Franchise agreements provide for payment of royalties in exchange for the franchisee licensing the rights to use the franchisor’s trademarks, logos, service marks and systems of operation. The amount of royalties is typically based on a percentage of gross sales, a specified minimum amount, or the greater of the two. Gross sales are generally defined very broadly in the franchise agreement which can lead to misunderstanding when certain types of revenue are included. This is particularly true in the restaurant industry.
The franchise agreement will often state that gross sales encompass all revenues from sales derived from the operation of the business. However, there may be some approved exclusions such as sales tax amounts collected by the franchisee and transmitted to the appropriate taxing authorities. Bad debt and returns may also be excluded. Beyond these exceptions, all other revenue is generally considered part of the gross sales calculation. Nonetheless, restaurant franchisees may take issue with certain revenue categories such as tips paid to employees and amounts paid to third parties in connection with delivery services.
With respect to tips that are paid to employees, franchisees do not recognize these revenues as royalties as they are often paid directly to the employees. Franchisors, however, argue that tip amounts are more akin to an expense associated with the business. While tips may not be revenue for a franchisee in an accounting sense, it is common for franchisors to treat those amounts as part of gross sales. As a result, the franchisee will pay royalties on tips.
The second area of revenue which causes concern relates to food delivery fees paid to third-party delivery services. In order to stay competitive, many restaurants offer delivery services. According to an NPD Group survey, “foodservice delivery posted sizable gains in both visits and sales over the last five years” with digital ordering a major contributor to the growth. In many cases, restaurants are using third-party delivery services such as Grubhub, UberEats and DoorDash which provide a streamlined ordering process for customers through a mobile app. Third-party delivery services typically charge restaurants 12%-40% of the menu price for each food order delivered. Disputes may arise over whether the franchisor should be paid a royalty based on the amount of the order or the amount realized after paying the delivery service fee. Franchisees argue that if they must pay a royalty on the service fee, it leaves them with little profit.
The specific language of the provision defining gross sales will ultimately govern. However, it is important to note that as new products and services are developed in the restaurant industry, franchisors should consult an attorney to periodically review their franchise agreement and ensure it addresses situations that were not contemplated when the agreement was first drafted.
Franchisees must understand that gross sales clauses are deliberately broad, and in most cases, they will have to pay royalty fees on all revenue derived from operations. An experienced franchise attorney can help franchisees assess how the franchise agreement will impact their business and in the event of a dispute, advise whether the franchisee can challenge the agreement.
Contact Lusthaus Law for a consultation about your franchise agreement.