How franchise fees are determined?

A franchise fee is the payment a franchisee makes to the franchisor for the right to use the company's brand, products, and intellectual property. This can be done up front or on an ongoing basis according to the terms of the franchise agreement.

Instead of creating a business from scratch, a franchisee benefits from the brand recognition and systems that the franchisor has already built. But these benefits come with a cost.

Franchise fees are the cost of entry. Paying the upfront franchise fee unlocks the door to the franchisors’ proprietary business systems and more. You get the complete setup. The franchise fee is literally a license to own and operate the franchise business. That’s why you must pay for it.

Franchisors tend to establish their royalty based upon a percentage of the franchisee's gross sales, and typically collect those fees on a weekly or monthly basis. More and more, franchisors are transferring the royalty payments via Electronic Funds Transfer, where the franchisee agrees to allow the franchisor to debit directly from their bank accounts.

However, there are many variations used by franchisors in structuring their royalties. These are some of the more common structures you will likely see:

Fixed Percentage of Gross Sales

It is the most common continuing royalty 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, traditionally on a monthly or sooner basis. It is often the simplest fee structure to administer, but might not always be the best method to ensure a proper balance for either the franchisor or the franchisee.

Variable Percentage of Gross Sales

Decreasing Percentage: This structure has the franchisee paying a lower percentage of gross sales as the total gross sales increase. It is favored by some franchisors who believe that reducing the percentage royalty on increasing sales is fairer to the franchisee, as it provides an additional reward for increased performance and still provides the franchisor with an acceptable rate of return. Some also feel that a decreasing percentage encourages franchisees to report total sales more accurately.

The basis of calculation can be accomplished in various ways, such as on monthly sales or adjusted for cumulative annual sales. For monthly sales, the franchisor establishes different royalty rates for various levels of monthly sales. As the monthly sales increase, the royalty rate goes down. The franchisee applies the royalty rate for all sales in that month. In subsequent months, the royalty rate will again be based upon the level of sales achieved.

For cumulative annual sales, the franchisee applies a decreasing royalty percentage based upon cumulative annual sales rather than individual monthly sales. The royalty report reflects the cumulative sales total, and as the franchisee exceeds the targeted sales, the royalty rate drops on future sales until the next sales target level is reached. Typical of this structure is that the lower percentage royalty is applied only to the sales above the prior limit.

Increasing Percentage: Some markets or locations are more likely than others to ensure a higher sales rate. A location with prime real estate in the middle of a well-populated town center may be more likely to do a higher sales volume than a rural location in a low-populated area. (Note: this is not always the case!) The rationale to use a higher royalty rate as sales increase is to provide the franchisor with additional compensation for granting a market which it knows or expects to traditionally have superior performance.