Franchising in Canada: understanding how royalties are calculated

A royalty rate alone is not enough to compare two franchises. The definition of sales, minimum payments and payment schedule can significantly affect the amount you actually owe. Before joining a franchise network in Canada, have these provisions worked through as practical calculations: you need to know what you will pay, on which transactions and when.

1. Identify the actual calculation basis

Start by finding the clause that defines royalties and the one that defines ‘gross sales’, ‘turnover’ or any equivalent term. Do not assume these terms match the revenue shown in your accounts. The agreement may use its own definition.

Ask the franchisor for a sample periodic statement and the instructions for completing it. Then check with your accountant how each category is treated:

• sales taxes collected from customers;
• refunds, returns and cancellations;
• discounts, promotions and products given away free;
• gift cards, both when sold and when redeemed;
• orders delivered through a third-party platform;
• sales invoiced but not yet paid for.

The crucial distinction is between a recorded sale and money you actually keep. If a platform deducts its commission before paying you the balance, is the royalty calculated on the price paid by the customer or the amount you receive? A commercial deduction is not necessarily deductible from the calculation basis set out in the agreement.

For gift cards that can be used at several outlets, also ask who receives the funds and how transactions are allocated. Have the reporting procedures checked to ensure they do not count the same transaction twice.

2. Check for minimums and variations

A royalty calculated as a percentage of sales is not the only possible arrangement. The agreement may specify a fixed amount, a minimum payment for each period or a combination of mechanisms. Each formula distributes risk differently between franchisor and franchisee.

If a minimum applies, check whether it is weekly, monthly or annual. Ask whether payments above the minimum in one period can offset a shortfall in another. Unless the agreement provides for this, do not factor it into your calculations.

Also examine the following:

• when royalties start, particularly whether this is before or after opening;
• any temporary introductory reduction and when it expires;
• sales-based tiers and how each tier is applied;
• index-linked adjustments or provisions allowing amounts to change;
• how temporary closures or business interruptions are treated.

An introductory reduction can make the first few months look misleadingly favourable. Always compare your initial obligations with those for a full year under the standard terms. Finally, distinguish royalties from advertising contributions, technology fees and other charges: the combined total matters, but they may be calculated on different bases.

3. Test the charges against actual transactions

Ask your accountant to prepare a table covering three scenarios: low sales, expected sales and strong sales. Use your own documented assumptions, without treating projected sales as guaranteed.

For each scenario, show sales as recorded in your accounts, the adjustments required by the agreement, the sales amount subject to royalties, the percentage-based royalty and any applicable minimum. Then express the final royalty as a percentage of sales to measure its effective cost. Where a minimum applies, this percentage can rise when business slows down.

Also test a few individual transactions: an order refunded after the reporting period has closed, a delivery subject to commission and an invoice paid late. Ask when any adjustment will appear on a subsequent statement.

Finally, check the practical arrangements: reporting deadlines, automatic payment collection, supporting documents required, late-payment interest and the franchisor’s audit rights. Does the agreement provide for audit fees if a discrepancy is found? Can you access the data used to calculate a payment and report an error? These details determine your ability to check the amounts paid.

4. Have the formula checked against provincial requirements

In Canada, franchise-specific rules vary by province. In Ontario, the Arthur Wishart Act (Franchise Disclosure), 2000 requires, subject to applicable exceptions, a disclosure document to be provided at least 14 days before a franchise-related agreement is signed or a payment is made. Among other things, this document must set out costs and include proposed agreements.

Have the royalty information in this document checked against the agreement and the sample calculations. A sales explanation is no substitute for a clearly worded clause. Your lawyer should investigate any discrepancies before you commit.

Quebec has no specific franchise disclosure legislation; the general provisions of the Civil Code of Québec apply, including to the contractual relationship. You should therefore explicitly request the information needed for these checks rather than assume that a standardised disclosure document must be provided.

Key takeaway: before signing, obtain a formula you can understand, test it with your accountant and have your lawyer confirm its contractual meaning. Quoted rates are only comparable if their calculation bases and conditions are comparable too.