US Franchise Royalties: Define Sales Before Setting Rates

A royalty percentage is only meaningful when everyone understands what it applies to. Before franchising an existing US business, define how sales will be counted, reported and checked. A clear royalty model helps you fund ongoing support while giving franchisees a predictable obligation. It also reduces avoidable disputes within your franchise community.

1. Test the royalty against real trading records

Start with the records from your existing business, not a competitor’s advertised royalty rate. Your accountant should model what the proposed royalty would have meant for the outlet across ordinary trading periods, including quieter months and periods with unusually high refunds or discounts.

Consider two separate questions:

• Could the outlet pay the royalty while meeting its other operating costs?
• Would the resulting income help the franchisor deliver its promised ongoing services?

Company-owned outlets do not usually pay a franchise royalty to an independent franchisor. Their historic profit therefore needs adjusting before it can inform your internal assessment of franchisee viability. Include the other charges a franchisee would face, without double-counting costs already recorded.

Compare percentage-based royalties, fixed charges and any proposed minimum payment. A minimum royalty may protect franchisor income, but it can also place greater pressure on a new or struggling outlet. Test that consequence explicitly rather than treating a minimum as a harmless contractual detail.

Keep this exercise internal unless franchise counsel approves its use with candidates. Statements about potential franchisee sales, income or profits can trigger the financial performance representation requirements of FDD Item 19.

2. Write a usable definition of sales

The franchise agreement should define the sales figure on which royalties are calculated. Avoid assuming that a till total, bank deposit and accounting revenue figure will always match.

Prepare a decision sheet covering the transactions your business actually processes:

• Sales taxes: identify taxes collected from customers and remitted to government, and specify whether they are excluded.
• Refunds and chargebacks: determine when adjustments are recognised and what evidence is required.
• Discounts: explain whether royalties apply to the amount charged or another defined amount.
• Gift cards: establish when the relevant sale is counted, avoiding unintended double-counting at issue and redemption.
• Delivery platforms: decide whether sales are measured before or after platform commissions.
• Deposits and subscriptions: specify how advance payments and later fulfilment are treated.

These are drafting decisions, not universal legal exclusions. The appropriate treatment depends on your model and must be reviewed by your advisers.

For example, a delivery platform may transfer customer receipts after deducting its commission. If the agreement bases royalties on sales before that deduction, the bank transfer alone will not supply the correct reporting figure. Your systems must preserve the underlying transaction data.

3. Make reporting and collection work together

Choose a reporting period and payment timetable that your franchisees’ systems can reliably support. Define who submits the report, which system supplies the figures, when payment becomes due and how corrections are handled.

Build a sample royalty statement using actual transactions. It should show the starting sales total, permitted adjustments, royalty base, applicable rate and amount payable. Have someone unfamiliar with the calculation reproduce it from the instructions.

Then test exceptions. What happens if a platform report arrives late, a refund relates to an earlier period or an automatic payment fails? Establish a documented correction process rather than relying on informal messages to the founder.

Ask counsel to draft appropriate record-retention, inspection and sales-verification rights. Any provisions for interest, late charges or recovery of verification costs should be clear and legally reviewed. Access to sales records should also be proportionate: collecting royalties does not automatically justify unrestricted access to every customer record.

4. Align the agreement with FDD Item 6

The Federal Trade Commission’s Franchise Rule requires prescribed pre-sale disclosures through a Franchise Disclosure Document. Item 6, headed “Other Fees”, covers royalties and other relevant fees, including their amounts or calculation methods, due dates and explanatory remarks. Initial fees are addressed separately in Item 5.

Give your franchise lawyer the calculation sheet, sample statement and exception rules. These help turn a commercial intention into consistent contractual terms and disclosures. Explain any minimum royalty, staged rate or adjustment mechanism; do not hide a material payment obligation in the operations manual.

The federal rule generally requires delivery of the FDD at least 14 calendar days before a prospective franchisee signs a binding agreement with, or pays the franchisor or an affiliate in connection with, the proposed sale. State franchise registration, disclosure and relationship laws may impose additional requirements. There is no single federal franchise registration approval.

Before launch, reconcile the agreement, Item 6, reporting instructions and collection software line by line. Recruitment staff should use the same explanation, without suggesting discretionary discounts that have not been approved.

Practical takeaway: settle the sales definition before the royalty rate. A model that can be calculated consistently from real records is easier to disclose, administer and explain.