starting out and revenues are typically low. Since out-of-pocket costs are typically higher in the beginning, lower fees can free up more money to invest in faster growth.
- When times are leaner (recession, changes in the market, shifts in interest rates, etc.) and revenues drop, royalty bills drop right along with them.
Sounds good, right?
Well, there are some potential drawbacks:
Since percentage-based royalties are typically calculated from gross sales, businesses with higher costs and lower profit margins tend to suffer more from this kind of setup. When profit margins are already lean, percentage-based fees can dig even deeper into profits and slow or hurt future growth.
As revenues increase, the royalty fees owed typically will also increase. Profits are harder to build, and fees can take larger and larger bites out of hard-won revenues.
A Forbes article on franchise royalty fees also notes: “… this can cause franchisees to become disgruntled – the harder they work the more they see the amount that they end up paying to the franchisor increasing! This can result in unmotivated and disengaged franchisees.”
Lastly, since these royalties are not fixed costs, they can make future business planning more difficult.
While the percentage-based model can work well for some businesses, it’s definitely not a one-size-fits-all solution.
Flat-fee franchise royalty model
Enter the concept of flat-fee royalties.
This option means a franchisee business pays the same amount in royalties every time (subject to modest annual adjustments), regardless of what their sales are. For example, a franchisee’s gross sales in June are $50,000 and by the terms of their franchise agreement, they owe $5000 in royalties. Come August, they’ve grown their revenues to $82,000 in sales. Their royalty bill is still $5000.
Then they have a whopper of a holiday season. Fueled by a brilliant TikTok campaign that goes viral, December’s top line is $122,000 in sales.
Their royalties? Yup. Still $5000.
The potential advantages of this kind of structure can be pretty clear:
- The more the franchisee’s business grows, the more their profits grow.
- Any increase in profits can go straight to their own top line, not to the franchisor.
- The business owner has more potential freedom to innovate, find creative solutions, and respond to their unique market without a chunk of their hard work going to increased royalty fees.
- It’s easier for the franchisee to be motivated to grow the business when he/she can also reap all the rewards of that growth. Who the heck wants to be in business for someone else anyway?
- A flat fee is predictable and consistent, which can make business planning easier.
And…
Even though their fees are flat, the franchisor still wants to see their franchisees succeed – when that initial franchise contract is up for renewal, you can bet they want to make sure each franchisee will sign on for another term.
Yes, there are a few potential disadvantages here too.
A flat fee can be more costly in the beginning when initial expenses are higher and revenues are still lower.
The good news? Some franchisors have created a ramp-up model so that early business costs are easier to handle. (Like, ahem, Motto Franchising, for example). This ramp-up approach might look something like this:
- You get an option to finance a portion of your initial franchise fee (we offer financing for up to 50% of the initial fee and charge no interest)
- Franchise fees are waived or ramped up over an initial period of time after your contract is signed (Motto charges no monthly fees for the first 6 months)
Flat fees can also add more financial stress to a business during times when revenues fall or costs outpace growth, but fees remain constant.
However, in the case of a diversified business (such as a real estate brokerage that has added mortgage professionals to their services) these drawbacks may have less impact.
For example, higher initial expenses for the franchise can be offset by revenue from the real estate business.
And fluctuations in revenues for mortgage brokers might be balanced by more consistency or opposing shifts in the real estate market.
So how do you know which franchise fee structure might be right for your business?
Take a good look at your business goals, balance sheets, financial forecasts, and business expansion plans.
Think through the best- and worst-case scenarios, and how those fit with the potential pros and cons of percentage-based and flat-fee franchise models.
Remember, you and your business are unique! Just because one structure may be more “typical” than another, it doesn’t mean that’s the right answer for you.
Published on June 22, 2023
