Latest / Franchise Conversations with Fexingo: Buying, Running, and Scaling Franchise Businesses / How Franchisees Use Royalty Audits to Recover Overpayments
Transcript
- Lucas: So there's this thing that happens in franchising that I think a lot of franchisees never even consider — the annual royalty audit. Luna: You mean the franchisor auditing the franchisee? Or the other way around? Lucas: The other way around. A franchisee audits their own royalty payments to the franchisor — and in a surprising number of cases, they find they've been overpaying. Luna: Right, because the franchisor sets the royalty rate and calculates what you owe. But if they miscalculate, the franchisee is the one who's out of pocket. Lucas: Exactly. And the numbers can add up. I talked to a multi-unit Subway franchisee in Florida who did a three-year audit and found that he'd overpaid $47,000 in royalties and ad fund contributions. The audit itself cost him about $4,000 — so a twelve-to-one return. Luna: That's a huge ROI. How does a mistake like that even happen? Isn't the royalty calculation pretty straightforward — a percentage of gross sales? Lucas: It should be, but there are a few common pitfalls. One is the definition of 'gross sales' in the franchise agreement. Some franchisors exclude certain items — like sales tax, returns, or employee discounts. If the franchisor's accounting system includes those, you're paying royalty on money you never actually kept. Luna: So the first step is to compare the franchise disclosure document's definition of gross sales against what the franchisor's royalty statement actually includes. Lucas: Right. And then there's the ad fund. Many franchise agreements require a separate contribution — say, two percent of gross sales — into a national advertising fund. But sometimes the franchisor applies the ad fund rate to the same base as the royalty, and if there's an error in one, it compounds in the other. Luna: And that's exactly what happened with the Subway franchisee — the ad fund was miscalculated on top of the royalty error. Lucas: Yeah. But there's another layer: tiered royalty rates. Some franchisors offer lower royalty rates once a franchisee hits certain revenue thresholds. If the franchisor's system doesn't properly apply the tier — maybe it resets at the wrong time or uses the wrong threshold — the franchisee could be paying a higher rate than they qualify for. Luna: That seems like something that would be caught in a standard accounting review. But I guess most franchisees just pay the statement as-is. Lucas: They do. And that's the thing — franchisees are busy running their businesses. They trust the franchisor's numbers. But the franchisor's accounting system might have bugs, or the person entering data might make a mistake. It's not malice; it's just volume. Luna: So what does a royalty audit actually look like? Do you hire a specialized firm, or can a franchisee do it themselves? Lucas: You can do a basic check yourself if you have the time. The key is to pull your point of sale system data — the raw transaction records — and compare them to the franchisor's reported gross sales figure for the same period. Any discrepancy is a red flag. Luna: But for a deep dive, especially across multiple units, you probably want an expert. Lucas: Absolutely. There are now boutique firms that specialize in franchise royalty auditing. They'll request the franchise agreement, the disclosure document, and several years of royalty statements. Then they run a statistical analysis to identify anomalies — months where the royalty rate seems off, or where the ad fund contribution doesn't match the stated percentage. Luna: And if they find an error, what's the next step? Do you sue the franchisor? Lucas: Usually not. Most franchise agreements have an audit clause that allows the franchisee to request a correction. The franchisee presents the evidence — a clean audit report — and asks for a refund. In many cases, the franchisor agrees, because they don't want to litigate a clear error. Luna: But what if the franchisor pushes back? Or says the audit methodology is wrong? Lucas: Then you escalate. Some franchise agreements have a dispute resolution process that includes mediation or arbitration. And the franchisee can also involve their attorney. But the key is that the burden of proof is on the franchisee — you need that clean audit trail. Luna: And if you're thinking about buying a franchise, is this something you should build into your due diligence? Like, ask the franchisor for a sample royalty statement and check it against the disclosure document? Lucas: That's a smart move. But even more important, I think, is to build a periodic audit into your ongoing operations. Maybe once a year, or every two years, do a deep dive on your royalty payments. It's a low-cost way to protect your margins. Luna: And if these conversations have moved your work forward in some small way, there's an easy way to keep them ad-free and coming — a couple of dollars a month is genuinely what keeps these going. You can find that at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small thing that makes a real difference. And on that note — back to the audit. I want to share one more example. There's a franchisee group in the Midwest that owns 14 quick-service restaurant units under a well-known brand. They did a royalty audit and found that the franchisor had been applying a flat five percent royalty rate instead of the four percent rate they qualified for under a multi-unit incentive program. Luna: So they were overpaying by one percent on all 14 units for how long? Lucas: Two years. The total overpayment was about $180,000. The franchisor refunded it within 60 days after the audit was presented. Luna: That's a massive recovery. And it makes me wonder — why don't more franchisees do this? Lucas: I think part of it is awareness. Most franchisees don't even know that royalty auditing is a thing. And part of it is inertia — the royalty statement comes in, you pay it, you move on. But the math is compelling. If you have ten units paying a hundred thousand dollars a year in royalties, a one percent error is ten grand a year. Luna: Right. And over a ten-year franchise term, that's a hundred thousand dollars — just from one small mistake. Lucas: Exactly. And the audit itself might cost you two to five thousand dollars. So even if you only find one error in ten years, you're still ahead. Luna: Are there any risks? Like, if you audit and find no errors, you're out the audit fee. But that's a small price for peace of mind. Lucas: I'd say the only real risk is if the audit reveals that you've been underpaying — which can happen if your system underreported sales. Then you could owe back royalties plus interest. But that's rare if your point of sale system is accurate. Luna: So the responsible approach is to audit your own numbers first, internally, before bringing in an outside firm. Lucas: Absolutely. And if everything checks out, you can present that to the franchisor as evidence of your good faith. But if you find a discrepancy in your favor, you want to be the one to flag it — not wait for the franchisor to discover an underpayment. Luna: That makes sense. So what's the next frontier in franchise auditing? Are there other areas where franchisees should be looking? Lucas: I think the next big one is technology fee audits. Many franchisors charge a monthly fee for their point of sale system, loyalty program, or other software. If you're not using the full suite — or if the system is down for days at a time — you might have grounds for a refund or a reduced fee. Luna: And you could apply the same audit approach — compare the services promised in the franchise agreement against what you actually received. Lucas: Right. And there's also the area of supply chain rebates. Some franchisors receive rebates from approved suppliers but don't pass those savings on to franchisees. If the franchise agreement says those rebates should be shared, you can audit for that too. Luna: So the broader lesson is: don't take the franchisor's numbers at face value. Build a culture of verification. Lucas: Exactly. And the beauty of it is that as more franchisees audit and share their findings, the whole system becomes more transparent. Franchisors clean up their accounting because they know they'll get called on it. Luna: And that's good for everyone — the honest franchisees who are paying the right amount, and the franchisors who want to maintain trust. Lucas: Yeah. So if you're a franchisee, maybe this is the nudge you need to pull out your royalty statements and take a closer look. Start with one unit, one month, and see if the numbers line up. Luna: And if you find something, you'll know exactly what to do next.