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METHODS OF DETERMINING ROYALTY FEE STRUCTURE
Most often franchisors establish their royalty based upon a percentage
of the franchisees gross sales. While it is often the simplest fee
structure to administer and explain to the franchisees, it is not
always the best method to ensure the best balance for either the
franchisor or the franchisee.
There are many variations used by franchisors. Some of the more
common fee structures include:
FIXED PERCENTAGE OF GROSS SALES
This is the most common fee structure. The franchisee reports gross
sales, after making certain approved adjustments (taxes, bad debts,
returns, etc.). The royalty is calculated by applying the fixed
percentage to the adjusted gross sales.
VARIABLE PERCENTAGE OF GROSS SALES
DECREASING PERCENTAGE - MONTHLY SALES
This structure is used by some franchisors in the belief that reducing
the percentage royalty on increasing sales is fairer to the franchisee
as it provides additional reward for superior performance and still
provides the franchisor with an acceptable rate of return. Some
also feel that the decreasing percentage encourages franchisees
to report total sales more accurately.
The franchisor establishes different royalty rates for various
levels of monthly sales. As the monthly sale increase, the royalty
rate goes down. The franchisee applies the royalty rate for all
sales in the month. In subsequent months, the royalty rate will
again be based upon the level of sales achieved.
DECREASING PERCENTAGE - CUMULATIVE SALES
This royalty structure is similar to above. except the franchisee
applies a lowering royalty percentage based upon cumulative annual
sales rather than individual monthly sales. The royalty report reflects
cumulative sales total, and as the franchisee exceeds the target,
the royalty rate drops on future sales until the next sales target
INCREASING PERCENTAGE - MONTHLY SALES
All locations and markets are not created equally. The rational
for the use of an increasing percentage is to provide the franchisor
with additional compensation for granting a market which has superior
5.2d INCREASING PERCENTAGE - CUMULATIVE SALES
This royalty structure is similar to above. The franchisee applies
a higher royalty percentage based upon cumulative annual sales.
MINIMUM FEE STRUCTURES
The franchisor grants a market with the expectation that the units
performance will meet certain minimum expectations. To provide the
franchisor with a minimum level of return on the market, regardless
of the sales at the location, a minimum fixed royalty is established.
In those periods in which the royalty as a percentage of sales
does not meet the minimum royalty, the franchisee remits a minimum
royalty fee. Minimum royalty fees are typically adjusted periodically
based upon a CPI or other basis.
Similar to the minimum royalty above, except the franchisees may
pay their royalty based upon a rolling average of sales.
Sales in periods which exceed the minimum requirements, may be averaged
with sales in periods which did not meet minimum requirements. This
method reduces the negative impact felt by franchisees who are required
to pay a minimum fee. The periods which may be averaged are typically
limited to three months.
The royalty is a fixed fee and is not affected by unit sales. The
franchisor is assured of a fixed dollar return each month, while
the franchisee receives the full benefit from increased unit sales.
The fixed royalty basis is similar to a commercial lease without
any sales override. The fixed fee is typically adjusted periodically
based upon a CPI or other basis.
START UP PERIOD ADJUSTMENTS
Franchisors recognize that during the initial period of operation,
the franchisee may have higher costs in establishing their business
and at the same time, lower sales until they reach maturity. To
assist their franchisees during this period, some franchisors will
eliminate or reduce the royalty rate during the development period.
The amount of royalty not collected is either treated as unearned
or may be considered as a deferral or loan to be paid at a latter
Franchisees are charged a fix fee based upon number of units sold,
transactions closed, rooms rented, bottles shipped, etc.
NO ROYALTY FEE
In franchise systems in which the franchisor earns income from the
sale of merchandise or services to its franchisees, the markup on
these sales and services is earned in lieu of royalty.
ESTABLISHING RETAIL ADVERTISING AND MARKETING FEES
Regardless of the structure a franchisor chooses to administer and
expend franchisee marketing contributions, they must be certain
that the amount of promotional dollars available is adequate for
the purpose. They also must be assured that the level of advertising
contribution required of the franchisee is affordable. Just as with
other continuing fees, the marketing contributions by franchisees
must be balanced.
Franchisors that set fees at unrealistically low rates, in order
to be competitive with other franchisors, will soon find that the
lack of effective advertising programs will be viewed by the franchisees
as a failure of the franchisor. Setting the fees at too high a rate
will be unaffordable by the franchisee and will therefore create
And, just as with the evaluation of other continuing fees, all
franchisees and markets are not equal. Unit sales, critical mass,
population densities, local media costs and effective marketing
methods and availability will vary.
Nor are all franchise systems equal. Large systems have national
marketing alternatives which smaller systems do not. Franchisors
that have effectively established critical mass have alternatives
which other systems do not.
Therefore before establishing advertising and marketing fees, franchisors
need to be aware of their retail and marketing positioning. Among
a host of considerations they must take into account:
- What are the effective retail advertising and marketing strategies
- What are the effective grand opening advertising and marketing
- What strategies are affordable for the system and markets today.
- With responsible growth expectations, what will be the affordable
marketing strategies in the future.
- How to structure the advertising fees to ensure that the franchisor
has the flexibility to meet future requirements.
RETAIL MARKETING EXPENDITURES
The amount the franchisee is required to expend on Grand Opening
marketing is usually stated in the franchise agreement. The methods
for implementing the grand opening program will vary, from general
guidelines established by the franchisor and provided to the franchisees
for their implementation, to a program planned and implemented directly
by the franchisor for the new franchisee.
Regardless of the approach taken , the general range of minimum
costs for the grand opening program can be estimated by the franchisor.
While the minimum level of grand opening costs are specified in
the franchise agreements, the franchisee always has the option to
expend more. And in established markets, the grand opening campaign
can often include support advertising from the other franchisees.
There are generally two methods franchisors utilize to manage the
grand opening expenditures:
- The franchisee pays for the cost of the program directly.
- The franchisee contributes the required amount to a designated
fund or cooperative.
In some franchise systems, in addition to the grand opening expenditure,
the franchisee is required to make an additional contribution to
a designated fund or cooperative. The purpose of this contribution
is to effectively compensate existing franchisees in the market
for developing the market prior to the franchisees entrance.
Most franchisors have some requirement for franchisees to advertise
locally. The amount required is often set as a fixed dollar amount,
a minimum dollar expenditure vs a stated percentage of gross sales
or simply as a percentage of sales.
Often franchisors will state the local marketing requirement as
a range which can be adjusted over time. The reason for establishing
the local marketing contribution as a range is to provide for future
changes to the franchisor's local marketing strategy as well as
to provide for changes in market dynamics and costs.
YELLOW PAGE ADVERTISING
The requirement to advertise in the franchisees local yellow pages
is often specified separately.
The determination whether to credit the cost of the yellow page
advertising to the franchisees minimum local marketing requirement,
or to specify that it is in addition to the local marketing requirement
varies among franchise systems.
LOCAL AND REGIONAL COOPERATIVE PROGRAMS
The use of advertising cooperatives by franchisors is growing. These
are marketing funds which the franchisees typically have a greater
level of control than they do over national fund contributions.
Even in franchise systems which have not established cooperatives,
it is not uncommon for the franchisor to provide for the right of
the system to establish the cooperatives in the future. In those
situations, the local franchisees will be required to participate
in the cooperative when they are established.
The amount of the franchises contribution to the cooperative is
usually stated as a minimum vs a percentage of gross sales. In some
systems the amount of fund contribution may be stated as a fixed
dollar amount, typically with an annual CPI adjustment.
As with yellow page advertising the contribution can either be
credited against the local minimum marketing requirement or as an
additional expense for the franchisee.
NATIONAL FUND CONTRIBUTIONS
There are very few franchisors who have not established a provision
in their franchise agreements for a national advertising fund.
As with other marketing expenditures, these can either be a fixed
dollar amount (with annual CPI adjustments), minimum dollar amount
vs a percentage of sales or simply as a percentage of sales.
Most franchisors attempt to spend their franchisee's fund contributions
in their markets even when it is not provided for by the franchise
agreements. The reasoning for providing the option to expend money
outside of the contributing market are:
- Strategic - Some markets may require more advertising expenditures
than can be afforded by the local franchisees. It is in the systems
interest to provide this additional support by taking money from
- National and regional advertising requirements.
Some franchisors, even though not required by the franchise agreement,
will manage the national funds, internally, on a market basis. They
will treat advertising advances to markets, in excess of the markets
contributions as inter-market loans.
SUPPLEMENTAL ADVERTISING CONTRIBUTIONS
Franchisors often specify minimum advertising weight by market.
This is to ensure that marketing dollars are spent effectively.
In situations when the available fund balance does not enable advertising
at this minimum weight franchisors may decide not to expend any
of the fund balance until the minimum dollars are available in the
In some systems, the franchisor may lend money, from their operating
accounts to the fund or may contribute the money. In other system,
the franchisor may give the franchisees the option to make supplemental
contributions to provide for the additional dollars. In those systems,
it is usually provided that when a majority of franchisees in the
market agree to the supplemental contributions, the other franchisees
are obligated to do so also.
FREQUENCY OF COLLECTION
Typically, royalties and advertising are collected on a weekly,
bi-monthly or monthly basis, although there are still a few franchisors
that collect their fees on an annual basis. The majority of franchisors,
especially those whose franchisees have considerable capital invested
in fixed assets, have elected a monthly basis.
Franchisors need to examine the cost benefit relationship of requiring
frequent franchisee remittances vs. working capital benefits. While
it is certainly feasible with electronic transfer to collect fees,
even on a daily basis, the transaction costs can be prohibitive.
Many franchisors who examine the cost of collecting fees on a frequent
basis discover that the cost, both for the franchisee and the franchisor
in administrative, banking, bookkeeping, lost management time and
opportunity costs, make the cost of improved cash flow an illusionary
benefit for the system.