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.

How much is my business worth?

As a Chartered Business Valuator (CBV), almost every business owner I meet wants to know the answer to this question: “How much is my business worth?”

There can be many reasons for asking this question: they may be planning to sell the business; they may be in litigation with another shareholder; they may be considering tax planning strategies; they may be getting expropriated by a government authority as part of a construction project; or they may be getting divorced.

Inevitably, my response to the question of “how much is my business worth” is to turn around and ask the business owner some questions of my own. These include:

1.       How much does the business earn?

o   This is a deceptively simple question. Unfortunately, it is not enough to look at last year’s financial statement; what I am interested in is the true economic profit of the business. This means adjusting the reported revenues and expenses to reflect how the results would look if the business were run by someone else. Thus:

§  Did the owner(s) receive a fair market salary for their services? If your business reported $50,000 in profits last year, but you, your husband and your children all worked there full-time without drawing a salary, how profitable was it really?

§  Were there any personal or discretionary expenses reported as business expenses? Common examples are meals and entertainment and automobile expenses. Such costs are often not necessary for the operation of the business and should be added back in estimating economic profit.

§  Is all revenue reported? Some businesses may appear relatively unprofitable, but may still have significant value once historically unreported sales are considered.

§  Are there other non-arm’s length transactions? For example, if the business operated out of a building you own and paid below-market rent, the rent expense will need to be adjusted to market rates.

2.       Are there plans to grow? And what will those involve?

o   Two businesses that earned identical profits last year may attract wildly different valuations depending on their potential growth prospects, so it is important to understand whether significant growth is expected. But growth comes at a cost: there are often significant upfront capital and operating costs that must be incurred in order to achieve growth, and these must be considered.

3.       Does the business have any assets it can sell off without any impact to its results?

o   Revenues and expenses are only one part of a business valuation. We always look at the balance sheet to see whether there are assets that can be spun off without impacting operations; if so, then the value of these assets is added to the overall valuation.

So how much is your business worth? Give some thought to these questions – and then call me (416-366-4968 ext 138).

Ontario's New Minimum Wage - Impact on Profits of the Restaurant Industry

Introduction

On January 1, 2018, the minimum wage in Ontario government changed from $11.60 to $14.00. It is scheduled to rise to $15.00 in 2019.

The move has provoked negative reactions from business groups. For example, according to Restaurants Canada:

“These aggressive changes to labour legislation will have severe and immediate consequences for the foodservice industry and the customers they serve every day. Prices for consumers will go up. Jobs will be lost, it’s as simple as that." A recent story in the Globe and Mail contains different reactions from restaurant owners; some are unfazed, others somewhat less so.

This issue is also of interest to business valuators such as myself. Valuations of established businesses are often based on the future anticipated profits or cash flows of a business. These are typically projected based on an analysis of the business's historical results, adjusted for forecasted changes. Valuators need to understand how the change to the minimum wage will impact profitability going forward.

The Data

Somewhat surprisingly, when we look at average labour costs for limited service restaurants (as a percentage of revenue) for the period 2001 to 2012, we see surprisingly little change:

The chart (which is based on data from Statistics Canada, CANSIM Table 355-0005) includes several periods where the minimum wage stayed constant in nominal dollars.

For example, in BC the rate was stagnant at $8.00 per hour from November 2001 until May 2011.  During that period, the CPI for restaurant food grew by 35%. Assuming that the average restaurant has 75% of its employees making the minimum wage, one would have expected the average cost of labour at BC restaurants to fall to 23% of revenue. Yet that did not happen.

The chart also includes periods in which the minimum wage grew very quickly. Again looking at BC, the minimum wage in 2010 was $8.00; in 2012, the average was approximately $10, an increase of 25% (slightly higher than the proposed Ontario change). A restaurant with 75% of its employees making the minimum wage would expect to see its cost of labour rise from 29% to 33%. Yet that did not happen.

Some (Tentative) Theories

What should one make of the data?

One theory might be that restaurants are able to pass along wage increases to consumers in the form of higher prices; the Globe and Mail article gives some examples of restaurants that are planning to do precisely this. Unlike, say, a manufacturing plant, restaurants cannot really be moved to other jurisdictions with more favorable labour laws. A change affecting all restaurants will therefore result in higher prices for consumers.

Another possibility is that the aggregate data shown above masks significant changes.

Imagine for a moment that there are two types of restaurants: prosperous ones who have an average wage cost of 25%, and less efficient ones whose average cost is 35%. The former have profit margins of 15%, the latter have profit margins of 5%. A rapid hike in wage costs equal to 5% of revenue will mean that the less prosperous firms will no longer be viable; they will be forced to close.  The more prosperous firms, meanwhile, will see an increase in their labour cost, such that the industry average will remain 30%.

A third possibility is that the increase in third-party wage costs results in owners (many of whom pay themselves via a salary) being forced to reduce their own wages.

Gift Cards and the Illiquidity Discount - A Valuation Perspective

With the busiest season of the year for retail sales upon us, you are no doubt wondering what to buy for that special someone. If you’re reading this blog – and I have every reason to believe you are – then what you really want to know is what a Chartered Business Valuator has to say about gift giving. In this post I look at gift giving – and in particular, the silly practice of giving gift cards - from a business valuation perspective.

The Discount for Illiquidity and Jerry Seinfeld

Let us forget about gifts for a moment and think about equity valuation.

Suppose you had the ability to acquire one of two securities. Both securities are in companies that are exactly the same in every way (Company A and Company B) – they are in the same line of business, have the same assets and liabilities, and earn the same amount of income each year. Each company will pay the holder of the security $1,000 per year into perpetuity. The only difference between the two investments is that the holder of the shares of Company B is restricted from selling them for 2 years, while the holder of the shares of Company A has no such restrictions.

Clearly, you would rather own the shares of Company A than Company B, since those of Company A are identical to those of Company B, only they carry no restrictions. Precisely how much more you would pay for the more “liquid” shares of Company A has been a matter of debate within the valuation profession for a number of years, and I have written a lengthy article on the subject (here). In brief, the main sources of data on this discount are so-called “restricted stock” studies.  These studies look at the price at which “restricted stock” is issued in private placements to accredited investors, relative to the current market price of that stock on the public exchanges. For example, if shares of a public company trade at $100 per share, and restricted stock are sold at $80 per share, then the illiquidity discount is $20, or 20%.

How useful are restricted stock studies? One analysis questions their validity. It shows[1] that the firms that issue restricted stock in private placements tend to be predominantly small firms listed “over-the-counter”. It concludes that much of the “discount” observed on these private placements is due to:

·     The relatively poor financial position of the issuing company, and hence its poor bargaining position when it comes to issuing new equity; and,

·     The fact that the observed market price for unrestricted shares of these companies (against which the restricted stock discount is calculated) is itself unrepresentative of the fair market value of those shares.

The Discount on Gift Cards

What does all this have to do with gift cards? It is many years since the great contemporary thinker and social critic, Dilbert, noted that gift certificates are “like money, only worse” (https://www.youtube.com/watch?v=OCvR9_W9osw). Like money, they can be used to purchase goods and services; but unlike money, they can only be used to make purchases from the issuing business. Gift cards are illiquid; they are in many ways like restricted stock. If you recognize the value of liquidity, you will agree with Jerry Seinfeld that cash makes the perfect gift: (https://www.youtube.com/watch?v=aQlhrrqTQmU). Elaine’s reaction betrays a basic unawareness of valuation theory.

So what is the discount for illiquidity on gift cards? How much would you be willing to sell a $100 gift certificate for? It will probably depend on a number of factors:

·         If the card is for a store at which you regularly shop, you may not be willing to sell it for much less than $100.

·         If the card is for a store at which you are likely to shop, but only irregularly, then you may be willing to accept a larger discount, in particular if you are short on cash.

o   For example, I buy my groceries at No Frills and my shoes at the Shoe Company. But I buy groceries every week, and shoes (very) infrequently.  I would not sell a No Frills gift card for less than face value, since I can redeem the full face value in a very short period of time. But I would be glad to get rid of a Shoe Company gift card, which I may not use for a few years, for more of a discount. And if I needed to make a big purchase and was short of funds, I would be willing to take an ever steeper discount.

·         If the card is for a large chain, it will require a smaller discount than a card for a small, speciality store.

o   Cards for large chains are easy to use. Even if the seller does not regularly shop at the chain, many others do, and the card should be easier to unload.

In order to see this phenomenon in effect, you can look at some of the websites that buy and sell gift cards. At www.giftrescue.com, gift cards for gasoline sell at a discount of 3%, while cards for more specialized consumer goods such as clothing can be had for discounts of 35% to 40%. On http://www.cardswap.ca/buy/list, it is grocery gift cards that trade closest to their face value. 

How is this relevant for equity valuations? It suggests that the value of liquidity is investor-specific. The discount given by firms issuing illiquid stock will depend on how badly they need immediate cash. And the illiquidity discount that a purchaser or owner of that stock might apply in valuing it will depend on how much they require liquidity.

Conclusion

So how valuable is liquidity? The short answer is that, with investments as with gift cards: it depends.

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[1] Robert Comment, “Revisiting the Illiquidity Discount for Private Companies: A New (and “Skeptical”) Restricted Stock Study”, Journal of Applied Corporate Finance, 24:1 (Winter 2012);

Inflation and Family Law

I was looking through my oldest daughter’s baby book last night and found that we had noted the price of gas at $0.70 per litre; I had noted at the time that this was “really high”! This got me thinking about inflation.

My daughter is 10 years old now, and gasoline has been hovering at between $1.00 and $1.10 in recent weeks here in Toronto. Some of the increase is due to volatile commodity prices, but a large portion of it is due to inflation.

We tend not to think about inflation these days; it is an unspoken part of our everyday lives. A friend of mine recently commented to me that inflation is a modern phenomenon and that in pre-modern societies people simply didn’t have to put up with it. I pointed out to him that a) he’s wrong, there have been four Great Waves since the 13^th century, (to borrow from the title of David Hackett Fischer’s excellent book on the topic), and that b) in modern times there have been periods of significant deflation (most recently during the Great Depression). Here is a graph showing the annual rate of change in the Consumer Price Index in Canada since 1919:

Anyway, as I said, we tend not to think much about inflation. Often, this is a good thing; many people feel good when they receive a 2% raise, and do not like to be reminded that they are just treading water. Deflation, meanwhile, can be crippling for debtors; over 100 years ago, the Democratic presidential candidate, William Jennings Bryan*, famously said that American farmers were being crucified on a “cross of gold” due to a refusal of the government to depreciate its currency.

*It still blows my mind that the Democrats gave Bryan three consecutive kicks at the can as their presidential candidate. Not until Mike Milbury took over the New York Islanders would an organization show such patience with an unsuccessful leader.

Inflation is something that we are comfortable with, so long as it is predictable. It is over 20 years since the Bank of Canada committed itself to fighting inflation, and we tend to assume that things will simply chug along. Yet inflation can cause tremendous distortions in the economy. It can lead to large losses on seemingly safe investments, such as government bonds, as anyone who purchased such bonds in the 1970s will know (or may not know). Payments on bonds are in nominal dollars; when the anticipated real (i.e. inflation-adjusted) value of a dollar declines, bond prices drop as well. If the annual yield on the bond you buy is less than the average rate of inflation over the term of the bond, you will lose money. Here is a look at the average real rate of return for holders of long term Government of Canada Bonds:

You can see that depending on where in the inflationary wave you purchased your bond, you could either make a lot of money, or none at all. (In general, bond yields tended to price in the recent history of inflation; they were lousy at predicting inflation. So, for example, if you bought a bond in 1982 – on the heels of the “stagflation” experienced in the late 1970s – the anticipated inflation built into your bond yield allowed you to make a killing).

Inflation and the Law

So much for the brief economics lesson. How is this relevant to lawyers?

Some areas of law consider inflation. One example is the Income Tax Act. One of the reasons that only 50% of capital gains are included in taxable income (for now) is because for assets that are held over a long period of time, there will have been an inflationary increase in the nominal asset value, which does not really represent incremental income to the asset owner. Tax brackets are also changed every year for this reason. Prejudgment interest is designed to compensate plaintiffs for inflation between the time of injury and trial.

One area of law that does not take inflation into account is family law (at least in Ontario). Consider the following case:

• A couple enters a marriage in the year 2000 with no assets or liabilities, other than a piece of land owned by the wife worth $100,000 (in 2000 dollars).
• Assume that the couple accumulates no additional assets or debts during the course of their marriage – they spend everything they earn, no more and no less. The land just sits there, but it has risen in value due to inflation. Assume that this occurs in a region of the province where inflation in land prices is equal to CPI (i.e. not Toronto). In 2010, assume the land is worth $120,000 (in 2010 dollars).
• In such a case, would there be any equalization payment to reflect the gain in the wife’s net family property? Or would the law recognize that, in real terms, the wife’s property has not appreciated at all?

I presented this scenario to a leading family law practitioner and asked whether it made any sense that an equalization payment would need to be made. He replied that under Ontario’s Family Law Act, any increase in the nominal value of family property, even if due to inflation only, is considered to be an increase and to be part of "net family property". Section 4 of the Act defines "net family property as:

the value of all the property, except property described in subsection (2), that a spouse owns on the valuation date, after deducting,

(a) the spouse’s debts and other liabilities, and

(b) the value of property, other than a matrimonial home, that the spouse owned on the date of the marriage, after deducting the spouse’s debts and other liabilities, other than debts or liabilities related directly to the acquisition or significant improvement of a matrimonial home, calculated as of the date of the marriage;

This issue arises in business valuations as well. As a result of inflation, a business will increase its selling prices (hopefully), its costs will increase, the replacement costs of its assets will increase, and a business that undergoes no fundamental change can find itself worth much more in nominal terms than it was at the date of marriage.

I suppose one could suggest a reading of the Act to the effect that the calculation should be based on real (and not nominal) values; but in my experience in dealing with family law matters, this is typically not argued.

Conclusion

One might ask, is this fair? There has been no real increase in the value of the property, why should the husband get anything? This was my first instinct In thinking about the issue. But I think now that perhaps that question - "is it fair?" - is not the right one to be asking.

Life is not fair. In some marriages, both spouses contribute equally (either to the business or to home life). This is not always the case, however. Rather than trying to assign points, the Family Law Act says simply: we will split the net increase down the middle.  It may not be “fair”, but it is impossible to legislate fairness with anything more than very broad strokes.

Statutory financial remedies will never be perfect. They cannot address all possible cases. The advantage of such relatively cut-and-dried remedies is that they provide a relatively simple system of efficiently adjudicating disputes and allocating money between the parties.

Of course, it does not always work out that way J