When a group of anonymous Subway franchisees asked in May for a lower royalties, among their contentions was the franchisor's generally high rate. At 8% of sales, they said, Subway charged more for the right to operate the brand than other fast-food chains.
A Restaurant Business analysis of the largest restaurant franchises in the country back them up. Subway’s combined royalty and ad fund payment charges are the second-highest among the 100 largest franchisees.
Operators who choose to pay a 10% royalty—an option the company is giving its franchisees as they renew their franchise agreements—will be paying the single highest rate among the 100 largest restaurant franchises.
On the other hand, the chain’s individual locations make so little in revenue that they pay among the lowest total dollar charges to operate and market the brand. Subway franchisees pay less than half the royalty and ad fund charges as rival Jersey Mike’s franchisees, for instance, despite sending a higher percentage of their revenues into the franchisor.
Still, the high charges make it that much harder for operators to turn a profit at a time when a lot of operators are struggling and shutting down as a result. Subway franchisees are closing about 1,000 locations a year.
“There is no doubt this is an economic transfer from franchisees to DAI,” said John Gordon, a restaurant consultant out of San Diego, using the abbreviation for Subway’s parent company, Doctors Associates Inc.
Subway, for its part, points to other elements of its franchise offering outside of the royalty payments such as the low cost of opening a restaurant. “Royalty and ad fund fees are not the only factors that prospective franchisees look at when deciding whether to invest in a franchise of one brand or the other,” a company spokeswoman said in a statement.
“They also look at things like startup costs, complexity of operations and leasing fees. We believe we have a competitive offering in an industry where there are lots of choices and tradeoffs for prospective franchisees.”
Royalty rates
Franchisors typically charge franchisees a percentage of sales for the right to use the brand. The royalty, as it’s usually called, is the franchisor’s primary form of revenue. It’s certainly not the only form, however—franchisors may charge for technology or rent or other ancillary costs. But royalties are the most common and consistent.
To analyze royalty rates, we used information from the website FranchiseGrade.com along with companies’ franchise disclosure documents as well as information available on their own websites.
The typical franchise royalty is 5% among the 100 largest restaurant franchises. The median average unit volume for those franchises is just over $1 million, meaning that the typical restaurant franchise in a big system pays nearly $55,000 per year to their franchisor for the right to use the brand.
Ad fund requirements are more variable. Among this group they ranged from no ad fund requirement to 7% of revenues. The rules surrounding how these funds are used also varies, as does who is in control of the funds. And many brands will require franchisors to pay additional dollars either into regional cooperatives or for local marketing.
Generally, however, advertising funds are a necessary expenditure. At just more than 3%, the ad fund adds another $30,000 annually to the typical franchisee’s regular charges.
Still, the combined royalty and ad fund charges limit operators’ ability to control their profitability. Because they have to pay these fees off the top, franchises have to make their living with less revenue than if they were to create their own restaurant from the ground up.
Think about it this way: Chipotle and Qdoba are both fast-casual burrito chains. The former is company operated. The latter is a franchise that charges a lower-than-average 6.3% in combined royalty and ad fund charges. Still, while Chipotle gets $1 for every $1 in revenue it brings in, the Qdoba franchisee gets 93.7 cents.
And the charges can penalize higher-volume stores. A location with twice the unit volumes pays twice the royalty and ad funds even though they theoretically receive the same benefit. Still, the revenue-based charges remain the industry norm.
Generally, franchisors hold these charges sacred, rarely changing them. Yet pressure builds on concepts to lower them when problems arise. Many franchisors, including Subway, provided operators with at least a temporary break on royalties during the pandemic last year.
Three years ago, Papa John’s gave breaks to its franchisees in a bid to keep them from closing when sales plunged. In 2016, Quiznos cut its royalty and ad fund rate in a bid to improve franchisee profitability and reduce store closures.
Caroline Bundy Fichter, a franchising attorney out of Washington State, said that royalty rates are a vital component in choosing a franchise. A royalty rate that is too high can be a problem. “You should be laser-focused on that royalty rate, and the ancillary rates,” she said. “It doesn’t matter how good you are in the business if you’re working on a narrow margin and most of that margin is going out the door to the franchisor.”
10 pricy restaurant franchises
Here is a look at how much franchises charge their franchisees for royalties and ad funds, as well as the average for the 100 largest.
How Subway stacks up
Subway’s operators have closed 5,000 restaurants since 2015, an average of about 1,000 per year. Franchisees also say thousands more are willing to walk away from their brand after their leases run up, frustrated with years of weak sales and diminishing profits.
The typical Subway restaurant generated just $365,000 in revenues last year, among the industry’s lowest unit volumes and lower than any other major sandwich shop. That said, that was a pandemic year. In 2019 those volumes were $420,000, which is still low.
Sales have grown this year as consumers have returned to dining out. But operators are now contending with skyrocketing labor costs and higher food charges. “Subway has no margin left,” one franchisee said. “With the increase in labor and food cost, where’s the margin that’s left over?”
Subway charges an 8% royalty, 300 basis points higher than average and higher than any of its primary competitors other than Penn Station East Coast Subs. Indeed, only seven of the 100 largest restaurant franchises charge royalties of 7% or more.
But the company’s ad fund is also higher than average. While the typical ad fund is 3% of sales, Subway charges 4.5%--more in line with other systems, but still among the 20 biggest charges for advertising.
The combined royalty and ad fund charge means a typical Subway operator pays the brand 12.5% off the top—or $45,630 per year. That means a franchisee has to turn a profit off 87.5 cents for every $1 it receives, while an average franchisee gets 92 cents. Only Little Caesars, which has a 6% royalty and a 7% ad fund, charges more.
Subway’s struggles and its high charges led some franchisees to ask for a lower royalty, citing Burger King’s institution of a 4.5% royalty while current Subway CEO John Chidsey was the chief executive there. “A reduced royalty would be a major boost for the brand and make us destined for success,” the operators said. “Just think of the possibilities that this could open. We could reinvest more money into our stores and hire more people.”
Instead, Subway is going in the other direction. The company is offering franchisees an option of a 10% royalty if they renew their franchise agreement with provisions that give a lot more power to the franchisor.
Operators who choose the 10% royalty would be paying the highest rate of any franchisor among the largest franchise systems, and the 14.5% they’d pay would be higher than any other franchise by 150 basis points. That Subway operator would have to make a profit off 85.5 cents on the dollar.
Low up-front costs
On the other hand, Subway has low average unit volumes traditionally, and so the company gets less from every store than other franchises. The company gets a lower amount in total dollars from its franchisees for royalties than all but 10 of the largest restaurant franchisors.
Low-volume brands are moderately more likely to charge higher royalties, in part because they have to work to generate more revenue.
The company’s statement refers to other elements, notably startup costs and complexity of operations. It’s easier to open a Subway than many other brands and its locations can go just about anywhere, given the fact that there are no grills or vats of hot grease and the most cooking is done in a tiny oven.
Subway’s relatively low cost of operation makes the brand more accessible to franchisees with less capital, less experience or both.
The company’s charges are moderately more comparable to low-volume franchises or sandwich chains, both of which average royalties of about 6% and total charges of just under 9%.
Still, Subway’s charges remain higher than all of them. Many franchisees say the charges stand out as the company’s sales have struggled and labor and food costs have increased.
Fichter noted that brands with high charges risk alienating franchisees and leading them to cut other costs, which hurts service and ultimately the brand’s success. “They start cutting corners and ultimately they fail,” she said. “Ultimately, unhappy franchisees will destroy a system.”
She said that high royalties should only be paid in systems with a unique product, high volumes or both. “You either need a killer system or name or a very reasonable royalty,” Fichter said. Subway doesn’t have a reasonable royalty, and its system and name aren’t as unique as they once were.
“It’s a Cadillac price for a Pinto product," Fichter said.