Buying into a franchise is one method an entrepreneur might undertake to start his or her own business. Franchises provide the entrepreneur with name-recognition, training and operational support from day one in exchange for an initial franchise fee and continuing franchise royalty payments. While the initial franchise fee is a one-time lump sum payment, the amount of a franchise royalty payment is usually paid monthly or quarterly and can be determined a few different ways.
Percentage of Revenue or Profits. This is the standard way to calculate a royalty. Multiply total revenue by a royalty percentage (typically 2%-10%) every period. Under this method, the royalty fee fluctuates and allows the franchisee to reduce his or her royalty fee expense when sales are slow. Alternatively, this allows the franchisor to collect a larger fee when a franchisee’s sales are great. Sometimes profits are used to determine the royalty fee, but trying to determine “profit” makes using profits unappealing.
Fixed Sum. Increasingly, franchisors are moving towards fixed royalty fee amounts. The benefit of the fixed royalty fee is that both franchisor and franchisee know exactly what the royalty fee will be, allowing both parties to develop more accurate financial forecasts. An additional benefit is that the fixed fee eliminates the need to audit a franchisee’s reported sales. The fixed fee tends to hurt the franchisee when times are bad, as the franchisee will still be responsible for the $X royalty fee when sales are $0. But when times are great, the franchisee will benefit as the royalty fee is essentially capped.
Fixed Sum Based on Square Footage This is a variation of the fixed sum royalty payment and it is determined by the square footage of the franchisee’s store. Basing the royalty fee on square footage provides the franchisee with incentive to take a smaller space, which can be good if the franchisor wants to maintain a boutique-like atmosphere.