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.