Canada's Fall Economic Update and Its Impact on Valuations

A couple of days ago, the federal government of Canada came out with its Fall Economic Update. One aspect of the update that impacts businesses (and business valuations) is the changes to the Capital Cost Allowance (“CCA”) system by which businesses get to write-off their capital assets for tax purposes. This brief article discusses some aspects of this change.

CCA and the Half-Year Rule

For non-manufacturing equipment, we used to have the “half-year rule”, whereby a purchaser of a new asset only got to apply half of the normal CCA rate in the first year; for example, if you bought an asset for $100,000 and the normal CCA rate is 20%, you’d only get to write off 10% (or $10,000) in the first year for tax purposes.

The half-year rule has now been replaced with a new first year rule which allows purchasers to apply 1.5 times the normal CCA rate in the first year; to continue the example from the previous paragraph, the CCA in year 1 would now by $30,000.

For valuators, this means that the tax shield formula on new capital expenditures will change from:

UCC x Tax Rate x CCA Rate / (Discount Rate + CCA Rate) x (1- (Discount Rate / (2 x (1 + Discount Rate))))

to

UCC x Tax Rate x CCA Rate / (Discount Rate + CCA Rate) x (1+ (Discount Rate / (2 x (1 + Discount Rate))))

Does this matter?

So, will this change impact a) actual capital expenditures and b) valuations in Canada going forward? The short answer is: in many cases, "not really".

The amount of CCA that businesses can take over the life of the asset in question does not change based on the new rules; all that is affected is the timing of CCA. By accelerating the CCA in the first year of the asset’s life, businesses will get to reduce their taxes in the first year, but their taxes will be slightly higher in subsequent years. The value of this timing difference depends on the discount rate one uses.

A common practice in valuations is to use a firm’s pre-tax cost of debt as the discount rate to calculate the present value of CCA. The reason for this is that the odds that a firm will have at least some taxable income against which to apply the CCA are fairly good, certainly less risky than the overall returns to equity holder as a whole.

Using a discount rate of 8%, I calculate that the impact of the new tax changes to the cost of asset purchases will be less than 1%, regardless of the CCA asset class. 

This is not to say that these changes will not spur a sudden rash of equipment purchases – they may have some psychological effect. But the actual savings, at least in most cases I can envision, are pretty marginal.
  

Springboard Profits/Damages in Canadian Intellectual Property Litigation

A few weeks ago, I co-presented at the Intellectual Property Institute of Canada’s annual conference in Vancouver on the topic of financial remedies in patent litigation. My portion of the talk focused on springboard profits as part of the accounting of profits remedy. In this post, I’ll share some of my thoughts from the presentation, as well as some other ideas that were suggested to me by my co-panelists and audience members.

The Concept

The concept behind springboard profits is that, by virtue of having infringed a patent, the infringer has achieved a financial advantage that continues beyond the expiry of the patent. This can occur for several reasons:

• A valid patent prohibits not only the sale, but also the manufacture and offering for sale of an invention covered by the patent. This means that had the infringer not infringed during the life of the patent, it would have taken some time to develop its product, to build up inventory, to market the product and build distribution channels. In short, it would have taken months, if not years, to build up their sales to a steady plateau. By infringing, the infringer is able to “hit the ground running” following the expiry of the patent.
• If the patented product is a durable good, then the benefits to the infringer in selling that good may include not only the initial sale, but also the sale of replacement parts, maintenance services, or other associated revenue streams. While the initial sale of the good may have taken place during the life of the patent, there will be additional benefits accruing to the infringer well beyond the life of the patent.
• In some instances, there may be an even longer-lasting benefit to the infringer. The existence of multiple firms already selling the patented product by the time of the patent’s expiry may dissuade additional firms from joining the market following the patent’s expiry, firms who may otherwise have entered the market if there had been only a single incumbent with whom to compete. In situations like this, the infringer’s benefit will continue into the indefinite future.

Are such post expiry springboard profits recoverable in an accounting of profits? In Dow Chemical Company v. Nova Chemicals Corporation, 2017 FC 350 (CanLII), Justice Fothergill found that they were. He was persuaded by Dow’s argument that if the incremental profits earned by the infringer following the expiry of the patent are not also disgorged, then the infringer will be left in a better financial position than if it had not infringed, a result that is antithetical to the very concept of the accounting of profits remedy.

Nova’s Argument

While they were ultimately rejected, the arguments raised by Nova also deserve some comment. Nova advanced several arguments. Conceptually, the most interesting arguments was the following:

• An infringer who disgorges its profits from infringement is implicitly acting as the agent of the patentee, and such payments implicitly serve to effectively condone the infringing activities themselves.
• The difficulty with this argument is that the profits remedy is not necessarily equal to the amount that, in the real world, the plaintiff would have agreed to in exchange for use of its patented technology. In many cases (such as the Dow case) the plaintiff would clearly never have agreed to license the technology under those terms, as its Minimum Willingness to Accept would be based on the damages it would suffer by reason of losing its monopoly over the invention in question.

The same argument would hold if the remedy awarded was lost profits (i.e. damages). The damages award compensates the patentee for its losses during the patent period only; any losses beyond that period would also need to be considered insofar as they are causally connected to the infringement.

Could Nova’s argument work in a damages context?

Is there a situation in which Nova’s argument would have carried more weight? Perhaps.

Suppose a plaintiff elects a damages remedy, which it measures based on a reasonable royalty since it is unable to prove it suffered any loss of sales as a result of the infringement.  In that scenario, the plaintiff’s MWTA is less than the defendant’s MWTP; that is, the benefit to the defendant from licensing is greater than the value to the plaintiff of its monopoly. This arises most commonly where the plaintiff is a smaller firm, while the defendant is much larger and able to scale to market.

In that case, a hypothetical royalty rate (and a fortiori an empirically based royalty rate, measured based on comparable transactions) should incorporate the fact that the defendant will thereby gain a springboard advantage. If so, then there should be no award of springboard damages.

This conclusion is implicit in the words of Justice Fothergill at paragraph 123 of the Dow decision:

[123]      Dow is entitled to awards under both ss 55(1) and 55(2) of the Patent Act. Even if the royalty rates calculated by Dr. Heeb and Dr. Leonard can be said to include the period following the expiration of the ’705 Patent, the royalty compensates Dow only for Nova’s infringement during the period December 9, 2004 to August 21, 2006. The accounting of profits extends over a much longer period.

Happy Belated Bobby Bonilla Day! Some Valuation-Related Thoughts on MLB Contracts

With the World Series upon us, I thought I’d do a post or two on valuation and investment principles involved in baseball player contracts. In this post I'll talk about fixed income valuation and interest rates, through the vehicle of the infamous Bobby Bonilla contract.

Bobby Bonilla was a fine player for the Pittsburgh Pirates in the early 1990s, and he and fellow "Killer B", Barry Bonds (who was a lot skinnier back then) went to three straight National League Divisional Series, losing all three.

Bonilla eventually arrived with the New York Mets (after stops in Baltimore, Florida, and the Mets themselves (in a previous go-round)), and by the year 2000 his skills were in severe decline. The Mets owed Bonilla $5.9M on the last year of his contract. Instead of paying Bonilla the $5.9M that year, however, the Mets and Bonilla agreed to a series of payments whereby the Mets would pay Bonilla $1.193M per year every year for a 25-year period, beginning on July 1, 2011 and ending in the year 2035, when Bonilla is 72 years old. The nominal value of the total payments will be just shy of $30M.

July 1 is now sadly observed by Mets fans every year as “Bobby Bonilla Day”. The sadness is due to three main reasons:

• It seems ridiculous that the team is still paying a former player, now in his early 50s, over $1M a year.
• Bonilla was somewhat of a disappointment even while he played for the Mets. While he made a couple of All Star teams in his first stint with the team, by 1999 he was producing a negative WAR value.
• It is commonly known that then-Mets owner Fred Wilpon was a major investor of disgraced Ponzi-schemer Bernie Madoff, and it is believed that the outsized “returns” Madoff was generating led to what was, objectively speaking, a foolish financial decision.

I’m not here to dispute the first two points, but I do want to talk a little about the financial principles of the third point. 
Discounting and Interest Rates in the Year 2000

It is often pointed out that the interest rate, or discount rate, on the Bonilla deal is 8%.  This is true, as I show in the table below. Thus, from the Mets’ perspective if they could invest the $5.9M at a rate of 8% per year for the next 35 years, they would earn exactly enough money to pay off the annual payments to Bonilla, leaving them with no balance owing at the end of the 35 years. 

Is it crazy for the Mets to have made that assumption? It would appear that the answer may be “no”. While it may be hard to remember based on the current low-yield environment, the US T-bond rate back in 2000 was in the range of 6.5% to 7% in the first part of 2000, while the 30-year “High Quality Market Corporate Bond Rate” at the time was around 8%. While that is a pre-tax rate, it nonetheless appears true that the Mets could have taken their money and invested it in a fairly safe investment and been none the worse for wear. So the deferral seems to make some sense from the Mets' point of view.

Another way to look at the deal is from Bonilla’s perspective. Effectively, Bonilla was agreeing to lend the Mets $5.9M for a long period of time, eventually getting paid back at an annual interest rate of 8%. Given the overall steadiness of Major League Baseball – no teams have folded for over 100 years - this would be similar to lending money to a high quality corporation. The one difference is that for Bonilla, there has been a significant tax advantage to a) spreading more of his earnings across lower tax brackets, and b) being taxed now as a resident of Florida (which has no state taxes) rather than New York (which does). So at the time, this was a win-win deal.

 

Interest Rates in 2018

There is a belief that bonds (lower case, the financial instruments, not the allegedly HGH-infused home run king) are a safe investment. After all, unlike the stock market they provide a fixed, knowable series of payments over time.

This is, in many ways, a mistake. While it is true that the payments on a bond are prescribed, the value of those payments will vary based on changes in rates of return on other investments. Bonds will fluctuate very significantly in value based on changes in nominal interest rates. Thus, if a ten-year bond with face value of $1,000 is issued with a coupon of 5% and the market interest rate at the time is 5%, the bond will sell for $1,000. If interest rates drop the next day to 3%, the same bond (paying a 5% coupon) will become much more valuable, and investors will be willing to pay almost $1,200 for the same bond.

If you think of Bobby Bonilla's contract as a bond with a coupon of 8%, it is clear that the cost of honouring that bond has gone up, with long-term interest rates in the 4% range now. Because the Mets did not (it would appear) secure the future Bonilla payments by matching them to a long-term fixed income investment back in 2000, the value of their liability has not been declining by nearly as much as it should have over time. The present value of the Mets' remaining payments to Bonilla is currently several million dollars higher than it should have been had interest rates remained high.

Conclusion

Trying to predict interest rates is a bit of a mug's game., and in any event the financial landscape in Major League Baseball has shifted so dramatically in the past 18 years that the money remaining on the Bonilla deal is really small change at this point, remarkable more for its strangeness and symbolism than its monetary significance. 

Bobby Bonilla has done well with his contract (assuming he did not sell or assign it!), but if interest rates had risen he would have been singing a different tune. The real advantage to this sort of a long term deal exemplified by Bonilla's is a) the tax savings, and b) the enforced savings and the knowledge that he will have over $1M coming to him for the next 17 years.

 



 

Buying Shares in an NFL Player? Business Valuation Principles Still Apply

In my last post, I argued that an investor in Kylie Jenner’s cosmetics company was essentially investing in Ms. Jenner’s personal brand, and that the earnings stream for that brand was of a finite life.

The post got me thinking: is it actually possible to invest in the future earnings of a specific, individual celebrity? Has anyone ever done that, and if so, how did it go?

The short answer is “yes” and “not very well”. For the longer answer, keep reading.

Fantex

In 2012, a company called Fantex Inc. was incorporated. Fantex’s business was to invest in minority stakes (typically 10% ) of the future earnings (from both on-field performance and endorsements) of professional athletes. It would raise money from the public in exchange for athlete-specific classes of common shares, and would pay the athletes a lump sum in exchange for the right to a share of their future earnings. Shareholders would receive dividends based on the pro-rata performance of their athletes.

The following table shows a list of some of Fantex’s early investments in National Football League players.

 

How have these investments done? Well, it depends.

The investment in Mohammed Sanu has turned out nicely. Sanu, who earned fairly little on his rookie contract with the Cincinnati Bengals, signed a big contract with Atlanta in 2016 (following his deal with Fantex), earning a base salary of $6M per year the past few years. His tracking stock has already paid out $1.41M in dividends to shareholders (close to the initial $1.63M raised), and he stands poised to earn over $6M per year over the next three years with the Falcons, although none of the money is guaranteed.

 

On the other hand, if you invested in the E.J. Manuel stock issue – well, let’s just say that your investment worked out about as well as every Buffalo Bills quarterback since the Doug Flutie era. The E.J. Manuel tracking stock has issued total dividends of only $0.41M, a mere fraction of the $5.2M that was raised to acquire a 10% stake in Manuel’s future earnings.

Overall, it appears that Fantex’s investments have underperformed; the company had a deficit of $14M as at September 30, 2016, the last published financial statement date before the company was delisted.

 

Valuing Fantex's contracts is really no different that valuing shares in a company: it is a function of three factors: the size, duration and risk of the future projected cash flows of the investment.

Fantex’s public filings make for interesting reading, and they talk about each of these valuation inputs. As part of its financial reporting, Fantex would need to re-value its contracts with its roster of athletes each year, adjusting its assessments of fair market value based on its estimates of future performance in light of how the athlete fared in the previous year; the deficit of $14M is largely a function of the write-down in value of underperforming contracts.

What sorts of assumptions does Fantex apply in its valuations? Here are some of the key ones for NFL players, based on Fantex’s 2015 10-K annual report:

• Discount rate of 4.5% to 20%, with a weighted average of 14.6%.
• Career length (I assume this means from the beginning of the player’s career: 5 to 16 years, with a weighted average of 9.7 years.
• Size of contract: $0.4M to $81.4M, with a weighted average of $23.9M.

My initial sense is that these assumptions seem fairly optimistic, given the average length on an NFL career is only 2.6 years, and has been decreasing recently, although of course once a player becomes more established the expected career length will tend to increase.

Let’s return to the Mohammed Sanu tracking stock. Before, I had presented my analysis without applying a discount rate. What if we apply a 15% discount rate to reflect the risk of the investment in Sanu (who was still a young player when Fantex invested) versus investing in a public company stock? You can see that whereas investors paid $1.4M for Sanu’s stock, the present value of dividends thus far has been only $927,000:

 

 

Based on the above, Mr. Sanu will need to remain healthy and avoid being cut by the Falcons the next couple of seasons in order for his investors to break even.

Conclusion

I'll have more to say about the idea behind Fantex , which more recently has expanded into other sports such as golf and baseball. But given that Fantex is no longer publicly traded, would-be NFL investors may need to suffice with the less expensive option of fantasy football.

 

 

Is Kylie Jenner Really a Billionaire, Or Even Close?

A few weeks ago, Forbes created a social media storm when it proclaimed that Kylie Jenner was poised to become the world’s youngest self-made billionaire. Many thumbs were worn out debating the appropriateness of the term “self-made”, and apparently a GoFundMe page was set up to try to get Kylie over the hump into official billionairedom, although mercifully this was only a gag.

As someone who is only peripherally aware of who Ms.Jenner is, I am perhaps not the best person to comment on all this. But as a business valuator, I do feel I should comment on the basic premise of Forbes' assessment that Ms. Jenner is worth anything close to $1B. So here it goes.

Inputs for Determining Value

In order to value a company or asset, we need four main inputs:

• Current level of cash flows
• Expected growth rate
• Expected capital reinvestment rate
• Discount rate

According to the Forbes article, the following are basic facts about Ms. Jenner’s business.

• Total sales in 2017 were $330M. Revenue growth that year was only 7%
• Production and fulfillment are outsourced to third parties, and overhead is minimal. Forbes estimates the cost of sales at 55%.
• Her mother takes a 10% cut (of profits? Or sales? The article is unclear) as a management fee.

The Forbes article seems to assume that Kylie’s net profit margins are in the range of 40%. This seems quite high, even given her lack of overhead costs. L’Oreal and Estee Lauder both have pre-tax net operating margins in the range of 15% to 20%. Given that Kylie appears to run a leaner operation, let’s assume a net operating margin of 25%.

Revenue growth last year was 7%, which seems very low for a business that started less than 3 years ago. I’m going to assume that growth will simply equal inflation going forward.

Capital reinvestment seems, in this instance, to be zero, given the image-based nature of the business. You would figure that at a certain point her manufacturer would pass along any such costs to her, but let’s ignore them for now.

For a discount rate, I estimate a rate of 10%, based on an estimated cost of equity consisting of:

• Risk free rate of 2%
• Cost of equity of 5%
• Firm-specific risk 3%

If I apply a basic Gordon growth model, I get ($337M x 25%) / (10%-2%) = $1,052M. So far, Forbes looks to be on solid ground.

The Problems

But there are two problems with this analysis.

First, most businesses are valued based on the assumption that they are going to operate into perpetuity.  Thus, L’Oreal has been around since 1909, while Estee Lauder has been in existence since 1946. Of course, when taken literally this is generally not a valid assumption; nothing is "forever". But it is normally valid to assume that a business will be around for the next 20 years. Any projected cash flows after that timespan have a fairly low present value, so the assumption of a perpetuity makes sense.

Will Ms. Jenner’s personal brand persist for the next 20 years? It is difficult to say, given the vagaries of celebrity culture. To give some context, here are the highest earning celebrities from 1998: http://www.wemakethefunny.com/?p=2116

If we assume that Ms. Jenner’s remaining shelf life is 5 years, the present value of her cash flows falls to $347M; even a 10-year forecast gives a valuation of $585M.

There are obviously a lot of assumptions in the above table, and in many ways that is precisely the point.

The more basic problem with Forbes’ analysis, however, is simply the question of what exactly one would be buying if one purchased Ms. Jenner’s company. It owns no physical assets, it doesn’t really have much of a labour force, and it does not seem to own much IP. Its ability to generate cash flows is tied solely to Ms. Jenner’s personal fan base. In theory, Ms. Jenner could sign some sort of contract to guarantee continual promotion of the company, which might tie her compensation to the continued success of her brands. But that is a far cry from being able to liquidate her company, right now, for $1B.

Valuing a Franchisee

In a previous post, I examined some of the key issues involved in valuing a franchise system. In this post, I take a look at valuing a franchisee.

Like any business, the value of a franchised business is ultimately a function of a) the level of future cash flows the business is expected to generate, b) the duration of those cash flows, and c) the risk associated with those cash flows. But franchised businesses come with a number of wrinkles, as we discuss below:

A. Level of Cash Flows

With respect to projected cash flows, every business will be different in terms of its operating and investment cash flows. The valuator will need to project sales and operating expenses based on the historic results of the business and any forecasted changes. There are, however, a few twists when it comes to assessing a franchise.

Royalties

Most systems charge a royalty that varies in line with sales. Royalty percentages will vary on a system by system basis, and may change over time. It is important to review the franchise agreement to understand how the royalty system works.

It is also important to note that royalties can come in different forms. For instance, in some systems a significant portion of the franchisor’s revenue comes from markups charged on the sale of inventory rather than from royalties as such.

Some franchisors charge a fixed monthly royalty that does not fluctuate at all. This type of arrangement can be beneficial to successful franchises, but can be a severe burden when sales do not perform as expected.


Capital Investments

When valuing a business, it is always necessary to consider the need for capital investments, and to deduct any planned expenditures from the value.

Franchise agreements often give franchisors the right to require franchisees to carry out capital upgrades. The costs associated with these can often be significant; in the case of McDonalds, for example, the costs can run into the millions. The valuator needs to gain an understanding of any requirements for capital expenditures: when they will be required, how much they will cost, and how they will be financed. 

Financial performance of franchisees is often dramatically affected by these renovations. A franchise that has already done its capital expenditures will likely exhibit a spike in sales during the period when other, nearby franchises are closed for their renovations. It is important to understand the reason for these spikes and to normalize results on a go-forward basis.

B. Duration of Cash Flows

Renewal Rights

In many business valuations, the valuator will assume that the business will carry on into the indefinite future. When we apply a multiple of 5 times after-tax cash flows (for example), that multiplier may be assuming that the discount rate is 22% and the growth rate is 2% into perpetuity.[1]

Franchise agreements typically have a finite term, often consisting of 5 to 10 years. While many agreements contain renewal options, those are normally not automatic.

Now, that does not mean that, in valuing the business, we should project cash flows only over the remaining term of the franchise agreement. But it does mean that a realistic assessment of a) the probability of renewal, and b) the impact of non-renewal on cash flows need to be undertaken. Thus:

• Is the franchisee compliant with the franchise agreement? Is it current with all of its payments? Have discussions occurred with the franchisor concerning renewal?
• If the agreement is not renewed, will the franchisee be able to “de-brand” and carry on business under a new name? If so, how will the business perform? If not, what is the liquidation value of its assets?

Restrictions on Resale
 Franchisors will generally have the right to veto any potential sale of the franchise if the proposed purchaser is deemed unsuitable. While this right cannot be exercised unreasonably, this right can sometimes be a burden to franchisees.
In addition, unlike most businesses, owners of franchises are sometimes restricted in their ability to sell their businesses for an amount equal to their fair market value.  In some systems, the franchisor sets the selling price. In those situations, the impact on "fair market value" may depend on why the business is being valued. Is the plan to sell the business, or to hold it indefinitely?

For example, in Cooke v. Cooke, 2011 BCCA 44, a family law case, the divorcing couple owned two Tim Horton’s franchises in separate companies. They jointly retained a business valuator to value the two companies. The valuator arrived at a value of $850,000 for the more profitable company, and $295,000 for the less profitable company.

Unbeknownst to the valuator, Tim Horton’s had placed restrictions on the resale value of the franchises, stipulating a resale value of only $440,000 for the more profitable of the locations.

Nonetheless, the trial judge ruled that since the husband had no plans to dispose of the business, the limitation on its resale value was largely theoretical, and the value of the business to him as an ongoing investment was $850,000, equal to the present value of projected future cash flows. This finding was upheld on appeal.

C. Risk

Management Expertise

Let’s begin with some positives. One of the reasons franchised businesses are so popular is because one is buying into a business model that is tried and true. There is an operating manual, and the franchisor takes responsibility for many decisions such as what vendors to source supplies from, how and where to advertise, and how the business should appear. All of these factors ought to result in a lower level of riskiness than for a comparable, non-franchised business.

Concentration Risk

The flip side of this is that franchised businesses are typically restricted in a variety of ways. Their rights are typically limited to a particular territory and to the sale of particular products at particular prices. Non-franchised businesses have more flexibility in terms of mobility and the ability to try new product offerings.

Other Issues: The Market Approach

One method by which valuators will sometimes appraise a business is through the use of market comparables. Use of the market approach by a business valuator as a primary approach is relatively rare. It is usually difficult to find sufficient data involving truly comparable transactions.

Franchised businesses would seem to present a rare exception to this. Ostensibly, franchise systems impose a level of homogeneity on their franchisees such that, in theory, the valuation metrics for a group of franchisees should be a good predictor of what a subject franchisee will sell for.

Yet even within the context of franchised businesses, the application of this approach is not easy. This was recognized in C.V.D. v. I.D., 2003 MBQB 274, where the Manitoba Court of Queen’s Bench rejected the application of a rule of thumb approach to valuing a McDonalds’ franchise at 50% of sales.

First of all, even within a franchise system, sales and profitability levels can vary dramatically. Below, I present information from 22 transactions involving Dairy Queen restaurants, based on data from the Pratts Stats database. The chart shows that the vast majority of these restaurants sold for an asset value equal to 0.2 to 0.6x sales. That might seem like a fairly narrow range, until you realize that it simply means that a restaurant with sales of $800,000 will sell for anywhere from $160,000 to $480,000.

Second of all, within any franchise system there will be a wide range of revenue levels, profit margins and other metrics. Every franchise is still, in many ways unique.

At the end of the day, valuing a franchisee is similar to valuing any other business. Buyers want to know the answer to two questions: how much they will make, and how risky the business is. Hopefully, this article has provided them with some useful tools for finding answers to these questions.

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[1] Using the Gordon Growth Model, 1/(22%-2%) = 5.

Valuing a Franchise System

Valuing a franchise system, or “franchisor”, is in many ways very similar to the valuation of any other type of business; it is a function of the forecasted levels of cash flows that the business will generate, and the risk associated with those cash flows. Yet there are some particular factors that make valuing franchisors very tricky. This brief article touches on some of them.

Franchisors – Who are they?

The first point we need to clarify is what we mean when we speak of “franchisors”.  Broadly speaking, a franchisor is a business that earns its income by granting the privilege to one or more franchisees to do business and offers some form of ongoing assistance and oversight in return for ongoing monetary consideration.

Franchisors operate in a variety of industries. The largest industry sector is in the food services; these businesses made up around 40% of the membership in the Canadian Franchise Association in 2017.[1] Tim Hortons’, McDonalds, Swiss Chalet – you get the picture. But there are many other types of franchisors in the retail and service industries. Most hotel chains are franchised, as are most automobile dealerships and the guys who promise to remove junk from your house at all hours of the day. These different industries obviously have different valuation characteristics.

There are also different types of business structures for franchisors. Thus:

• Some franchisors are what one might call “pure plays” (i.e. their income derives almost solely from the sale of franchises and the receipt of royalties). On example of this type of franchisor is Dine Brands Global Inc., the franchisor for the “Applebee’s” and “IHOP”.
• Other franchisors have structured their publicly traded shares as “royalty income funds”, which receive a portion of the royalties from the franchisees, while many of the expenses of operating the system are incurred in a separate company. Examples include Keg Royalties Income Fund and Boston Pizza Royalties Income Fund.
• Still other franchisor companies are hybrids, with a significant chunk of their revenue (though not necessarily their profit) coming from corporate-owned stores or from the sale of inventory to franchisees.

In a similar vein, while some franchisors hold a lot of real estate (e.g. McDonalds, Canadian Tire (until recently)), others do not.

What this means is that it is very important to understand the business of the franchisor you are valuing. It may hold several different sources of value: a stream of royalties, one or more actual operating businesses, and real estate. In order to gain a true grasp of the value of the business, you need to disaggregate and understand the different sources of value.

Valuation Approaches

There are three main approaches to valuing a business or asset: the income approach, market approach and asset approach. Of these, only the first two have any real relevance to valuing franchisors.[2] Stated very briefly:

• Under the income approach, the business valuator quantifies the present value of future cash flows associated with share ownership. The calculated future cash flows are discounted at a rate of return appropriate for the risks associated with those cash flows.
• Under the market approach, the business valuator determines the fair market value of the company based on comparable public companies and/or transactions involving comparable companies. 

Income Approach

The three main drivers of value under the income approach are a) the current level of cash flows, b) projected growth and associated reinvestment, and c) risk. Let’s take a look at each one.

Cash Flows

For “pure play” franchisors, this issue can be relatively simple. Operating margins for franchisors are generally high; there is also typically fairly little in the way of capital expenditures. Furthermore, franchisors as a whole tend to carry fairly little debt relative to their equity values (unless they have made acquisitions). They also tend to carry fairly low working capital balances. All of this means that in general, after-tax net income can serve as a reasonable proxy for cash flows.

For franchisors who also earn revenue from other sources (e.g. sale of inventory, operation of corporate stores), the analysis can become more complicated, and it will be necessary to consider things like capital expenditures to upgrade stores, changes in minimum wage legislation and commodity prices, and all of the other complicating factors that go into valuations of businesses in other industries.

Growth

For franchisors, growth can come from two main sources: a) growth in the number of franchisees and b) growth in income per franchisee. In addition, growth can also come from acquisitions.

Growth in the number of franchisees can lead to multiple sources of revenue growth. In additional to new royalty streams, franchisors also typically charge an initial franchise fee that is payable upfront; this can often be substantial and can be a significant source of revenue. Some franchisors also serve as suppliers to their franchisees and earn income from markups on the supplies they sell. Franchisors can also assist their new franchisees manage the build-out of their locations, charging a management fee.

In many businesses, growth is accompanied by significant cash outflows as companies are required to carry additional inventory, carry more accounts receivable and build larger facilities. Franchisors do not have to deal with these issues to nearly the same degree.
That said, franchisors face other issues when it comes to growth. There is a cost associated with finding new franchisees in new territories, and for that reason many franchisors outsource that function to master franchisees. The master franchisee will assist the franchisor in developing franchisees in a given territory, but only in exchange for a significant cut of the new franchisees’ franchise fees and royalties.

Moreover, growth within a territory can result in friction with existing franchisees. The addition of a new location within proximity to a franchisee can lead to great overall system sales (and thus more royalties and other payments to the franchisor); but this comes at a cost to the existing franchisee, who in some sense becomes a competitor to the newcomer and will likely see a reduction in income. If the reduction is too great, the existing franchisee may go out of business.

Risk

Established franchisors are relatively immune from macro-level trends. To understand why this is the case, consider the difference between a franchisor and a franchisee of a restaurant chain. Assume that each of a chain’s 100 franchisees earns an average of $500,000 in revenue per year, that the costs of sales equals 30% of sales, the royalty is 5%, and fixed costs (labour, rent, utilities) equals 55% of sales, giving it a profit margin of 10%, or $50,000 per year. The franchisor makes $25,000 in royalties (5% of $500,000) per franchisee, and $2.5M overall from the 100 franchisees.

If the market shifts and the franchisees sales decline by 15%, the franchisor’s profit from the restaurant will also drop by around 21%;[3] however, the franchisees’ profits will drop by almost 98%.

The fact that a franchisor’s profits are less subject to large swings based on small changes in revenue is an advantage and lowers the riskiness of an investment in a franchisor.
On the other hand, there are also risk factors that are significantly higher for franchisors than for other businesses. Many of these are legal in nature. Franchisors can be susceptible to class actions of various types, although the success rate for these so far in Canada has been poor.[4] Franchisors are also subject to a rigorous disclosure regime in many Canadian provinces; the failure to provide a proper Franchise Disclosure Document (“FDD”) can be severe, with franchisees potentially eligible to rescind their agreements and recover all of their costs and losses within the first two years of signing the franchise agreement. In my experience dealing with quantifying such claims, the average bill to a franchisor is somewhere in the $300,000 to $500,000 range, plus legal costs.

Market Approach

As we discussed above, franchise systems derive their value from many different sources. That can make the market approach difficult to apply; it is difficult to speak of a standard valuation multiple based on revenue in the franchising industry.  Thus:

• While royalty income funds (e.g. Boston Pizza Royalties Income Fund, Keg Royalties Income Fund) have tended to trade at multiples of over 10 times revenue, other hybrid franchisor public companies (e.g. Imvescor Restaurant Group Inc.) have traded at around five times revenue.  Multiples of revenue are therefore generally not a good approach to use.
• As described above, franchisors who derive most of their revenue from franchising (as opposed to corporate stores) generally are less subject to volatile changes in their profits. Royalty income funds are even less volatile, since their costs are minimal.
• Differences in growth rates can also affect multipliers; firms that are expected to grow rapidly will attract higher multipliers.

In summary, the market approach is a difficult approach to apply for franchisors.

Conclusion

Conceptually, valuing a franchise system is in many ways no different than valuing any other business: it requires an understanding of the industry and the business, and the assessment of cash flows and risk. Executing on these concepts can pose a challenge.

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[1] 2018 CFA Accomplishment Report

[2] The asset approach is generally one that is more applicable to companies whose main value derives from their individual asset holdings (e.g. real estate holding companies).

[3] I have assumed a level of fixed costs for the franchisor similar to Dine Equity, a “pure play” franchisor.

[4] Several notable examples include:

-          Fairview Donut Inc. v. The TDL Group Corp., 2012 ONSC 1252 (brought by Tim Horton’s franchisees over the introduction of a breakfast menu). Certification denied.

-          1250264 Ontario Inc. v. Pet Valu Canada Inc., 2016 ONCA 24 (brought by Pet Valu franchisees over the alleged failure of the franchisor to share volume rebates with franchisees). Certification denied.

-          2038724 Ontario Ltd. v. Quizno’s Canada Restaurant Corporation, 2014 ONSC 5812 (brought by Quizno’s franchisees over allegations of price fixing). Certification granted, but later settled for a small amount.