November 2, 2016
While there can be prestige in developing your business into a franchise, that’s not why you put in the massive amount of work and invested heavily into growing your business. You’re here to collect the royalty checks. Prestige only goes so far, after all.
Royalties capitalize on your ability to create a sound business plan, grow your own company, and then teach others to execute the same model. Typical franchises collect royalties based on a percentage of the gross revenues. It’s the ultimate reward for all the risk you took building the business.
With a revolving monthly number, this model depends on franchisees paying accurate royalties. That’s why it’s essential to build in checks and balances to ensure the integrity of the system, keeping the franchisees honest when it comes toward the end of the month.
As the first step, franchisors require that each unit submit a profit and loss statement in addition to a balance sheet at the end of each month. The franchisor can review these, comparing month over month, as well as expectations compared to how other units have fared at similar stages.
Even in today’s primarily digital age with dependency on credit cards, many business models still operate with mainly cash. For example, car washes and laundry facilities depend largely on coin-operated machinery. Even the best point of sales systems falters to keep diligent track of revenues there.
Instead, franchisors may elect to deploy a different royalty model than straight percentages. This could either look like a flat fee each month based on how long they’ve been in business or a flat fee plus a percentage of gross revenue whichever is higher. It’s common for franchisors to adjust the flat fee based on length of time the business has been operational, realizing that a unit open six months will most likely not have the same revenue as a franchise open ten years.
No one wants to be blindsided at the end of the month. This includes franchisors. Many point of sale systems give the parent company the ability to monitor the day-to-day revenues. If a unit is underperforming for several days, or even weeks, it shows up in the real-time reporting.
This gives the franchisor the ability to step in and assist the franchisee early on before their earnings fall far behind for the month. After all, the franchise system is mutually beneficial when each unit succeeds. Possible scenarios could include a unit falling into some amount of disarray, understaffing or being closed on days not outlined by the FDD. Realizing the problem early on gives each party the ability to course correct before the problem becomes too large or the unit damages their reputation in the community.
Every franchise agreement builds in an audit provision to review the books and ensure that a unit is reporting all of their incomes. Many times, as a franchise becomes more established, they are able to predict the range of revenues a particular unit should be producing at each milestone in the business. Units grossly missing those marks raise red flags. These red flags give the company the ability to utilize their audit powers.
An alternative to a complete audit, some franchises reserve the right in the FDD to do forensic work to determine the revenues a unit should be bringing in based on ordering qualities. For example, if a pizza franchise unit orders enough dough, sauce, and cheese to make 500 pizzas each week for the last ten weeks, yet their profit and loss statements only indicate they sold 100 pizzas each week, there is a discrepancy in the books. In short, what are they doing with the supplies to make the other 400 pizzas?
Using the forensic information, the parent company can then determine what the revenues should be based on supply qualities.
Should a franchisor find that a franchisee has under paid by more than 2-3% depending on the provisions in the FDD, there are very serious repercussions. First, if the parent company audited the franchisee, that owner will most likely be required to cover all the costs of the audit, late fees and interest. This can include the auditor’s time, travel, meals, and other related expenses.
That’s just the start. Typically, they will also be required to pay the missing royalties back with interest, as well as possible penalties. Depending on the severity, this can also be grounds for termination.
If you’re in the process of converting your thriving business model into a franchise, partner with an experienced franchise lawyer. In addition to specializing in franchise law, I am a part owner of the franchise PLAYLive Nation. My in-depth perspective on the legal side as well as the comprehensive business acumen gives you a competitive edge in creating the legal foundation to grow your business.
Set an appointment today to start your franchising journey right.