Royalties are a hot topic in franchising, but how they are tallied can be misunderstood or overlooked. Franchise agreements typically require the franchisee to pay royalties in exchange for the right to use the franchisor’s trademarks, system, and operating methods.
As previously discussed, the royalty fee is different from the initial franchise fee. The initial franchise fee is a one-time, upfront amount that a franchisee pays for the rights to acquire a franchise, develop the location and join the franchise system.
Royalty fees are calculated as a percentage of gross sales, a minimum amount, or the greater of the two. “Gross sales” can have a broad definition. This is often the case in most restaurant systems and many other sectors. So let’s discuss ways to avoid the term from becoming a source of disagreement when new revenue streams emerge.
How the FDD Addresses Sales
In restaurant and food retail services, the Franchise Disclosure Document (FDD) often addresses sales and operating issues, for example:
- Item 8 explains restrictions on the franchisees’ products and supplies, including any required suppliers, as well as the amount of revenue that the franchisor may have received from suppliers.
- Item 12 addresses territory rights.
- Item 16 details restrictions on what the franchisee may sell.
Those provisions may address how the system handles delivery zones, online ordering, and third-party platforms. As restaurant brands continue to evolve and expand through digital channels, these issues are increasingly important for both franchisors and franchisees.
How the Franchise Agreement Addresses Sales
Most franchise agreements define gross sales to include all revenue derived from the operation of the franchised business. The definition often excludes sales taxes collected from customers and remitted to taxing authorities. Some agreements may also exclude bad debt or customer returns. Outside those exceptions, the default rule is usually that all receipts tied to the business are included in the royalty base.
That broad drafting can create disputes over categories such as employee tips and delivery-related charges:
- Franchisees may argue that tips are not business revenue because they are paid to employees and are not retained by the restaurant.
- Franchisors, by contrast, may contend that tips are a typical business expense and therefore fall within the contractual definition of gross sales.
Whether tips are included depends on the precise language of the agreement, but many franchisors take the position that they are royalty-bearing.
How Delivery and Third-Party Fees Factor Into a Franchisee’s Gross Sales
Delivery fees present another recurring issue. Many restaurant systems now rely on third-party delivery providers such as Grubhub, Uber Eats, and DoorDash. These services make it easier to reach customers, broaden a brand’s market presence, and support growth in a highly competitive sector. At the same time, delivery providers often charge significant fees that can materially affect margins.
A common dispute arises over whether royalties should be calculated on the full ticket amount or on the amount remaining after the third-party delivery fee is deducted.
- Franchisees often view the fee as a direct cost of service and argue that it should not be included in gross sales.
- Franchisors may respond that the customer generated the full sales amount through the branded system, regardless of how much was paid to the delivery platform.
Again, the outcome usually depends on the exact wording of the agreement.
The governing principle is straightforward: the contract controls. If the definition of gross sales is broad, courts and arbitrators are likely to enforce it as written, absent a specific statutory or contractual limitation. For that reason, franchisors should review and update their FDD and agreements periodically to address new products, technologies, and revenue models that may not have been available or contemplated when the system was first documented.
A Final Tip for Franchisees
Franchisees should understand the royalty base before signing and evaluate how the agreement treats tips, delivery fees, discounts, coupons, online ordering charges, and similar items. Even small differences can have a meaningful financial impact over time.
An experienced franchise lawyer can help interpret the definition of gross sales, identify ambiguous language, and assess whether a particular charge should be included in the royalty calculation. For both sides, careful drafting and periodic FDD and franchise agreement review can reduce disputes and support a stronger, more durable franchise system.
Contact Lusthaus Law
Lusthaus Law’s website is a resource for New York franchisors and franchisees. We have published two downloadable and complimentary e-books and our Insights blog is regularly updated to reflect industry trends, state and federal legislation and recent achievements in client representation.
Contact us today to learn more about how Lusthaus Law P.C. can help you navigate a clear path for your franchise’s successful future.
