Setting a Fair Franchise Royalty for Franchisees

A business that is profitable under owner management may not remain attractive once its outlets have to pay royalties. Before offering a franchise, business owners need to test whether the proposed royalty can fund head office support without consuming franchisees’ earnings. Across a franchise network, this balance matters: growth should not depend solely on selling new outlet packages.

1. Separate the royalty amount from the payment arrangements

The royalty amount answers the question: what is a fair ongoing fee for the franchisor to receive? This is distinct from billing dates, payment accounts or late-payment penalties. Copying another brand’s percentage is not enough, as its cost structure, product margins and support requirements may differ.

The main legislation to consider in Indonesia is Government Regulation No. 35 of 2024 on Franchising, which replaced Government Regulation No. 42 of 2007. Among other things, it requires a business system, a business that has demonstrated profitability, recorded or registered intellectual property, and ongoing support. The relationship between the parties must be based on a franchise agreement that gives them equal legal standing and is governed by Indonesian law.

These requirements do not provide a formula for setting royalties. The amount needs to be a commercial decision that can be explained and agreed, rather than assumed to be reasonable simply because the business meets the requirements for franchising.

Start by listing what the royalty pays for: use of the business system, access to product development, maintenance of operational tools, or specific support services. Separate out services already covered by the initial fee or other charges to avoid double counting.

2. Calculate what an outlet can afford before choosing a figure

Use records from existing outlets to prepare an outlet profit and loss statement before royalties. Do not consider only turnover and raw material costs. Include all the costs needed to operate the outlet to the standards that franchisees will be required to meet.

Your checklist should include:

• Cost of goods sold, wastage and stock losses.
• Staff wages and the cost of a manager to take over the owner’s duties.
• Realistic rent, utilities, maintenance and administration.
• Sales channel commissions and discounts funded by the outlet.
• Marketing contributions and system fees that will be charged separately.

Normalising costs is a crucial step. An owner-operated outlet may occupy a family-owned building rent-free or rely on the owner’s unpaid labour. Using those profits directly as the basis for royalties could produce an overly optimistic picture for franchisees who must pay all costs in full.

Next, calculate outlet profit after deducting the proposed royalty. Check cash flow separately too: an accounting profit does not automatically mean there is cash available for debt repayments, equipment replacement and day-to-day operations.

Do not set the royalty by taking all the remaining surplus. Franchisees need a return that reflects their investment, work and risk. Record these assumptions so that the decision is not driven solely by head office revenue targets.

3. Compare royalty models through stress testing

Three options to test are a percentage of sales, a fixed fee, or a combination of the two. No single model is always the fairest for every business.

A percentage-based royalty moves with sales, but not necessarily with profits. Sales through delivery services, for example, may generate different margins from direct transactions. A fixed fee makes costs easier to forecast, but places a relatively heavier burden on an outlet when turnover falls. A combined model needs careful scrutiny to ensure that its minimum payment does not undermine the protection it appears to offer when sales weaken.

Build several scenarios using realistic business data:

• Sales at the outlet’s normal level.
• Lower sales while rent and staffing costs remain unchanged.
• Rising ingredient or material costs without an immediate increase in selling prices.
• A shift in the sales mix towards higher-cost channels.

For each scenario, show profit before royalties, the royalty charge and profit after royalties. If using a percentage of sales, clearly state how discounts, cancellations, refunds and taxes are treated so that the calculation basis in the projections matches the agreement.

Also compare head office royalty income with the cost of the promised support. If that support only becomes affordable once the network is very large, do not hide the funding gap behind uncertain projections for new outlet openings.

4. Document the rationale and the conditions for review

Keep calculation sheets, data sources, cost assumptions and the reasons for choosing the royalty model. This internal documentation helps the franchise sales team provide consistent explanations without promising profits to prospective franchisees.

Ensure that the figures and calculation basis are consistent across sales materials, the prospectus, financial projections and the agreement. Government Regulation No. 35 of 2024 requires the prospectus to be provided at least 14 calendar days before the agreement is signed. Use this review period to explain the impact of the royalty, rather than simply quoting a percentage.

If royalty reviews are planned, work with a legal adviser to clearly define the triggers, procedures, notice requirements and approval mechanism. Avoid relying on verbal promises that the rate will be adjusted if an outlet struggles.

Practical step: before offering a franchise, prepare a single table bringing together outlet profitability, the royalty burden and head office support costs. If any of these does not stack up, improve the business model before setting the rate.