Latest / Franchise Conversations with Fexingo: Buying, Running, and Scaling Franchise Businesses / Why Franchisors Are Using Revenue-Based Royalties
Transcript
- Lucas: If you've ever looked at a franchise disclosure document, you know the royalty line is usually a flat percentage of gross sales. Six percent, seven percent, sometimes eight. But I'm seeing a growing number of emerging franchise brands move away from that fixed number toward something more responsive: revenue-based sliding-scale royalties. Luna: Sliding scale — so the royalty percentage changes depending on how much revenue a unit does? Lucas: Exactly. And the philosophy is pretty straightforward. A franchisee running a unit that does $500,000 a year has a very different margin profile than one doing $2 million. A flat 6 percent on the $500,000 unit might be crushing — especially in a high-cost market. The same 6 percent on the $2 million unit might feel like a bargain. Luna: So the franchisor is basically saying, we'll take a smaller piece when you're smaller and a bigger piece when you're bigger. But doesn't that create a disincentive to grow past a certain point? Lucas: That's the tension, and some franchisees have raised that concern. But the way the better structures work, the scale is designed so that even at the top tier, the franchisee keeps a higher net margin than they would under a flat rate that averaged out. Let me give you a concrete example. There's a regional QSR chain called The Human Bean — they're mostly drive-thru coffee, about 300 units. They moved to a royalty model where the percentage starts at 4 percent for units under $600,000 in annual revenue and steps up to a maximum of 8 percent for units over $1.8 million. But they also cap the dollar amount at $120,000, so nobody pays more than that per year. Luna: Interesting. So a high-volume store doing $2 million pays 8 percent on the first $1.8 million, but then the cap kicks in and the additional $200,000 is free. Lucas: Right. That top-end cap is key because it removes the penalty for exceptional performance. The franchisor is saying we want you to aim high, and we're not going to keep taking a bigger slice as you overshoot. Meanwhile, the low-end relief is real. A new franchisee in their first year doing $450,000 pays only 4 percent instead of 6 — that's $9,000 in savings they can reinvest into staffing or local marketing. Luna: And presumably that lower rate helps reduce the churn we see in the first two years, when margins are thinnest. Lucas: Exactly. FranConnect put out a study last year — I think it was their 2025 franchise performance report — showing that franchise systems with variable royalty structures had a 12 percent lower unit churn rate compared to those with a flat percentage. That's a massive difference over a 10-year horizon. If you have 300 units and you're losing 15 percent a year under flat royalties, you're replacing 45 units annually. Drop that to 13 percent churn — which is roughly what the variable systems saw — and you're replacing 39. Those six extra units staying in the system each year add up fast. Luna: And that stability probably makes the brand more attractive to lenders and future franchisees, too. Less turnover signals a healthier system. Lucas: You're hitting on something important. The franchisees who stay are your best recruiters. If they're not leaving, they're more likely to open a second or third unit. And that's where the real growth comes from — multi-unit operators. The variable royalty model aligns the franchisor's incentive with that expansion path. Luna: It's also interesting because it shifts the relationship. Instead of the franchisor being a fixed-cost landlord, they're more like a partner whose take fluctuates with your success. Lucas: Yeah, and I think that's the underlying trend here. A lot of the emerging brands in QSR, fitness, and home services are deliberately choosing this model because it signals partnership. It tells prospective franchisees: we understand you'll have tough months, and we're not going to pile on. It's a different recruiting pitch. Luna: That resonates. And it makes me think — if you're a franchisee evaluating two similar brands, one with a flat 6 percent royalty and one with a 4-to-8 percent sliding scale and a cap, the sliding scale looks like it's built for the long haul. Lucas: You'd think so, but it's not as simple as just comparing percentages. You have to look at the total effective royalty you'd pay at your projected revenue level. A sliding scale might actually be higher for a mid-range unit if the tiers are set poorly. Some brands set the low tier at 5 percent, the middle at 7, and the top at 9 — and if you're sitting right at the boundary, you could be paying more than a flat 6 percent would have cost you. Luna: Good point. So the devil is in the tier thresholds and the cap. The Human Bean example sounds well-tuned, but not every franchisor gets it right. Lucas: Right. And that's where the due diligence comes in. If you're looking at a franchise with a variable royalty, you need to model out your own realistic revenue scenarios. What do you pay at $600K? At $900K? At $1.2 million? Compare that to what you'd pay under a flat 6 percent. The difference might be small, or it might be material. And if the franchisor doesn't provide clear historical data on how many units fall into each tier, that's a red flag. Luna: You know, this is exactly the kind of practical analysis that makes this show useful. Understanding the mechanics of a royalty structure can save a franchisee thousands over the life of a deal. Lucas: That's the goal. And honestly, if these conversations have moved your work forward in some small way, the way we keep this ad-free is through listener support. If today's episode helped clarify something for you, consider buying us a coffee — just head to buy me a coffee dot com slash fexingo. It's a simple way to keep the show going without any corporate sponsors. Luna: Absolutely. And it means we can keep drilling into these specifics without anyone pulling punches. So thank you to those who already support us. Lucas: Right. Back to the mechanics. There's another variation I want to flag — some franchisors are experimenting with a hybrid model. A low flat royalty, say 3 percent, plus a profit-sharing component that kicks in above a certain EBITDA margin. Luna: So the royalty is tied to profitability, not just revenue. That seems even more aligned with franchisee success. Lucas: It does, but it also introduces complexity. EBITDA calculations can be disputed. You need clean financial reporting from every unit, and not every franchisee runs their books the same way. A revenue-based royalty is much easier to audit because top-line sales are harder to manipulate. That's why most franchisors stick with a revenue base, even if they adjust the percentage. Luna: Makes sense. Keep it simple, keep it auditable. So for a franchisee, the key takeaway is: when you're reviewing the FDD, don't just look at the royalty percentage. Look at the structure. Is it flat? Is it tiered? Is there a cap? And then run your numbers. Lucas: Exactly. And for franchisors, the message is that variable royalties can be a competitive advantage in recruiting and retention. But you have to design the tiers carefully. If you set them too aggressively, you'll scare away the low-revenue prospects. If you set them too generously, you leave money on the table from your best performers. Luna: What about the established big brands? Are any of them adopting this, or is it mostly newer systems? Lucas: Mostly newer systems, because switching is hard. Imagine McDonald's trying to tell its 40,000 franchisees that the royalty structure is changing. The legal and operational friction would be enormous. But I have seen some regional chains within larger parent companies test variable royalties on new franchise cohorts. For example, a few Yum! Brands' smaller concepts — not KFC or Taco Bell — but some of their emerging brands are using tiered royalties. Luna: So the innovation is happening at the edges, where flexibility is higher and the stakes are lower. Lucas: Right. And that's where we can learn the most. These smaller systems are the proving ground. If their churn keeps dropping and their unit growth accelerates, I expect we'll see more adoption in the next five years. Luna: One more question — what about the advertising fee? Is that also variable in these models? Lucas: Usually not. The ad fund contribution tends to stay flat as a percentage, because it's pooled and spent collectively. But some franchisors are separating the two — they'll keep the ad fee fixed and vary only the royalty. That seems like a smart compromise. The ad fund needs predictable revenue to plan campaigns, while the royalty can flex to support unit economics. Luna: That makes a lot of sense. Thanks, Lucas. This was a really practical breakdown. Lucas: Happy to do it. If you're looking at a franchise and wondering about their royalty structure, pull out that FDD and model it. And if you've got a specific example you want us to dig into, let us know. We'll see you next time.