Buying a franchise: check how royalties are calculated

A low royalty rate can prove expensive if the fee is calculated on revenue you do not get to keep. When buying a franchise and joining a franchise network, you therefore need to understand the full calculation model, not just the percentage. Here is a practical way to check the ongoing franchise fee before you sign.

1. Find out exactly what the fee is calculated on

A royalty is an ongoing payment to the franchisor. It may be turnover-based, fixed or made up of several components. Do not assume that the word ‘turnover’ means the same thing in the franchise agreement as it does in your accounts. Ask for an explicit definition and check which schedules affect it.

Pay particular attention to the following questions:

• VAT: Is the calculation basis expressly stated to exclude VAT?
• Discounts: Is the fee calculated on the price the customer actually pays or the price before discount?
• Returns: When and how does a refund reduce the royalty calculation basis?
• Bad debts: Must you pay royalties even if a customer buying on credit never pays the invoice?
• Gift cards: Does the fee arise when the card is sold or when it is redeemed, and how is double counting avoided?
• Sales through intermediaries: Is the fee calculated on the full customer price or the amount remaining after an external sales platform deducts its commission?

There is no single, automatic contractual answer to all these questions. The point is that each answer should be clear and usable in your financial projections. Also ask whether sales to other units in the network and any ancillary income in your business are included.

2. Look for minimum fees and overlapping charges

Read the royalty clause alongside price lists, administrative schedules and references to other documents. The stated percentage may be supplemented by a minimum monthly fee, a fixed base fee or a separate charge for particular sales channels.

A minimum fee means that your payments will not necessarily fall in line with sales. This is particularly important during the start-up phase, seasonal downturns and temporary interruptions to trading. Ask when the obligation to pay begins: on signing, when the systems are activated or when the unit opens to customers.

Also check whether the fee has tiers. If higher sales trigger a different percentage, the agreement needs to clarify whether the new rate applies to the entire period’s turnover or only to the amount above the threshold.

Next, draw up a simple fee table with four columns: fee name, calculation basis, payment date and what you receive in return. Keep royalties separate from charges such as system fees and marketing fees. The aim is to identify overlap and understand the total cost, not to assume that all separate charges are improper.

Finally, ask for clear rules on changes. Can the franchisor change the percentage or the definition of turnover during the agreement’s term? What notice must be given, and is there an agreed limit?

3. Run sample calculations for both profit and cash flow

Ask the franchisor to show you an anonymised royalty statement or a complete worked example. Then reproduce the calculation yourself with your accountant. You should be able to follow an example all the way from the sales report to the royalty invoiced.

Test at least three scenarios: a normal month, a month with low sales and a month with many returns or late customer payments. Use your own budget figures and the contractual terms, rather than general assumptions about what a franchise usually costs.

Distinguish between two questions:

1. Profitability: How much remains after the cost of goods, royalties and other operating expenses?
2. Liquidity: Will the money be in your account when the royalty invoice falls due?

If royalties are calculated when you invoice customers but those customers pay later, you may need to fund the fee before the sales have generated cash. Also check how quickly corrections and credits are reflected in the charges.

Establish which system provides the data used for the calculation. If the point-of-sale system, the accounts and the franchisor’s report show different amounts, the agreement or a documented procedure needs to specify how discrepancies will be investigated. Ask who is entitled to inspect the underlying records and who pays for any checks.

4. Ensure the calculation is reflected in the disclosures and agreement

Sweden has specific legislation: the Act (2006:484) on Franchisors’ Duty to Provide Information. It requires franchisors to provide clear, comprehensible written information in good time before an agreement is concluded. This information must cover, among other things, the fees you will have to pay and the other financial terms.

However, the Act does not set a permitted royalty rate or guarantee profitability. The agreement and general contract law, including the Swedish Contracts Act, therefore play a major role in determining your obligations. There is no universal standard agreement that you can assume applies to every franchise network.

If the presentation says ‘royalties on net turnover’ but a schedule to the agreement uses a different definition, resolve the discrepancy before signing. Ask for definitions, exclusions and correction procedures to be included in the contractual documents. Have a lawyer with franchise experience review any unclear or far-reaching terms.

Practical takeaway: Do not sign until you can calculate the royalties yourself for both a normal month and a difficult month, and show when the money must be paid.