The Franchise Model: Royalties, Franchisees, Refranchising

Introduction

Franchising solves a restaurant brand's biggest constraint: growth capital. Opening thousands of restaurants means buying or leasing thousands of sites, building kitchens and hiring and training staff, which would take a single company decades to fund. Under a franchise, independent owners put up that money and run the restaurants, and the brand owner collects a share of every sale for as long as the agreement lasts. The franchisor supplies the brand, the menu, the systems and the marketing; the franchisee supplies the capital and the day-to-day operation. The same model runs through hotels, fitness clubs, car washes and many other services, as covered in how multi-unit consumer services businesses work, but restaurants are where it is most developed.

The share matters, and it rarely changes. McDonald's raised the royalty rate for new franchised restaurants in the US and Canada from 4% to 5% from January 2024, the first increase in about three decades, bringing North America in line with its other markets, according to FOX Business. A one-point change sounds small, but on a system with more than $139 billion of annual sales, each point applied across the whole system would be worth well over a billion dollars a year. This article explains how franchisors earn their money, what franchisees earn, why brands refranchise and how both sides are financed.

A franchise is a long-term contract, often 10 to 20 years for a restaurant, under which the franchisee may operate a restaurant under the brand in return for fees and adherence to the brand's operating standards. The franchisor's income comes from several fee streams, each serving a different purpose.

Royalties: a share of sales, not profit

The royalty is charged on gross sales, not on the franchisee's profit. That makes franchisor revenue simple and predictable: it rises with systemwide sales and new openings, and it does not depend on how well each franchisee controls costs. The same feature creates tension. A franchisor benefits from anything that raises sales, including discounts and value promotions, while the franchisee bears the cost of those discounts and must still pay royalties on the sales they generate.

Royalty rates for large restaurant systems commonly sit in the mid-single digits as a percentage of sales, and they are among the stickiest terms in the business. Rates are fixed in each franchise agreement, so a franchisor usually changes them only for new restaurants, renewals or transfers, as McDonald's did. That gives existing franchisees rate certainty for the life of their agreements and means a brand's average royalty rate moves only slowly as the system turns over.

Development agreements and territories

Growth in a franchise system is organized through development agreements, under which a franchisee commits to open a set number of restaurants in a territory over several years, usually paying part of the franchise fees up front. In return it may receive rights over that territory, protection from other franchisees opening nearby or both. Territory rules are one of the most negotiated terms in a franchise system: too much protection slows the brand's growth, while too little invites encroachment, in which a new restaurant takes sales from an existing one. Bankers read the development pipeline, the signed but unopened commitments, as a leading indicator of a franchisor's unit growth.

Advertising funds

Franchisees also pay a share of sales into an advertising fund for brand marketing, which the franchisor manages to buy national and regional media, run promotions and develop marketing. The fund is meant to pay for marketing rather than profit the franchisor, and franchisees often have a say in how it is spent through advertising cooperatives. How well the fund is used is a frequent source of friction, since franchisees pay into it whether or not a campaign works.

What the franchisor's P&L looks like

A pure franchisor carries few costs beyond its head office, franchise support teams and technology, so most of its royalty income turns into profit and its capital spending is minimal.

Company restaurants inside a franchisor

Most franchisors still run some restaurants themselves. A company-operated base gives the franchisor an operating laboratory: it lets the brand test menu items, technology and new formats before asking franchisees to adopt them, train managers and keep first-hand knowledge of restaurant costs. It also gives the franchisor credibility when it asks franchisees to invest: a remodel program is easier to sell when the franchisor has already done it in its own restaurants and can show the results. The size of that base is a strategic choice, and it shifts over time as companies refranchise or buy restaurants back.

Franchise regulation and disclosure

In the US, franchise sales are regulated by the Federal Trade Commission's (FTC) Franchise Rule, and some states add registration requirements of their own.

Franchise Disclosure Document (FDD)

The disclosure document a US franchisor must give prospective franchisees before they sign or pay anything. It covers 23 required items, including the franchisor's background, litigation, fees, initial investment, restrictions, renewal and termination terms, financial performance claims, outlet data and audited financial statements.

The FTC says a buyer must receive the FDD at least 14 days before signing a contract or paying money, and that any claims about sales or earnings must appear in Item 19, the financial performance representations, according to the FTC's guide to the FDD. Item 19 is optional, but most franchisors provide one, and for bankers the FDD is a valuable source of data on unit volumes, openings, closures and transfers across a system.

A franchise system is only as healthy as its franchisees, and franchisee profitability is the number that decides whether the system grows. If they cannot earn a good return on capital, they stop opening restaurants, defer remodels and eventually sell or close, and the franchisor's growth stalls.

The franchisee's P&L

A franchisee runs the same restaurant P&L described in how restaurant companies make money, segment by segment, then pays the franchisor's royalty and advertising fees out of the restaurant's margin, and rent if the franchisor is the landlord.

When those returns fall, a system shows strain: fewer new-unit commitments, more restaurants for sale and resistance to remodels or new technology that franchisees must pay for. Bankers studying a franchisor therefore ask for franchisee-level economics as well as the franchisor's own numbers.

Initial investment and build costs

The franchisee's initial investment covers the franchise fee, construction or fit-out, kitchen equipment, signage, opening inventory, pre-opening training and working capital, and the FDD sets out an estimated range. Build costs have risen faster than sales in many systems, as construction, equipment and land prices increased, which squeezes cash-on-cash returns even when restaurant volumes hold up. Franchisors respond with smaller prototypes, drive-thru-only formats and conversions of existing buildings, all designed to cut the investment needed for each unit.

Renewals, transfers and terminations

Franchise agreements end, and what happens then matters to both sides. At renewal, franchisors often require a remodel to current standards and may update fees, which can make renewal expensive for an operator with an older restaurant. Transfers let a franchisee sell restaurants to another operator, usually with the franchisor's approval and a transfer fee, which creates an active market in franchised restaurants. Franchisors can terminate agreements for serious breaches, such as failing to pay royalties or meet standards, though state laws in some places limit termination. These terms, set out in Item 17 of the FDD, shape how freely restaurants change hands and how much a franchisee's business is worth when it sells.

Multi-unit operators

Most large systems are no longer made up of single-restaurant owners. Multi-unit franchisees run dozens or hundreds of restaurants, sometimes across several brands, and the largest operate more than a thousand.

Multi-Unit Franchisee

A franchisee that owns and operates many restaurants under one or more franchise brands, often under development agreements that commit it to open a set number of new units in a territory. Large multi-unit operators are often backed by private equity and can be significant businesses in their own right.

Scale gives these operators advantages: professional management, better purchasing, access to bank and sponsor financing and the ability to spread overhead across many units. It also gives them bargaining power with franchisors, since a large operator's decisions on remodels, openings and pricing can move a brand's results. Sponsors buy and build multi-unit franchisees as investments in their own right, a theme covered in consumer private equity: the specialist sponsors.

Where franchisor and franchisee interests diverge

The relationship works when both sides earn well and breaks down when they do not. Common sources of tension include:

Many brands that once owned most of their restaurants have sold them to franchisees, a process called refranchising, turning restaurant profit into royalty streams. The aim is an asset-light model: a company that earns royalties rather than running restaurants, with higher margins, lower capital spending and steadier cash flow.

Why markets reward asset-light

Investors have tended to value franchisors more highly than operators because their earnings are more predictable, their margins higher and their capital needs lower. Royalty income does not swing with food or labor costs, and free cash flow is close to earnings because the franchisor builds nothing. That valuation gap is the main reason companies refranchise, along with free cash flow that no longer funds restaurant capex: selling restaurants at one multiple and keeping a royalty stream valued at a higher one can raise the company's total value even as its reported profit shrinks. The gap is discussed in valuing restaurant companies: operators vs franchisors.

How a refranchising program runs

Large refranchising programs follow a common sequence over several years, and buyer quality and package design matter at every step.

The costs of going asset-light

Refranchising also has costs. The franchisor loses direct control of operations and the profit of the restaurants it sold, and it becomes dependent on the financial health of its franchisees. A system that refranchises to weak operators can find itself with neglected restaurants and falling sales, which hurts the royalties it kept. Selling restaurants in a single large package to one operator creates concentration risk, since that operator's problems become the brand's problems.

Buying back to refranchise

Sometimes a franchisor buys restaurants back to fix them before selling them again, a buy-fix-sell approach. Restaurant Brands International (RBI), owner of Burger King, completed its acquisition of Carrols Restaurant Group, its largest US Burger King franchisee, on 16 May 2024 for $9.55 per share in cash, an enterprise value of about $1.0 billion, according to RBI's completion announcement. Carrols operated 1,023 Burger King and 59 Popeyes restaurants; RBI committed a further $500 million to remodel more than 600 of them and planned to refranchise most of the portfolio to new or existing smaller operators over about seven years.

The deal shows refranchising as a cycle rather than a one-way move. When a large franchisee underinvests, the franchisor can take the restaurants back, fund the remodels itself and then sell them to operators better placed to run them, restoring the asset-light model with a healthier system.

When franchisees fail

The alternative can be worse. When a large, heavily indebted franchisee fails, as NPC International, a major Pizza Hut and Wendy's operator, did when it filed for bankruptcy in 2020, the brand faces closures, a fire sale of restaurants and disruption in whole regions. A franchisor that buys back a struggling operator before it fails keeps control of the outcome, at the cost of temporarily taking restaurants and capital spending back onto its own books.

The warning signs of a franchisee in trouble are usually visible well before a filing:

Bankers advising franchisors watch the largest operators' credit closely, since a failure among them is a system event rather than a single-restaurant problem.

The two sides of a franchise system borrow in very different ways. Franchisors, with predictable royalty income and low capital needs, can carry high leverage, and many of the largest use whole-business securitization, pledging royalties, fees and sometimes rent to bondholders. Domino's, for example, refinanced part of its securitized debt in 2025 with $1.0 billion of new notes and a $320 million variable funding note facility. The structure is covered in whole-business securitization for franchisors. Its appeal is cost and duration: because the royalty stream is diversified across thousands of restaurants, securitized notes can carry investment-grade ratings and fixed rates for years, even for a franchisor whose corporate debt would be rated well below that.

How franchisees borrow

Franchisees fund themselves like other small and mid-sized businesses. Single-unit owners use personal equity and bank loans, often government-guaranteed through the US Small Business Administration, whose lenders favor established franchise brands with long performance records. Large multi-unit operators use bank facilities and sponsor equity, and many sell restaurant properties to net-lease investors and lease them back to fund growth. Franchisee leverage matters to the franchisor, since an over-indebted operator is the one most likely to defer remodels or fail.

The franchise model extends well beyond food. Hotels, fitness clubs, hair salons, car washes, home services, childcare and tutoring all use franchising to grow with franchisees' capital, and the same logic applies: the franchisor earns royalties on sales while franchisees carry the investment. The unit economics differ by sector. A hotel franchise involves large property investments and long contracts; a home services franchise may need little more than a van and equipment, so franchisees can open quickly but also churn quickly.

The asset-light appeal makes franchisors in every sector popular with sponsors and public investors, and many of the same financing tools, including whole-business securitization, have spread from restaurants to services. For bankers, the analysis transfers directly: systemwide sales, franchisee returns, development pipelines and closures tell the story of a franchisor in any industry, which is why franchise expertise is a core skill in consumer coverage.

When advising franchisors, franchisees or their buyers, bankers focus on the health of the whole system:

The deal activity around franchise systems, from franchisee roll-ups to brand portfolio sales, is covered in restaurant M&A: sponsors, portfolios and franchisees. For a coverage banker, the key insight is that a franchisor sells two things at once, a brand to customers and an investment to franchisees, and the system grows only while both are worth buying.