Buying a US Franchise: Check How Royalties Are Calculated

A franchise royalty percentage means little until you know what it applies to. Two brands quoting the same rate can produce different bills because their contracts define sales differently. Before joining the US franchising community, examine the calculation behind the headline figure, including exclusions, minimum payments and collection arrangements. This is a contract check, not simply a comparison of advertised rates.

1. Find the complete royalty obligation

Start with Item 6 of the Franchise Disclosure Document (FDD), which discloses royalties and other fees. Read the footnotes as carefully as the table: they may explain minimum charges, increases or circumstances in which a different calculation applies. Then locate the corresponding provisions in the franchise agreement and any relevant addenda.

The Federal Trade Commission’s Franchise Rule, 16 CFR Part 436, generally requires franchisors to provide an FDD at least 14 calendar days before a prospective franchisee signs a binding agreement with, or makes a payment to, the franchisor or an affiliate in connection with the proposed franchise sale. Disclosure is not government approval of the royalty structure or a guarantee that the business is viable.

State franchise registration and disclosure laws may add requirements. Some states also have franchise relationship laws that can affect contractual rights. Ask a US franchise solicitor or attorney familiar with the relevant state to assess the documents and any state-specific addendum; do not assume the federal rule is your only protection.

Create a one-page royalty summary recording:

• The rate or fixed charge and the sales base used.
• Any minimum, tiered rate or introductory concession.
• The reporting period and payment deadline.
• Any contractual right to change the calculation.
• The consequences of under-reporting or late payment.

Where the FDD and contract appear inconsistent, request a written explanation and legal review before committing.

2. Test what counts as gross sales

A royalty based on gross sales is generally payable before deducting ordinary operating expenses. Rent, wages and other costs can therefore leave you making a loss while still owing royalties. The exact contract wording determines the calculation.

Ask your accountant to work through how the definition treats these transactions:

• Sales taxes: Are taxes collected for the authorities expressly excluded?
• Refunds and returns: Can you deduct them, and in which reporting period?
• Discounts: Is the royalty based on the amount actually paid or another stated value?
• Gift cards: Does the obligation arise when a card is sold, redeemed or at another point? How is double counting avoided?
• Delivery platforms: Is the base the customer’s payment before the platform deducts commission?
• Credit sales: Are royalties due when you invoice, even if the customer has not paid?
• Tips and service charges: Which amounts are included, and how are they distinguished?

Do not assume an accounting label settles a contractual question. Your accounts might show net receipts from a delivery platform while the franchise agreement requires reporting the full customer purchase amount.

Request a worked example covering transactions your proposed business will actually handle. Treat the example as an explanation, not a substitute for clear contractual wording.

3. Model minimums, tiers and concessions

Some agreements impose a minimum royalty regardless of actual sales. Others use fixed periodic payments, percentage charges or a combination. Check whether a minimum applies per outlet, territory or another contractual unit, and when it starts.

An opening concession can make the first months look attractive without changing the longer-term obligation. Record its expiry date and any conditions that could end it early. Check whether deferred royalties are waived entirely or merely become payable later.

For tiered rates, establish whether crossing a threshold changes the rate on all sales or only the portion above that threshold. Also check whether thresholds reset monthly, annually or on another schedule.

Ask your accountant to calculate royalties under lower, expected and higher sales scenarios, using your own clearly labelled assumptions. Include a delayed opening or temporary closure where relevant. The purpose is to expose how the contractual charge behaves, not to create an earnings forecast endorsed by the franchisor.

4. Check collection, correction and audit terms

Read the provisions governing sales reports, access to payment systems and automatic bank debits. Establish whether the franchisor can estimate sales when a report is missing and how an incorrect debit is corrected.

Review audit rights, record-retention duties, interest and late charges. Ask when an underpayment could make you responsible for audit costs and whether reporting errors can trigger contractual default provisions.

Do not assume you can withhold royalties if support disappoints. The FTC warns that royalty obligations may continue even when a franchisee is losing money or believes promised services were not provided. Obtain legal advice before withholding payment or claiming a right to offset another amount.

Practical takeaway: Before signing, have your accountant reproduce a royalty bill from sample transactions and your legal adviser confirm the contractual basis. If the calculation remains unclear, resolve it before you commit.