Royalty reticence

Why franchisees question the payment of royalties. JASON GEHRKE

By Jason Gehrke

“What am I getting for my royalties?” is a question no franchisor likes to hear, and one which is usually met with a response that involves referring to the franchise agreement.

When established franchisees start to question what they are getting for the royalties they pay, it may indicate a source of potential future conflict with the franchisor based on two possible scenarios:

• The franchisee is not making money and therefore becomes fixated on reducing expenses to create profit.
• The franchisee is making money, but of all their expenses sees royalties as the one that contributes the least to the success of their business.

For new franchisees – and particularly those in business for the first time – royalties are just part of the cost of starting-up and get lost in the hurly-burly of building a business for the first six to 12 months. However as time passes and they become increasingly attuned to the operational and profit drivers of their business, they will be seeking improved value on all fronts.

They often will look back on the high levels of support provided at the outset by the franchisor and take that as a baseline level of support to be extended throughout the term of the franchise. Franchisees will draw heavily on a franchisor’s support resources at start-up, for in-store or in-territory technical, sales, marketing, HR and other operational support, as well as remotely via telephone and electronic communication.

The first few royalty payments will seem like excellent value for the support received, but as the franchisee becomes more proficient, the ongoing value of the royalties paid will diminish by comparison. This is particularly so for any franchise whose royalties are calculated as a percentage of turnover. As the turnover of the business increases, the royalties paid to the franchisor actually goes up, while the amount of support provided after the initial opening rush may actually go down.

Even fixed-fee royalties (where the amount paid does not vary according to turnover) will create the same feelings of diminishing value, as support reduces after start-up.

This condition, which I call “royalty reticence”, is a part of life for both franchisors and franchisees. Franchisees will naturally question the value of royalties and experience some reluctance to pay at some point during their term, and despite their contractual obligation to do so.

Royalty reticence in its extreme form could result in a mass-boycott of royalty payments by franchisees, which would result in financial disaster for the franchisor, and potentially the system as a whole. But in its milder and most common form, royalty reticence is often demonstrated by isolated underpayment, late payment or non-payment of royalties by individual franchisees.

This creates a greater administrative burden on the franchisor which may be used by a franchisee to offset the decreased value of the perceived benefits provided for the royalties paid. (In other words, by making the franchisor work harder to get their royalties, the franchisee feels less dissatisfied about paying them).

Overcoming royalty reticence is a challenge for any franchisor, and a factor that should be built into its business model at the outset. Over the years, I have seen this tackled in many different ways.

Here are some examples:

Waiving renewal fees: The royalty payments in second and subsequent terms might stay the same, but the franchisee is not required to pay to renew their franchise at the end of their first term;

Sliding scale of franchise fees: Particularly useful for turnover-based royalties, the greater the performance of the business, the less the franchisee is required to pay as a percentage of their turnover (for example, 8% on turnover up to $10,000 per week, and 6% above $10,000 thereafter).

Greater franchisee engagement: As franchisees mature and their operational expertise grows to equal or exceed that of the franchisor, involving them in new initiatives, advisory councils, training, mentoring, product or service innovation, etc, will provide greater recognition to match their royalty contribution to the system while simultaneously building their understanding of the “behind the scenes” work done by franchisors that adds value to franchisees’ businesses, but which may not previously have factored as part of the royalty value proposition;

Reduced royalties: While it is unlikely a franchise system would introduce a unilateral variation to reduce franchisee fees across the board, individual instances may occur temporarily (or as a fee holiday altogether) when a franchisee is in financial distress. Alternatively, a reduced royalty may be appropriate where the franchisor can reasonably reduce the level of support provided to a highly experienced and operationally proficient franchisee after a qualifying period of time or other criteria has been achieved.

Any strategy to reduce royalty reticence must be considered for its long-term implications to the viability of the franchisor’s business model, as well as to the integrity of the brand and network as a whole.

They should be communicated up-front to franchisees, but designed to come into effect at different stages over the term of the franchise, or the overall average term of the franchise relationship (if longer or shorter than the term itself) in order to “reward” the franchisee progressively and provide incentives for ongoing systems compliance.

However strategies that add value to, or discount royalties must be tested and measured appropriately before system-wide introduction.

Overcoming royalty reticence is not a silver bullet to guarantee everlasting harmony in franchise relationships, but is one of many key ingredients that help create a successful franchise formula.

Jason Gehrke has a passion for franchising. He has been involved in the sector for 17 years as a franchisee, a franchisor, provided PR and marketing services to more than 30 leading Australian franchise systems, and presented to literally thousands of potential franchisees and franchisors over the years. He is a director of the consultancy Franchise Advisory Centre and is the immediate past CEO of automotive paint and plastic repair franchise, Kwik Fix International, a 2004 Australian Franchise System of the Year winner.

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