Understanding Franchise Royalties

a man holding wallet and counting money
Tetra Images/Getty Images

One of a franchisee's ongoing business expenses is typically a royalty fee regularly paid to the franchisor. In some cases, it can add up to a pretty significant amount of money. So what does he get in exchange for these payments? Is it worth it?

Definition of a Royalty Payment

Royalty payments are paid for the continuous use of a piece of work, such as payments made to an author for a book that is on the market. These expenses are in addition to one-time initial fees, such as for the purchase of the property.

The payments are usually lower than upfront fees because they're a continuous regular expense. A franchisee experiences daily sales as his main source of revenue. However, the regular monthly income that the franchisor earns is based on royalty payments from each franchisee.

Why Royalty Fees Are Charged

Recurrent royalty fees are effectively contributions to the entire organization. The payments are used to maintain the system and ensure that all avenues flow smoothly between the franchisor and franchisee.

Royalty payments are typically paid to the franchisor to stay current on technological advances, as well as to enable the creation and marketing of fresh products and services. Also, these payments are used to pay expenses that are incurred at the franchisor's headquarters, such as rent, utilities, and employee compensation.

Royalty payments can enable the franchise company to extend its products and services into other regions and possibly into other countries. As more creative advertising is launched, the organization's brands become increasingly identifiable, so higher business and profits are ideally realized for both the franchisee and the franchisor.

What's in It for the Franchisee

Although the franchisee may not understand the need for royalty fees at first, the payments create a win-win situation for both sides.

Let's say you want to open a pizza restaurant. You can hang out your sign and advertise as "Joe's Pizza," or you can do it as "Domino's" or "Papa John's." In your initial months of operation and before word gets out that your pizzas are incredibly good and worthy of purchase, the bulk of your sales will most likely come from name recognition. Customers call Domino's or Papa John's for their pizzas because a certain quality is implied by the name, and people tend to gravitate toward what is familiar.

But you can't advertise as Papa John's unless you pay a franchise fee and ongoing royalties. And franchisors definitely don't let just anyone hang out those signs. In exchange for initial royalty fees, you'll most likely receive some extensive training into how to make fantastic pizzas and how to most profitably run your new enterprise so as to reflect well on the brand. There's definitely something very valuable in the equation for franchisees as well.

How Much a Franchisee Should Expect to Pay in Fees

Royalty payment systems can follow one of several formats. The most common type is a fee that's calculated on anywhere from 5 percent to 8 percent of the franchisee's total gross sales, but there are some franchise organizations that charge a higher percentage based on net sales, that is, income after expenses. This rate is usually somewhere between 6 percent and 10 percent. Fees are typically paid on a monthly basis.