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Appraisal of Franchises Requires the Use of
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Franchise operations, however, are a breed unto themselves, and this makes the valuation of these enterprises a unique process. The chief reason for this is the fact that the relationship between franchisors and franchisees is a business partnership in which each party owns and derives value from different forms of property.
Typically, the franchisor owns and manages only the intellectual property involved in the relationship, such as goodwill, logos,
brands,
trademarks, advertising slogans, and business systems and processes (for
Through its relationship with the franchisor, the franchisee, on the other hand, possesses the right to use these assets in its business but usually owns only the tangible assets it needs to conduct business, including equipment, inventory, and supplies. The franchisor may own or lease real estate, leases, and equipment and subleases these items to the franchisee, or the franchisee may own or lease these items directly. What Is a Franchise?Whatever the details of the particular arrangement, the task for the appraiser is to discover the degree to which each asset contributes to the success of the operation as a whole—a job that is more easily said than done.
The process begins with an understanding of the franchise relationship as defined in state law. Under the laws of many states,1 a franchise relationship exists when the following occurs:
As these terms suggest, the relationship between the franchisor and the franchisee is intimate and ongoing. But since each party owns different assets but puts them to use in a joint effort, it is often not readily apparent exactly how much each asset contributes to the value of any given enterprise. Indeed, given the differences in the assets owned by the parties in the enterprise, franchisors and franchisees in many ways engage in different businesses that create value when joined together. Appraising the Franchisor’s ValueConsider the franchisor first. As owners and managers of intellectual property, franchisors generally do not earn profits directly from the sale of the products or services bearing their names at all. Hence, the value of the franchisor’s business operation derives mainly from the skill with which the franchisor manages its intellectual property and, importantly, the relationships with its franchisees.
This skill can create substantial value in franchise versus non-franchise operations. For example, assume two restaurant companies selling the same fast food products and generating equal revenues and profits. The first is a franchisor owning no tangible assets (that is, no real estate, no equipment, no outlets, etc.), and the second is a chain operation owning all of its outlets. In a sale, the franchisor might command a multiple of six to eight times EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), and the nonfranchisor a multiple of only four to five times EBITDA. It should be noted, however, that skill in managing intellectual property is not the only factor in creating this difference (see sidebar on page 68).
Thus, given the importance of intellectual assets in a well-managed franchise operation, the process of valuing the business begins with an assessment of the premium commanded by the franchisor’s brand over similar generic brand products, and it continues with a step-by-step calculation of the values associated with every other item in the franchisor’s inventory of intellectual property.
The franchisor’s growth prospects are also important in deriving value. How large is the universe of possible buyers for the franchisor’s product or service? Where are these buyers? How many more territories must the franchisor open up to reach these buyers? How long will it take the franchisor to do this? What will this effort cost? What revenues and profits will it produce? Franchise Agreements Drive ValueThe agreements between franchisors and franchisees are also important in driving value, particularly those governing the rights of each party when renewing the arrangement. These may permit the franchisor, for example, to increase royalties, fees, or rents, or require franchisees to remodel their outlets, upgrade their equipment, etc. The more these terms favor the franchisor, the more value they yield for that party—and, often, the less for the franchisee.
Although franchisors derive much value from the management of their intellectual property, such items as real estate and equipment must also be considered. The more of these assets the franchisor owns, the better. They generate rental income for the franchisor in addition to the royalty and fee income from franchisees with relatively predictable increases over time.
Royalties reflect the marketplace value of the franchisor’s intellectual property, and because competition is extensive in many franchising niches, royalties are also relatively predictable. In most cases, data are readily available on royalty rates, making it possible to judge their impact on the value of a franchise operation. In the fast food industry, for example, royalty rates typically range between 3 and 8 percent, with most franchisors charging 6 percent or less.
Up-front franchise fees paid by new franchisees reflect marketplace value as well. Some top-tier franchisors charge as much as $1 million per store and sometimes more, with an obvious impact on value. Don’t Try This at HomeClearly, these factors make for a complex valuation process best left to professionals who understand how to give proper weight to each of the factors in question.3 The process begins with an assessment of the franchisee’s hard assets, including plant, equipment, supplies, and inventory. In addition, it is necessary to judge how much value the franchisee derives from its association with the franchisor. It is also important to judge the franchisee’s production capacity and its right to expand into new territories. Local economic and social conditions may enhance or diminish profitability and hence value.
When valuing a master franchisee, the questions begin with whether state law gives the master franchisee the right to bargain over royalties, fees, territories, and other factors. If so, what value does the master franchisee derive from this right? Does the master franchisee achieve economies of scale by operating its own training program, by reducing the cost of supplies through bulk purchases, or by negotiating special real estate leasing terms? The Internet
In recent years, the Internet has become another source of value for both
franchisors and franchisees, and sometimes a point of contention between
them. Does the franchisor possess the sole right to sell to catalog or
Internet customers within the territories of its franchisees? If so,
this may increase value for the franchisor and decrease it for the
franchisees. Conversely, if the franchisees have the right to sell to
catalog or Internet customers irrespective of territory, the impact on
value for the franchisor is obvious.
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To avoid conflict over Internet sales, many franchise agreements give franchisors sole right to such sales but require them to funnel orders to franchisees in whose territories the sales originate, thus enhancing value for both enterprises. Nevertheless, the remaining gray areas give rise to a good deal of litigation between franchisors and franchisees over the value of intellectual and other items of property that are held by each party, with consequent impact on value for each. Most franchise agreements specify that goodwill, for example, is the sole property of the franchisor as an item of intellectual property, but case law shows that a franchisee’s specific goodwill can become an item of community property in a divorce action.4 In addition, under certain circumstances a franchisee may generate goodwill specific to its own operations and hence lay claim to compensation for its loss when a local governing body condemns the property on which the franchisee operates in an eminent domain action.5 |
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Why Are Franchises Worth More?There is no doubt that, comparing apples to apples, a franchised business is likely to be more valuable than a nonfranchised business. But no one factor accounts for this truth, according to researchers at the University of New Hampshire. “Franchising firms minimize agency problems and have access to cheaper capital, motivated managerial expertise, and better local market knowledge,” according to E. Hachemi Aliouche and Udo Schlentrich, senior research fellow and director, respectively, of the William Rosenberg International Center of Franchising at the University of New Hampshire, in their 2005 study Does Franchising Create Value? An Analysis of the Financial Performance of U.S. Public Restaurant Firms.1 Franchised businesses minimize agency problems (that is, the problems facing any principal who delegates decision-making authority to an agent hired to provide a service) by giving the agent/franchisee powerful incentives to do well, according to the researchers. Franchised businesses gain access to cheaper capital by requiring new franchisees to front certain start-up costs, in essence requiring new franchisees to become suppliers of expansion capital for the franchisor. And franchised businesses gain access to motivated managerial expertise and local market knowledge because it is a good bet that new franchisees will sign on and risk their own capital only if they are confident that they have the managerial skill and market knowledge to succeed.
It is also true that successful franchisors, keenly aware that their intellectual property is their core asset, develop substantial skill in managing it, thereby adding to the inherent value of a franchised business. Last, but not least, because of the maze of federal and state laws, statutes, and regulations that require franchisors to treat franchisees fairly and openly, franchisors tend to keep better books, i.e., audited financial statements, than do many nonfranchised businesses. Thus, when a franchised business goes on the block, potential buyers gain increased confidence that the numbers they see on the franchisor’s financial statements represent the true state of the business. The accompanying charts bear this out. We analyzed transaction data reflecting sales of 77 franchised and 356 nonfranchised restaurant companies over five years beginning January 2001, showing clearly that franchised restaurant companies command higher prices when they are offered for sale. As chart A shows, over the five-year period the mean multiple of deal price to EBITDA was 4.11 among franchised restaurants versus 3.30 for nonfranchised restaurants. It was not uncommon for successful franchised restaurants to command multiples of eight times EBITDA. The mean multiples of deal price to EBIT were 4.68 and 2.94, respectively, and the mean multiples of deal price to discretionary cash flow were 2.93 versus 2.29. Meanwhile, as chart B shows, the median multiple of deal price to EBITDA was 3.80 for franchised restaurants versus 2.58 for nonfranchised restaurants. The median multiples of deal prices to EBIT were 3.47 versus 2.19, respectively, and those of deal price to discretionary cash flow were 2.66 versus 1.84. Thus, it is not surprising that franchised businesses as a whole play an increasingly important role in the U.S. economy, as borne out by the University of New Hampshire study. In 2001, the most recent year for which data were available, franchised businesses provided jobs for nearly 9.8 million people, or 7.4 percent of all private-sector jobs—about the same number of jobs attributable to all U.S. manufacturers of durable goods, including cars, trucks, aircraft, computers, communications equipment, wood products, and instruments of all kinds, according to the study.2 In addition, franchised businesses met payrolls exceeding $229 billion and generated nearly $625 billion of output, constituting nearly 4 percent of all private-sector output. NEVIN SANLI AND BARRY KURTZEndnotes
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Published in Franchise Law Journal, Volume 26, Number 2,
Fall 2006. © 2006 by the American Bar Association.
Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. |
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ppraisers operate on the presumption that however different the individual business is from all others, businesses within a specific industry nonetheless share certain characteristics that make it possible to compare one to another and thus derive a value.
example, recipes in the case of the fast food
franchisor). The franchisor generally does not engage in the delivery of products or services to the consumer unless, of course,
it operates company-owned stores or manufactures or sells products to its franchisees.
