What is royalty

An article about one of the main franchise fees in simple words.

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Royalty is one of the main franchise fees.

Royalty is paid by the franchisee for the use of elements of the franchise program: trademark, names and designations, technologies, know-how and other elements that were transferred by the franchisor under the agreement concluded between the parties.

Royalty payments also compensate for the amount of support, consulting support and training provided by the franchise founder.

The royalty rate is determined by the franchise agreement and is a regular payment.

As a rule, the royalty rate is calculated as a percentage of the turnover of the franchise object, so the franchisor becomes interested in increasing the turnover.
Why are royalties often calculated as a percentage of turnover rather than as a percentage of profits?
- The franchise founder has less influence on the expenses of the franchise business, and therefore the accrual of royalties should not depend on the actions of the franchisee.

- The franchisee is incentivized to show lower profits to reduce the amount of royalties, which is not beneficial to the franchisor.

- Tax optimization can affect the amount of profit, which means that royalties can be reduced. This is also not beneficial to the franchisor.

Due to the listed reasons, the accrual of royalties in the vast majority of cases occurs in the form of a percentage of revenue.
Fixed royalty
In some cases, franchise agreements may include a fixed royalty structure, meaning that the franchisee pays a set amount for a specific period. This could be a fixed royalty for half a year, a year, or a month.

At first glance, such a system might seem to indicate a lack of interest on the part of the franchisor in the success of their partners. However, in reality, fixed royalty can be particularly appropriate for certain types of businesses, especially when:

1. Concealing actual revenue is relatively easy.

2. The franchisor does not track partner performance indicators (revenue, profit, etc.).

3. The profit margin of the service itself is low.

4. Royalty is a relatively small amount.

Here's an example of how fixed royalties can be effectively implemented:

In our retail project, we implemented a fixed royalty system. The network sold goods with very low margins, and imposing a percentage-based royalty would have made sales unprofitable. Instead, we decided to charge a fixed royalty fee for using the system, with payments made every six months. This system proved to be successful and sustainable for both the franchisor and the franchisees.

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Royalty vacation
Sometimes franchise terms offer royalty holidays for a short period. In addition to the fact that this is a tool in the negotiation process, it is also a tool for reducing the burden on the franchisee’s business in the first months of gaining momentum. In my opinion, this path is not very suitable for our conditions, because a very serious moral shock for an entrepreneur will be the moment when he receives a bill for royalties for the first time, even if, according to the rules, he had to pay it from the first day of his existence business.
Reluctance to pay royalties
Any entrepreneur is mindful of their expenses. Franchisees carefully evaluate the value of the royalties they pay to the franchisor in relation to the benefits, services, and support they receive in return. At some point, this comparison may not favor the franchise owner, meaning that the franchise is paying more than it is actually worth. This is a crisis moment.

There are two obvious reasons for such a crisis:

1) The franchisor does not provide enough support to its partners.

2) The royalties are too high.

In our franchise packaging projects, we use our own royalty calculation system to ensure that the royalty amount does not become a deterrent to business growth and does not lead to the termination of partnerships.

Example: I was a third party in a dispute between a partner and a franchise founder. The partner summed up all the royalty payments he had made over several years and demanded that the franchisor justify what exactly these payments were for. The issue was resolved amicably through a compromise, but I suggest remembering the form of the question itself and never creating such a situation.
Franchises without royalties
I don't believe in franchises that don't have regular royalty payments. I consider that if a franchise lacks recurring payments, it's not a true franchise in the full sense of the word. Royalty payments are the way the franchisor compensates for their expenses in supporting their partners. If there are no royalties, it can only mean three things:

1. There is simply no ongoing support, and it's basically just consulting on how to open a location.

2. It's a distribution program, not a franchise.

3. These expenses are compensated from other sources (supply of raw materials, equipment, packaging, etc.), and in this case, the business is more like a supply system with an additional service in the form of consulting on how to use it.
Royalty calculation
When developing a franchise, an important issue is the development of correct conditions, including royalties.
I suggest several strategies for calculating royalties:

- Focus on competitors.
- Focus on the financial model.
- Focus on the cost of activities to support partners.
Royalties and lump sum fees are the main payments of most franchise programs.

However, royalties have an even stronger impact on the franchise business. If the lump sum fee is a one-time payment that a successful business will eventually pay off, then having an additional expense could put the entire business at risk. That is why the calculation of royalties is an extremely important issue and requires special attention.