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).

Cara's Purchase of The Keg - Part II: Main Components of Value

In our last post, we looked at what Cara will be acquiring when it closes its acquisition of Keg Restaurants Ltd. (KRL). In this post, we dig into the Keg’s numbers a little more to try and figure out why Cara is reportedly paying over $200M for KRL’s shares. Bear in mind that these observations are based on a somewhat cursory review of the transaction and the limited data that is publicly available; I certainly would not recommend basing any investment decisions on them.

As we discussed previously, Cara is acquiring three main assets in this deal:

• KRL’s 3.5M units in the partnership that underlies Keg Royalty Income Fund (KRIF), an investment vehicle that receives a royalty equal to 4% of the gross sales from all Keg restaurants. These are assigned a market value of $73.9M on KRIF’s 2017 Q3 financials (the units are recorded as long term liabilities on KRIF’s balance sheet).
• A 2% royalty (i.e. the 6% charged to franchisees, minus the 4% paid to KRIF) on the gross sales of the 56 franchised Keg restaurants.
• The revenue and expenses from the 48 corporate-owned restaurants that do around $300M in annual sales.

Let’s take a closer look at each of the above.

Partnership units

KRIF reports that it has around 11.4M units outstanding, but that on a fully-diluted basis the number of units would be 14.9M (2017 Q3 report, p. 12). This is because KRL’s 3.5M partnership units are exchangeable for KRIF units on a 1:1 basis. Given that the 11.4M fund units have a market cap of around $220M (it was slightly higher at the time the 2017 Q3 balance sheet was prepared), the 3.5M partnership units would therefore now be worth around $68M ($220M/11.4M x 3.5M = $68M).

Looking a little closer, I am not sure if the math is as simple as that. It appears that the partnership units get a slightly better distribution from KRIF than the regular unit holders; they have received around 27% to 28% of KRL’s total operating income over the past year, as opposed to 23% (which they would receive based on 3.5M/14.9M = 23% of the fully diluted units), as shown below:

There also appears to be some reference to this in the notes to the latest quarterly report; for example, Note 7 to the financial statements says:

The Class D units were issued to KRL in return for adding net sales from new Keg restaurants to the Royalty Pool and are entitled to a preferential proportionate distribution and a residual distribution based on the incremental royalty paid to the Partnership.

This would imply a somewhat higher valuation for these partnership shares ($220M/73% x 27%) = $81M.

Now, this assumes that the cash flows for both the KRIF units and the partnership shares will continue to grow at the same rate. This is likely not reasonable; as we discussed in our previous post, when a new Keg store is added, most of the value of the incremental royalties from that store accrue to KRL in the form of new partnership shares. How do we adjust for that?

The yield on the KRIF units is around 6%; that is, the annual distribution is around $1.20 for every unit worth $20. The yield, or capitalization rate, is a function of:

a) the risk free rate,

b) the equity risk premium,

c) an industry risk factor (this will likely be negative, since the cash flows of KRIF are very stable, as we’ll discuss below)

d) a projected growth factor.

Without getting into the details of all this, if one assumes that the income allocated to KRL’s partnership shares will increase, say, 1% per year faster than the income to the regular KRIF fund units, then the required yield on the KRL shares would be 5%, and the value of the shares would be 20% higher than the KRIF units. If we make that adjustment, our $81M suddenly becomes $97M ($81M x 6%/5%).

The 2% royalty

The 2% royalty alone would appear to be worth around $6M per year in revenue (based on annualized franchised sales of around $320M. How much of this flows to the bottom line? Looking at Cara's segmented reporting for 2017, it seems like around 85% of royalties flow to the bottom line as pre-tax operating income:

So the $6M in revenue yields around $5.2M in pre-tax profit, or $3.9M after tax (using a tax rate of around 25%). Assuming a capitalization rate of 5% (based on the same growth assumptions as above) would give a value of around $77M for the royalty stream to goes directly to KRL.

The Corporate Stores

This is a bit more tricky to figure out.

We know the existing 48 corporate-owned restaurants do around $300M in annual sales (2017 Q3 report, p. 13).

Based on Cara's management presentation, normalized EBITDA for KRL prior to payment of royalties to, and receipt of interest income from, KRIF, was $41.9M; after considering those amounts, the EBITDA is $23.5M. I find these figures somewhat puzzling; the corporate stores only pay around 4% x $300M = $12M in annual royalties to KRIF, and the partnership shares receive around $10M in annual distributions, so I don’t see how you get an adjustment to EBITDA of $18.4M.

In any event, the value of the interest paid to the partnership shares is the basis for the value of those shares, so to value the corporate stores on a standalone basis, we need to take their pre-royalty EBITDA (which I’ll assume for purposes of this exercise is $41.9M) and deduct $12M in royalties paid to KRIF. We also need to strip out the $5.2M in royalty operating income, which we’ve treated separately. This suggests that on $300M in annual sales, the corporate stores are generating EBITDA of around $25M, or around 8%.


Interestingly, this is very similar to the EBITDA margin that Cara’s corporate-owned restaurants earned in Q3 of both 2016 and 2017. At first glance, this is somewhat surprising, given that the narrative around this deal is that the management team from the Keg will be coming in to improve operations at some of Cara’s higher end brands. However, don't forget that our 8% margin is after deducting a 4% royalty paid to KRIF; Cara's corporate stores (I assume) do not pay such a royalty, so actually KRL's operations do seem to be more efficient than Cara's.


So that’s EBITDA; how much free cash flow does KRL make on these restaurants? Unfortunately, we don’t have enough information to say. Cara’s financial filings indicate that capex for corporate stores for the past couple years have averaged around 10% of sales. I haven’t researched whether this is a long-term average or just a temporary surge; if the former is the case, then it would suggest that corporate restaurants are not generating much, if anything, in the way of free cash flows or standalone value.

Debt

So far, we've looked at the cash flows to KRL before consideration of debt. To get the share value, you need to deduct the value of the interest bearing debt.

Cara's management presentation shows that KRL has net debt of $25M ($35M in debt less $10M in cash).

KRIF's balance sheet shows that KRL owes it $57M on a note payable, which pays an interest rate of 7.5%. KRIF thus gets around $4M in interest payments from KRL per year.

Conclusion

After all that, things are still pretty murky. However, we can offer a few tentative conclusions:

• The main source of value in KRL lies in the royalties that are generated from The Keg restaurants. This value is split between a) KRL’s partnership units in the underlying partnership of KRIF and b) the additional 2% royalty stream that franchisees pay to KRL.
• The corporate owned stores, while they generate $300M in annual revenue, do not have as much value, at least on a standalone basis.

This does not mean that KRL should simply close up these locations, of course; the larger footprint created by having over 100 restaurants creates value to the brand, and absent those stores the other sources of value would shrink dramatically.

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