Financing

Is it a service fee or a royalty? To McDonald's franchisees, the difference is huge

The burger chain's operators say their cash flow has not kept pace with inflation and the higher royalty on new units and acquisitions will make matters worse. But they say a term change is the bigger problem.
McDonald's royalty
McDonald's operators say cash flow hasn't kept pace with inflation, but the company says otherwise. | Photo by Jonathan Maze

On Friday morning, McDonald’s told U.S. and Canadian franchisees that it would start increasing their service fees come January to 5%, from the 4% they had paid for 29 years.

The increase would only take place when operators built new units or acquired one from the company, but the reaction among the owners of most of the chain’s 13,500 U.S. locations was swift. They did not like it. Several operators complained to us about the move. And an independent group of franchisees said it is damaging the return on investment for new locations.

“If you are looking at opening a new restaurant, making such investment at this time will not provide a historical return for the franchisee,” the National Owners Association board said in a statement late on Friday. The group said that operator EBITDA, or earnings before interest, taxes, depreciation and amortization, was expected to hit a 12-year low as a percentage of revenue later this year.

And yet much of operator frustration was over a word. McDonald’s is changing the terminology it uses to describe the monthly charge operators pay to run the McDonald’s brand from “service fee” to “royalty.” The latter term is commonplace in the franchise world.

“Moving forward, all markets will adopt the more commonly used nomenclature of ‘royalty' to define the payment franchisees make to access the power of the McDonald’s brand,” McDonald’s CFO Ian Borden and SVP of Global Franchising Andrew Gregory said in a system message on Friday, viewed by Restaurant Business. “We believe this change more accurately reflects the intent behind this payment and will resolve any confusion in the system.”

Yet, to operators, that word alone could change the legal responsibilities of the company. A “service fee” implies that McDonald’s provides a certain set of services in exchange for that cut of the revenue. A “royalty” implies a charge for the right to operate a brand and does not imply services.

“The change in nomenclature from service fees to royalties is very significant,” the National Owners Association, an independent group of McDonald’s operators, said in a message to its membership on Friday. “Do not underestimate the profound and transformational impact this will have on our rights to receive the all-important services, support and assistance that McDonald’s is now obligated to provide us. It also greatly affects our relationship with McDonald’s corporation.”

A changed relationship

The move, in other words, is the latest by the company to fundamentally change the relationship between the company and its operators.

The Chicago-based burger giant is the largest franchise in the world as well as one of the most valuable brands, period. And its sales in recent years have thrived, particularly in its home U.S. market where the chain’s same-store sales have increased each of the past 12 quarters and all but one since 2019.

And the company has argued that this performance has made operators wealthier. Cash flow is up 35% since 2018.

To McDonald’s executives, the brand has earned the right to charge a higher price for its services, and to be selective when it comes to its franchisees.

“To be a McDonald’s owner/operator is to be a part of something special,” Joe Erlinger, president of McDonald’s USA, said in a system message on Friday, viewed by Restaurant Business. “It is an investment that comes with great economic opportunity and growth potential for independent small business owners and their families.”

The company stepped up the requirements for franchisees to renew franchise agreements, in part arguing that McDonald’s should have tough standards for operators remaining in the system. It has also toughened standards for spouses or children of franchisees to become franchisees themselves.

The change in terminology to “royalty” from “service fee” only adds to that. Royalty is common nomenclature in the franchise world. Almost every franchise brand, whether it’s a fast-food restaurant or pet store retailer or a disaster cleanup brand charges its franchisees a cut of their revenue for the right to operate a brand, which is called a royalty.

McDonald’s has always called its charge a “service fee,” and it has traditionally been lower than average. The typical royalty for the 100 largest franchises is 5%, according to an analysis Restaurant Business did two years ago when Subway upped its charges to 10%.

The company had also kept its service fee at 4% for nearly 30 years. “We are outpacing the competition, and our combined investments have made the brand stronger and more accessible than ever,” Borden and Gregory wrote. They noted that McDonald’s now rates as the fifth most valuable brand in the world, according to the consulting firm Kantar.

Cash flow debate

But operators argue that the company’s moves have shifted more costs onto them while helping boost corporate profits. And they argue that the royalty change will only make matters worse.

NOA in its statement argued that franchisee restaurant cash flow has not kept pace with inflation. If cash flow had simply kept pace with inflation between 2012 and last year, a typical McDonald’s restaurant would have generated another $166,000 last year.

The association also argues that per-restaurant EBITDA “is crashing and will likely hit a 12-year-low of around 12.25%” in the fourth quarter, or come 2024.

“In spite of the incredible sales growth the restaurants are driving, franchisees are making less money per restaurant today than they did in 2010,” NOA said.

The company argues, however, that franchisee cash flow this year is expected to be one of the highest in McDonald’s history. It also says that cash flow this year is increasing “at the same rate as same-store sales growth.”

McDonald’s, like almost every other publicly traded franchisor, does not report franchisee EBITDA numbers. And the company would not provide the data for this story.

One reason operators believe they are making less is through corporate moves to cut its own costs. McDonald’s has been cutting its corporate overhead spending over the past several years, and now a typical field officer covers much more ground than they did 10 to 15 years ago.

When McDonald’s restructured its corporate offices, it closed field offices and eliminated more than 100 support jobs, NOA said. This move “transferred millions of dollars of [general and administrative expenses], training, technology and development costs to franchisees for services that they are contractually obligated to provide,” NOA said.

“The change of classification to royalties will remove the duty to provide vital services,” the association added. “Most importantly, it has always been these services that separated McDonald’s from every other QSR competitor.”

Other experts agreed that the terminology change is significant. “Obviously, contract nomenclature is subject to which side of the contract you’re on,” said Kim Perrotta, a franchisee advocate. “There’s no question that the term change could indeed pack a serious punch upon any instance of interpretation or, unfortunately, litigation.”

McDonald’s argues that it isn’t cutting services as a result of the change in terminology and referred to a comment Erlinger made last week to CNBC. “We’re not changing services, but we are trying to change the mindset by getting people to see and understand the power of what you buy when you buy into the McDonald’s brand, the McDonald’s system,” he said.

Nevertheless, NOA now argues that McDonald’s as an investment may simply not be worth it. As it is, operators have been arguing that their restaurant valuations have taken a big hit this year. “In the last two years the value of my restaurants have dropped about 40%” between decreased cash flow, higher interest rates and lower prices, one franchisee argued.

There are fewer buyers of McDonald’s locations than there were a year and a half ago, which has dropped the overall value of the restaurants. The higher royalty, operators say, will only make it worse. The association recommended its franchisees invest in McDonald’s stock or even an index fund rather than new restaurants.

“In its full context, these charges are detrimental to the brand and its franchisees,” NOA wrote. “It’s time for every owner/franchisee to begin focusing on protecting their business, their employees and their family. Every reinvestment decision should be reconsidered; only investing in programs and items that generate a commercially reasonable return on investment.”

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