Royalties 101: Daring to touch the sacred cow
As the lifeblood of a franchise, royalty fees are sometimes a sacred cow—never to be changed, let alone discussed. Times change, though, and in the wake of unprecedented competition for “sophisticated multi-unit franchisees” every franchisor covets, some brands are changing up their royalty programs or offering discounts to stand out from the herd.
Different from the franchise fee that’s paid up front for permission and intellectual property to operate an individual franchise location, royalties are recurring fees to remain part of the system. They often cover the costs of administrative, operational assistance, advertising and social media assistance. In some companies, royalty fees can also be collected through mandated supply chain purchases, like a proprietary baking mix at a cupcake store.
With many new concepts hitting the industry—a projected 355 new concepts in 2016, up from 258 five years earlier—some franchisors have unveiled new royalty fee structures designed to attract multi-unit franchisees that need less operational support or to compensate new and existing franchisees for the timely addition of new units. Wireless Zone and Checkers & Rally’s are two franchises taking a fresh approach to setting royalties.
Swapping sales for profits
At Wireless Zone, the largest Verizon agent selling cell phones, GPS and wireless services through its 380 stores, the previous model was a constant conflict between a franchisor that wanted to maximize its profits, while also not overcharging its franchisees for its products.
“Our only interest at the store level was driving commissions and I didn’t think that was right,” said CEO Joe Johnson. “The retail locations are a lot more holistic than just the commission on the sale of a device, and I wanted to make sure my operation had the proper incentives in place to drive store-level profitability.”
Before blowing up the legacy model, Johnson reached out to a handful of its franchise advisory council members, asked if they’d gather to discuss a confidential matter, required them all to sign nondisclosure agreements, met at a neutral location and began an anything-goes conversation on how to change the royalty fees.
He began shadowy congress by asking the group, if they were starting the company from scratch and sitting on the same side of the table, how they would build the incentive structure.
“We are at an inflection point in our space. We’ve been incredibly successful for 27 years,” Johnson told the group. “‘We want to continue to be in the future, but we see some pain points and challenges, and I bet you there are enough smart people in this room that we can come up with a solution that’s going to work for everybody.’”
He likened the process to the pre-marriage counseling he and his wife went through, and said chosen franchisees were “honored and humbled” to be a part of the conversation.
Rather than charging franchisees a markup on products sold, the new royalty plan—presented as a voluntary option until the point of contract renewal—charges a fee based on gross store profits.
“The gross sales model didn’t necessarily align the interest of the franchisor with the franchisee, and there are a lot of great examples from the fast food industry where there could be something that’s a very low margin, the franchisee loses money but the franchisor still collects a royalty,” he said. “That created conflict that we didn’t need to have and I can only imagine what it said to franchisees, that we care about us and not you, ad that’s not true—we care about them immensely.”
Aside from time spent discussing options and picking up a few travel tabs, the new model relies on a new POS system and sharing the franchisor’s supplier pricing with franchisees. This setup, he said, avoids adding another layer of reporting for the franchisees, and also has protections built in to protect against fraud in the form of under-reporting store-level profits.
While it’s too early to tell the full impact of the change after implementing the new system last fall, Johnson reported more than 90 percent of franchisees adopted the new system and January store-level profits were up six percent over the previous year.
At Checkers and Rally’s, Chief Development Officer and Senior Vice President Jennifer Durham is responsible for franchise recruitment, making sure the right real estate sites are chosen and supporting franchisees after sign-up.
Starting in 2015, the Tampa, Florida-based company implemented a unique royalty program that provides incentives based on three key milestones in the opening of a new unit.
“In years past we had opening incentives to get restaurants open by a certain time of year, but that became a disincentive if you found a site opportunity in March or April—you had to push a lot harder than somebody who already found their site in September of the year before,” Durham said. “Now what we’ve done is effectively created a target on a rolling 12-month cycle so it’s not bound by year end.”
Because most restaurants are typically opened in the fourth quarter of the year, the previous royalty structure overloaded the franchisor’s operational support team during the fourth quarter of every year. Under the new system, key royalty incentive points include gaining control of the property, initiation of the municipal permitting process and the final opening date of the restaurant.
“Most organizations that I’ve seen have an incentive around the opening date and it’s really focused on that end goal, which is important,” she said. “But you may have hit other milestones along the way, and frankly, the only way you get to that aggressive opening goal is if you hit the other milestones along the way. So it was a way in which to align our franchisees with the process and the timing of that process—we’re rewarding them at each step.”
Offering discounts on royalty fees, rather than the franchise fee, initially received some pushback from the franchisee community, but Durham said she communicated the motivating benefits of the new plan, which can make a bigger difference in cash on hand for new and growing owners.
“A lot of times the initial franchise fee is incorporated into their financing, so that’s not necessarily a check they’re writing,” she said. “It wasn’t as notable as writing that royalty check, and particularly in our business when there’s a spike at opening, that first-year performance is a really strong indicator of future success.”
‘A real struggle’
Although the program is still new, Durham said it’s already exceeding her projections for the year and helping the brand attract new franchisees.
“It’s the toughest I’ve ever seen it in the four and a half years I’ve been leading the development team,” she said of the competition. “It’s a real struggle, and the brands that don’t innovate are the brands that will get left behind.”
This is part one of a two-part series. Next month: How to create a royalty system that franchisees won’t hate.
Creative approaches changing today’s royalty structures
Sean Fitzgerald, chief development strategist at No Limit Agency with C-suite experience at many franchised brands, sees an emerging shift where franchised brands are coming up with more modern and, in some cases, creative approaches to charging royalties.
“The old rule of thumb going back to the early ‘90s was you didn’t mess with royalties—that’s the rate and that’s it, regardless,” he said. “That’s the old approach, and I think you’re starting to see a trend of discounting royalties or people taking a different approach.”
With the rise of some very large and powerful multi-unit franchisees, Fitzgerald said charging flat royalty rates can mean that top producers who need less operational support can be charged significantly more than lower-end franchisees that need much more hands-on attention from the franchisor.
“That’s where you’re starting to see a lot of these tiered royalties where, after a certain level, your royalties begin to drop because you’re rewarding those franchisees for being top producers,” he said.
The challenge, he said, is such a structure inherently reduces the amount of revenue coming in to pay for operational, accounting or marketing support provided by the corporation. He added that young brands, in particular, need to make sure their royalty structures are both fair for a diverse array of franchisees, and also sustainable as it becomes a more mature brand.
“That can be a very dangerous precedent if you’re not bringing enough money to provide a high level support to your franchisees,” he said. “It could be disastrous, because now you’re setting yourself up for a long-term issue.”
A healing economy and increase in start-up brands translates to a shrinking pool of attractive franchisees, as well as more multi-unit operators diversifying their portfolios with many brands—with many different royalty structures under one roof.
Kenneth Levinson, partner and head of the international tax practice at Faegre Baker Daniels, said franchisors have to be careful setting up or changing royalty structures to avoid alienating franchisees who may be paying a different rate than newer or larger fellow ‘zees. In some cases, however, he said it does make sense to offer royalty discounts to larger, more sophisticated operators.
“That guy and his management team is going to know a lot more about franchising on day one than anyone else the franchisor could possibly attract,” he said. “Ultimately the flip side is how much revenue is coming into the franchisor would necessarily be less.”
He advises franchisors to sit down with a team of advisers and gather significant franchisee input before making any changes or developing a new royalty plan to avoid making critical mistakes to finances or relationships.
“You need a fair return on your investments and the franchisees need a fair return,” he said. “If you overcharge the franchisee or they believe they’re being overcharged, they’re not going to stay in your system and you’ll have a whole bunch of frustrated, disgruntled franchisees.”