How to set royalties, without guesswork
In this diverse universe of franchising, there may be sexier topics than setting royalty rates, but no discussion is more important to the ultimate survival and profitability of your franchised company.
At the heart of the franchise business model (and as stated in the first part of this story, “Daring to touch the sacred cow,” in the May issue), royalties are recurring fees paid to remain part of the system, covering the costs of administrative, operational assistance, advertising and social media.
Set them too high and franchisees will grumble or leave your system for greener pastures. On the flip side, royalties that are too low can be just as catastrophic, depriving the franchisor of the funds it needs to support franchisees and promote the business.
With competition for high-quality franchisees tougher than ever and with more franchisors reevaluating long-standing royalty structures, setting royalty fees is a critical decision.
Franchises new and old need to evaluate their royalties to ensure the company is competitive—and that it’s also not leaving significant money on the table.
If you’re at the helm of an existing franchise with a royalty structure that’s been in place for years, collecting dust and untouched, it’s worth opening the crypt and asking the question: Are our royalty rates good for franchisees of all sizes?
“While the topic may be wonky to some people, I think fee determination and especially royalty determination is probably the single most crucial question that any new franchisor looks at, and it’s all too often done by sticking a needle in the dartboard or copying the other guy out there,” said iFranchise Group’s Mark Siebert, author of the recently released book titled Franchise Your Business.
“This leads to a lot of companies that end up in financially precarious waters because they don’t take the time to really go through an analytical process to determine where their fees should be at.”
As Siebert explains it, picking an arbitrary number or setting royalties too high or low can raise a flock of chickens that may come home to roost when the company grows or shrinks, is impacted by external forces (such as commodity price shift) or its franchisee makeup shifts over time. Setting royalties at five percent, he said, when they should instead be six, is a mistake that can quickly equal hundreds of thousands of dollars—or even millions—when multiplied by the number of franchisees or compounded over the years.
“In franchising, you’re talking about growth on steroids, not setting up a franchise program” to sell a single franchise, he said. “If your average franchisee does $500,000 a year in revenue and you’re off by one percent, that’s a $5,000 mistake.”
Doing a little back-of-the-napkin crunching, Siebert said that $5,000 mistake can morph into $500,000 in a chain with 100 franchisees. That’s $2.5 million over five years and a hefty $5 million after a decade—more than enough reason to use stringent analytics or an industry expert to set royalty fees at the balance point between operational service and franchisor profits.
Beyond recurring cash flow, he added royalty fees that are too low can have an adverse impact on the valuation of a business. “A billion here and a billion there, and pretty soon you’re talking real money,” he said, quoting a politician from his home state of Illinois—a state with experience frittering away vast sums of money.
Plan for the future
Jim Wahl, lead franchise attorney at Monroe Moxness Berg, advises his clients to carefully determine the amount of support they need to provide their franchisees, as well as the cost that doing so requires.
“The franchisor should be able to cover their expenses and have a little something left over out of the initial fee in terms of their costs of getting the franchise sold and getting the operator up and running,” he said. “That’s the starting point.”
Beyond that, franchisors need to make sure their chosen royalty structure—be it a flat fee, a percentage of sales or a percentage of gross profits—is something that’s easy to understand, audit and verify.
Increasingly, he said, there’s pushback from operators who feel the franchisor ignores their profitability. Similarly, franchisors charging based on profit margins need a way to ensure that non-essential items like an operator’s vehicle or “your nephews who don’t really do anything” aren’t living off of the individual location’s balance sheet.
“With more sophisticated POS systems, the franchisor does get a lot more information about what’s happening at the store level, so there are some systems that are starting to look at charging the royalty based on a gross profit number,” he added.
Wahl said he regularly sees some companies that aren’t charging appropriate royalty fees or are basing the decision solely on what their competitors are doing. “In an early-stage concept, they may just say we don’t really know at this point what it’s going to take,” he said. “That’s often something they work out as they go along and become more mature.”
Whether it’s an existing franchise or a brand-new company, Wahl added it’s critical to put yourself in the shoes of a franchisee who may grouse at other ‘zees being charged a different royalty. That can happen for a variety of reasons, like larger, more sophisticated franchisees being charged less or the franchisor making allowances for an operator that ran into temporary financial trouble.
“If I’m the operator that has stayed up to date with my royalty payments, haven’t been in default and the guy down the road maybe didn’t watch the expenses quite as well, that’s got some built-in unfairness to it from the standpoint of the person who’s been in compliance all along,” he said.
Simplicity is best
Brian Schnell, partner and chair of Faegre Baker Daniels’ franchise practice, said the primary keys in setting franchise royalty rates are the sustainability of the system and that they are equitable for the entire network of franchisees.
“There’s no one way of doing any of this, but what is often forgotten or not truly analyzed or thought through is, what does it all mean from a sustainability standpoint,” he said. “What is this going to look like in five, 10 or 20 years—that’s what the prospects need to pay attention to.”
He added companies with complex royalty structures may have other things that are far too complicated, giving potential franchisees (and their attorneys) pause in evaluating the concept.
Wahl underscored the importance of full disclosure, wherever royalty rates may be. “I’ve got one client that charges a below-market royalty because they make money off certain product sales, and that’s all disclosed in the FDD,” he said. “It’s all based on maintaining system standards, so there are reasons behind it, they disclose it, discuss it and say this is how our cost structure is built and here are the reasons for it—if that makes sense to the operator, then I think it can work very well.”
Siebert agreed that simpler royalties are best, adding that franchisors should include franchisee input into the discussion.
“The amount of money you can take out of your franchisees, whether it’s by rebates or royalties, has to deliver a good return on investment to the franchisee,” he said. “If you’re trying to find more ways to take things out of the franchisee’s pocketbook, one of the things you have to be cognizant of is the best franchise systems are the ones where the franchisees are happiest.”
Crunching the scenarios
If you’re not copying (or undercutting) your competition, setting the proper royalty rate is an intense process that ensures a greater chance of pleasing franchisees and sustaining the business.
The first step, Mark Siebert of iFranchise Group said, is going through a “cost-plus” analysis to determine the price of supporting a single franchisee. That’s the “hard floor” cost, he said.
Then, determining the “soft floor” costs means inflating those per-franchisee costs and a hypothetical ceiling that envisions the highest such costs could grow.
“Once you’ve done that, you now have to develop a financial model to say how does this actually work in reality where you’re building in all of those salaries, projected growth and the support that you’re going to provide,” he said. “Then it’s time to do some sensitivity analysis,” which means looking at the ways this might grow under different circumstances.
If average unit volumes of a system change from $500,000 to $400,000, for example, completing these financial models will prepare the company to ensure its franchisees remain happy as times change.
“If I’m in the breakfast business, what happens if the price of eggs or cheese goes up?” Siebert asked. “That’s going to impact the food cost of the franchisee and may mean that the franchisee ends up with a lower return on investment—and maybe now I’m below that threshold in which this is an attractive investment.”
Existing franchises looking to change pre-existing royalty rates, he said, will have to await the expiration of existing franchisee contracts or get them to sign new contracts. That can be particularly challenging if royalty rates rise above the current level.
In the case of rising royalties, existing franchisor credibility and a thorough explanation of increased benefits or marketing dollars can be pivotal.
“Nobody’s going to go back and say, I want to pay more royalties,” Siebert said. “If you’re talking about a different royalty structure, you need to get franchisee involvement” to obtain buy-in.