In our recent bulletin titled How to Determine if Your Initial Franchise Fee is Really Appropriate?, we discussed how to determine an initial franchise fee.
Following the release of that bulletin, several franchisors have asked us if the same considerations apply to setting an appropriate royalty rate.
Some aspects are common to both fees, while others are quite different.
Common considerations include:
- Because each franchisor is different and, more importantly, because franchisee services differ greatly from one franchisor to another, the appropriate royalty rate is not the same from one franchisor to another.
- As for the initial franchise fee, the franchisor must also ensure that royalties do not impose an undue burden on the franchisee or pose an undue obstacle to the profitability of the franchised business.
- Also, the royalty rate must pass the market test, i.e., the test of comparison with the royalty rate charged by other franchisors offering franchises similar to that offered by the franchisor.
- This does not mean that the royalty rate must be identical to that of competing franchisors, but that the franchisor must be able to justify any significant differences (particularly in relation to the franchisee's anticipated return on investment).
- As a minimum, the fees should eventually (once the network has a certain number of franchisees) cover all the costs incurred by the franchisor in managing the franchise network, in providing the franchisees with all the services necessary for the management and operation of their franchises, and in ensuring the continuity and development of the franchise network.
On the other hand, and contrary to the initial franchise fee, royalties are a source of profit (often the main and sometimes the only one) for the franchisor.
Therefore, the royalty rate should not be established on the basis of the costs incurred by the franchisor (which must, however, be well covered by the royalties), but much more on the basis of the added value brought by the franchisor and its concept to the operation and profitability of each franchise.
This added value can be expressed in the following way: A rate that ensures that the franchisee who operates his or her franchise in accordance with the franchisor's concept and standards can realize a better return on her or his investment (in money, labour, and risk level) than by operating a similar business alone or within another franchise network. This rate should also allow franchisees who manage and operate their franchises particularly well to be properly rewarded for their exceptional management.
We invite you to reread our bulletin entitled What is the Real Contribution of a Franchisor for its Franchisees? which deals with the added value of a franchisor and its concept.
Obviously, translating this principle into an appropriate royalty rate is not an easy task and requires the assistance of financial, accounting and franchising experts.
It is also prudent for the franchisor to specify in its franchise agreement what services are included in its royalty and what services will be charged to the franchisee in addition to its royalties.
This is particularly important because, as any franchise network evolves or because of changes in the environment and business reality of its network, the franchisor will add services to the franchisees.
If the franchise agreement is not clear on this point, then it is possible that franchisees will consider that any services added by the franchisor are included in the royalties and cannot be charged in addition to those.
This has raised important issues and debates within several franchise networks, particularly with respect to new technological tools and to e-commerce.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
