There are many reasons you may need a valuation performed for a franchise you own. These can include mergers and acquisitions, estate planning, divorce, taxation and litigation. Often, valuing a franchise is just like valuing any other type of business. However, there are additional unique factors to consider as they relate to the franchise business model.
In this article, we will focus on the valuation of a single franchise location. In many situations, the addition of multiple-unit franchise locations can cause additional factors to come into play.
Pay Attention to the Franchise Agreement
To understand how to value a franchise, it is important to first understand how a franchise works. Under a typical franchise arrangement, the franchisor specifies a particular region, which the franchisee is granted the right to sell their product or service. This geographic location is determined by the franchisor based upon numerous factors related to that region. Some of the benefits that the franchisees enjoy include the franchisor’s brand name, access to proven systems and processes, business plans, corporate’s marketing program, operations manuals, training and support. In exchange for these services, the franchisee agrees to pay the franchisor agreed upon royalties, allowances related to advertising and other fees.
You might think that a franchise is more valuable than a similar independent business with comparable earnings or cash flow. This might be due to the franchisee’s instant access to the franchisor’s proven business model and well-known brand identity. Your average investor might conclude that this reduces the franchisee’s risk, thereby increasing value. But what many do not realize is that there is another side to that coin, which comes in the form of the restrictions and requirements on the franchisee. An example of this might include a required level of working capital on hand or maintaining real estate image requirements which require significant investment in capital expenditures.
To understand how the specifics of the franchise agreement might impact cash flow, it is necessary to review the Franchise Disclosure Document (FDD), which the franchisor should provide. The requirement put in place by the Federal Trade Commission states that a franchisor must provide an FDD to a franchisee at least two weeks before the franchise agreement is signed. The FDD is intended to provide detailed information regarding the franchisor’s business. This includes items such as its executives’ business experience, agreements with franchisees, financial performance, litigation and bankruptcy history, and intellectual property.
Factors That Add Value
One of the keys to adding value is to reduce risk, and there are several aspects of the relationship between a franchisor-franchisee that help reduce the franchisee’s risk. As mentioned previously, one of the most noteworthy benefits is the franchisor’s brand name and reputation. Other factors include tools, systems, processes and support that have been tested over time and proven to be effective. These items give a valuable benefit to the franchisee over comparable independent businesses. Another important benefit of many franchise businesses relates to advertising. The franchisor usually oversees most, if not all, of the marketing for their franchises. This frees up their franchisees to focus more of their time on the operations of their business.
In addition, franchisees often enjoy cost savings through access to the franchisor’s volume purchasing arrangements. This allows the franchisee to obtain inventory at a lower cost than many of the competitors. When coupled with taking advantage of the franchisor’s established business systems, which can help franchisees enhance quality and efficiency, the franchisee can realize higher profitability than their independent business owner counterparts. These established business systems may include access to cloud-based, integrated point-of-sale and accounting systems that provide franchisees with powerful financial tools and real-time business performance information that your typical business owner would need to invest in separately.
Factors That Diminish Value
Even though in most cases franchises offer product consistency upon which customers can rely, restrictions imposed by the franchise agreement may diminish a franchise’s value relative to comparable standalone businesses. For example, franchise agreements typically restrict franchisees to a defined geographic territory. Though the benefit of this is that territories rarely overlap in an effort not to cannibalize their own brand, issues could arise related to the growth of any one location. Another potential pitfall relates to the limited products and services they can offer and the lack of control of the prices they charge. All these constraints can inhibit a franchisee’s ability to expand and grow.
Though the marketing of products is typically overseen by the franchisor, in many cases this can be a double-edged sword. The franchisor’s marketing program is a significant benefit, but many franchise agreements prohibit franchisees from doing their own marketing. This deprives franchisees of the opportunity to tailor their marketing efforts to the specific locale and changing conditions of their local markets or otherwise to differentiate themselves from the competition.
Restrictions on the franchisee’s ability to sell or otherwise transfer the franchise may also diminish its value. Many franchise agreements require franchisor approval of a proposed transfer, and some impose additional conditions, such as the refurbishment of the franchise facilities or payment of a transfer fee. Other agreements give the franchisor a right of first refusal. Although the franchisee has the right to transfer the franchise if the franchisor declines to exercise its right of first refusal (usually within 30 or 60 days), the existence of the right may deter potential buyers from making an offer.
The Value is in the Details
These and other factors make valuing franchises more complex than valuing comparable standalone businesses. As one would expect, investors prefer more franchise-friendly agreements to those that are highly restrictive. To arrive at an accurate value, appraisers analyze the franchise agreement and evaluate the terms that have a positive or negative impact on value — and, if possible, compare it to other franchisors’ agreements.
At Windham Brannon, that’s why we understand that the value is all about the details. For more information about a valuation of your franchise, reach out to your Windham Brannon advisor, or contact Matt Stelzman.
