For franchisors, royalty leakage can be a recurring problem and an ongoing headache. While most franchisees will do an effective job of managing the financial side of the business, problems do occur, and discrepancies need to be addressed promptly. Many of these franchise royalty leakage problems come from multi-location franchisees who are managing a disparate group of financials for their different storefronts. However, it’s important to remember that any franchise location or franchisee may develop royalty leakage issues for any number of reasons. Understanding what royalty leakage is, what causes it, and signs that your franchise network has a royalty leakage problem can help franchisors protect their brand and their investment while still encouraging and supporting franchisees.
Executive Summary
- Franchise royalties are the percentage of gross profits paid by the franchisee to the parent brand, or franchisor.
- Franchise royalty percentages and the particulars of payment agreements may vary from franchisor to franchisor, but generally the royalty payment is a set percentage paid on a monthly basis.
- Franchise royalty leakage is a discrepancy between the agreed-upon payment amount and the actual amount paid by the franchisee to the franchisor. Royalty leakage may be an occasional issue or a recurring issue and may affect a single location or a string of locations owned by a given franchisee.
- Franchise royalty leakage may occur for a number of reasons. Dishonest franchisees or location managers may intentionally under-report gross income or intentionally miscalculate franchise royalty payments. However, it’s more likely that a simple error or series of errors in accounting or reporting is to blame.
- Detecting franchise royalty leakage can be a complex task. There are a host of potential warning signs that may indicate an issue exists.
- Diagnosing the causes of franchise royalty leakage is equally complex, requiring both real-world experience and an understanding of franchisee practices and business culture.
What is Franchise Royalty Leakage?
Let’s start by defining and exploring franchise royalty leakage. In a broader business context, royalty leakage refers to royalty-derived income that is delayed, inappropriately allocated, or otherwise uncollected. Most of the time, this is accidental, caused by faulty bookkeeping practices, problems at the point of sale, or just plain old human error. Sometimes royalty leakage is intentional; someone in the chain is either misreporting sales or deliberately misdirecting funds.
Royalties can take many forms, but for franchises, royalty leakage most often relates to one of the franchise fees paid to franchisors by the franchisees who own franchise locations. Depending on the nature of the franchise business, franchisees pay franchisors somewhere between 4% and 12% of gross sales income in royalties. The gross sales usually are just that: the total sales before expenses or taxes are taken into account. Franchise royalty leakage occurs when the royalty percentage is miscalculated or misreported at the franchisee level.
What Causes Franchise Royalty Leakage?
The basic problem becomes obvious: franchise royalties are calculated based on the numbers collected at the point of sale and are only as accurate as the PoS numbers and the spreadsheets used to calculate royalties. For franchisees, misunderstandings may exist about what constitutes “gross sales” or “gross income” per the terms of the contract. And there’s an additional complication: royalty payments are only as reliable as the people handling the money. There’s room for error in any system, even under the best of circumstances, and franchise royalty leakage is a case in point.
Another possible issue behind franchise royalty leakage is owner disengagement. Franchisees sometimes come to view their locations as passive income, letting the store manager deal with the day-to-day operations. This can allow small errors in service and execution to compound and lead to bigger issues with royalty leakage. Some of the signs of franchise royalty leakage we’ll discuss below are the result of a disengaged or distracted owner and can be addressed with a simple and direct conversation.
Signs of Franchise Royalty Leakage
Spotting the signs of franchise royalty leakage is often a matter of noticing patterns—and changes in patterns. The following list isn’t conclusive, but it does contain some of the most common signs and indicators that franchise royalty leakage may be an issue for a franchise location.
- Early Warning Signs: Many early warning signs of royalty leakage are unfortunately crystal-clear in hindsight. However, it’s worth knowing them and being on the lookout. Erratic sales patterns, patterns that don’t match peak times for that particular type of business, and absentee owners can all indicate that a nascent leakage problem may exist. These warnings are often easier for experienced eyes to spot and may require a specialist consultant.
- Changes in Sales Patterns: This is the big one. Changes in sales patterns, including sudden drops in overall sales volume, shifts from higher value to lower value items, or a more subtle gradual decline in sales, may all indicate that royalty leakage is a problem with a particular location or franchisee.
- Increasing Vendor Debt or Late Vendor Payments: This is another sure sign that something is amiss. If the franchisor is getting complaints from vendors about late payments, vendor debt, or poor communication, it’s time to take another look at that particular franchisee and see where the problem might be and what can be done to correct it.
- Changes in Reporting Patterns: A more subtle issue, changes in reporting from a franchisee can be both an additional sign of trouble or an early indicator of a royalty leakage issue. The occasional late report or even late payment is understandable; everyone’s human and life happens to us all. However, if a given location or franchisee consistently submits reports or payments late, it’s time to take another look at their numbers and overall situation.
- Unreliable or Evasive Communication: This may be difficult to spot—again, we’re all human and sometimes things get busy. But a franchisee who isn’t returning calls or emails from a franchisor in a timely manner may indicate an issue. This is especially true if those communications are an attempt to address a late payment, late reporting, or vendor payment issue. If a franchisee is being consistently evasive, it’s time to address that directly.
To reiterate, royalty leakage isn’t necessarily a sign of malfeasance by a franchisee or franchise employees. Mistakes may happen, and systems can be faulty. If you suspect that franchise leakage has become an issue with one or more of your franchises, it may be best to approach it initially as a “We’ve noticed an issue, let’s work together to resolve it” rather than a confrontation or legal action.
Managing Franchise Network Royalties
Franchise royalties are how franchisors get paid. They are the financial reward for all the effort that goes into building a franchise network and franchise brand, and like all ROI, franchise royalties should be appropriately recorded and monitored. Avoiding franchise royalty leakage prevents more than just financial loss; it saves time, energy, and frustration for everyone involved while potentially preventing future legal actions or taxation issues. By understanding what franchise royalty leakage is and how to spot it, franchisors can better enjoy the fruits of their success and ensure the ongoing stability of their business and brand.
Contact the Mershimer Group today to protect your franchise income, improve compliance systems, and build a stronger, more profitable franchise network.
FAQs
What causes franchise royalty leakage?
The reality is that franchise royalty leakage may have a number of causes. Sometimes misreporting of payment is deliberate; franchisees encounter some form of financial trouble and hope that a quick “mistake” can help them get back on track. Sometimes franchise royalty leakage is deliberate, a matter of grift and dishonesty. Many times it’s just a mistake: the spreadsheet isn’t set up correctly, there’s a misunderstanding about the franchise agreement, or a series of accounting errors leads to under-reporting gross income.
How can franchisors detect franchise royalty leakage?
The reality is that while there are some accounting and communications issues that may indicate a royalty leakage problem, the best way to detect and document a franchise royalty leakage issue is a close examination of a franchisee’s practices in the form of an audit. An effective audit must be backed by both appropriate “best practices” and a depth of experience in working with franchisors, franchisees, and royalty leakage issues.
What role does communication play in addressing franchise royalty issues?
The answer here is twofold, addressing different angles of the franchise royalty leakage question. Communication can be a sign that there’s a problem: franchisees who are intentionally or knowingly causing a royalty leakage problem often become evasive or just sporadic in their communications with the franchisor or with vendors. On the other hand, communication is often part of the solution. Addressing a potential franchise royalty issue with open and clear communications geared toward building a mutually beneficial solution is often the best approach.
Why is experience so important in detecting and addressing franchise royalty leakage?
Firstly, because experience and specialized knowledge are important in all things; we’re the sum total of our learned experience, and expertise comes from applying those lessons effectively. In this particular application, experience counts because franchisee culture and franchisee/franchisor relationships are a particular niche within the worlds of investment, entrepreneurship, and business practices. Detecting, documenting, and addressing franchise royalty leakage involves a diverse skill set and a depth of experience with every aspect of the dynamics in question.