Franchise valuation asa feb 2015 v2-20-15

The Impact of Franchise Agreements on Small Business

Valuation

Theresa Zeidler-

Shonat

Director of

Valuation

Service

Content Overview

Today’s Mission

Franchise Rights and Organization

What is a Franchise?

• Simply put: : the right to sell a

company's goods or services in a

particular area; also : a business that is

given such a right

13

Forms of Franchising

• Single Unit Model

• Master Franchising Model

• Regional Developer

14

Single Unit Model

Franchisor

Franchisee Franchisee Franchisee Franchisee

15

Master Franchising Model

Franchisor

Master Franchisee

Franchisee Franchisee

Master Franchisee

Franchisee Franchisee

16

Regional Developer

• Has the rights to market and award

franchises within a defined region

• Acts like franchisor within that region

17

Franchises and the Economy

Sources of Franchise

Information• U.S. Census Bureau

• IHS Global Insight & IFA Franchise

Business Economic Outlook for 2014

• IFA (International Franchise

Association)

Franchises in the U.S.

• IHS and the IFA estimate that in 2013 there

were:

• 757,453 franchised businesses in the United States

• employing 8.3 million people

• with an output of $801 billion.

18


• IHS IFA estimates for all of 2014:

– Quick-Service Restaurants, sometimes

called fast food restaurants, had the

highest number of establishments with

(155,571)

– followed by Personal Services (111,370)

– Retail Products & Services (98,475)


• IHS IFA estimates for all of 2014:

– Quick Service Restaurants also led in

number of employees across the

different franchise business types

with 3.23 million employees.

– Table/Full Service Restaurants

employed the second most

employees with 1.08 million

– Business Services employed the third

most with 0.96 million employees.


• IHS IFA estimates for all of 2014

that in terms of output:

– Quick Services led the franchise

business segments with $220 billion,

– Business Services will have the

second highest output with $155

billion,

– Personal Services will have the third

highest output with $91 billion.

Franchise Output Per Worker

• For 2013 according to IHS and IFA:

– Automotive franchise employees had

the most output per employee with

$212,301,

– Real Estate had the second highest

output at $161,022 per worker,

– Business Services had the third highest

output with $159,439 per worker.

Three Essential Characteristics of

a Franchise System

26

Trademar

k

Significan

t

Control

Required

Payment

Trademark

• A franchisor creates a brand identity

for a product or service

• The brand identity normally includes

products or services that bear a

trademarked symbol or name

27

Significant Control

• The franchisor exercises significant

control over the franchisees’

operations

• This typically includes following certain

standards for representing the brand

and for service and product delivery

28

Required Payment

• In return for the use of the

trademarked product or service and

other benefits of being part of the

franchise system, the franchisee pays a

fee, royalty, or other amount to the

franchisor

29

The Documents that Govern the

Franchise Relationship

30

Franchise Disclosure

Document• The Franchise Disclosure

• The Franchise Agreement

31


Document• The Exhibits

– Guarantees

– General Release

– Confidentiality Agreement

32


Document• The Exhibits (cont.)

– Consent to Transfer

– Financial Statements

– State Addenda to the Disclosure

Statement Document

– Operations Manual Table of Contents

33

Franchise Agreement

• A Franchise Agreement is a legal, binding contract

between a franchisor and franchisee

• Prior to a franchisee signing a contract, the U.S. Federal

Trade Commission regulates information disclosures under

the authority of The Franchise Rule

• .

34

Franchise Agreement

• The Franchise Rule requires a

franchisee be supplied a Uniform

Franchise Offering Circular (UFOC) or

Franchise Disclosure Document (FDD)

prior to signing a franchise agreement

a minimum of fourteen days before

signing a franchise agreement

35

Franchise Agreement

• Once the Federal fourteen-day

waiting period has passed, the

Franchise Agreement becomes a

State level jurisdiction document. Each

state has unique laws regarding

franchise agreements.

36

Key Components of Franchise

Agreements

• Training and/or support provided by

the franchisor

• Assigned Territory and Rights

– Can be exclusive or non-exclusive


Agreements

• Duration of the franchise agreement

• Franchise fee and total anticipated

investment.

• Trademark, Patent, and Signage

Usage

• Royalties and other fees the franchisee

is expected to pay

39


Agreements

• Franchisor constrains advertising or

manages advertising

• Amount franchisees are expected to

pay toward franchisor advertising costs

43


Agreements

• Operating Protocol

• Renewal rights and franchise

termination/

cancellation policies

• Resale rights

– Buyback or first refusal clauses

44

Examples of Business Format

Franchises• Automotive

• Commercial and Residential Services

• Quick Service Restaurants

• Table/Full Service Restaurants

• Retail Food

• Lodging

• Real Estate

• Retail Products and Services

• Business Services

• Personal Services

47

Examples of Product Distribution

(Trademark) Franchises

• Automotive and Truck Dealers

• Gasoline Service Stations without

Convenience Stores

• Beverage Bottling

Sources of Franchise Business Value

Sources of Business Value

• The value that arises from the future

stream of expected profits on the

current brand in the current market

area

50


• The growth option for that brand, or

variants of that brand, that may be

offered in the future and for which the

franchisee would be expected to be

appointed a distributor in that market

area

51


• The value that arises from the future

stream of expected profits on the

current brand in the current market

area

– Substantially under the control of current

business managers

52


• The growth option for that brand, or

variants of that brand, that may be

offered in the future and for which the

franchisee would be expected to be

appointed a distributor in that market

area

– Only partially under the control of

current business managers

53


• A reduction in value for the risk that

the brand itself may decline or the

manufacturer may cease to do

business

54


• A reduction in value for the risk that

the brand itself may decline or the

manufacturer may cease to do

business

– Almost completely outside the control of

the managers of the franchisee

55

Valuation Considerations

• Determinants of value

• Demand for the product provided by the business?

• Industry growth

• Competition

• Business lifecycle

• Seasonality• Location

• Amount of capital required to run the business

• Management team

• Franchise Specific– Royalties

– Limits on Expansion

– Restricted ability to make business decisions (menu offerings, services, etc.)

– What is buried in the franchise agreement

Franchise-Specific

Marketability Considerations

Marketability

• Well established franchises/brands

– There are known players – franchisees that

have a relatively large number of

locations that are likely interested in

buying franchises that become available

– It’s almost like an exchange for

established businesses

• Less well established brands don’t

have this

56

Franchises Can Impede

Marketability

• Franchisors typically have the Right of

First Refusal on any sale of the business

– Franchisor is always a potential bidder

– Franchisor knows more about an

available franchise than any other

potential bidder

– Any outside bidder would have to expend

a great deal of money and effort to even

approach the franchisor’s knowledge of

the available franchise57

Franchises Can Impede

Marketability– Without that knowledge, the outside

bidder may bid too low and lose out to the franchisor or bid too high and make a bad deal

– Because the franchisor may have special interest in expanding its position, it might have the tendency to drive up the price beyond what a potential buyer might be willing to pay based on the present value of the cash flows

• These factors can act as a significant deterrent to would-be bidders

58

Market Considerations: Buying a

Franchise

• Acquiring an Existing Franchise

Location

– Same process as buying any other

business with addition of

• Approval of franchisor

• Starting a new franchise location

– Same as any other start-up decision with

the addition of

• Evaluation of franchise-specific costs,

risks rewards61

Franchised Business Risks

Sources of Risk to Franchise

Businesses

• Variety of different sources of risk to a

franchise business

– Normal business and industry risk

– Risk associated with terms and conditions

of franchise agreement

– Risk associated with risk of franchisor

– Risk associated with being unable to

manage brand

63

Franchise Disputes

• Franchise disputes can represent a

significant risk to franchisee

– One potential outcome is the loss of

ability to continue doing business

64

Franchise Disputes

• What drives disputes?

– Business issues (cash flow issues, lack of

profitability)

– Differing expectations

– Changes in the relationship

– Market- or competition-driven changes

– Inconsistencies in treatment, including

means of dispute resolution

– Lack of clarity in franchisor

communications 65

Impact on Business Value

• When circumstances exist that could

trigger a franchise dispute, there is a

negative impact on business value

– Either take a probabilistic approach to

cash flows or account for extra risk in

discount rate

66

Rules Change Quickly

• Rules can change very quickly –

franchisees have no control over

changes

– Restaurant makes $300k in improvements

to dining area

– Franchisor changes restaurant

design/layout and franchisee is required

to make changes despite recent

improvements

67

Impact on Valuation

• Request or research information on

how often the franchisor changes

requirements or if franchisee is aware

of planned changes

– If the franchisor has the tendency to

make changes, include adjustments for

this risk in the cash flows or discount rate

68

Franchises Are Contract

Rights• Franchises are contract rights, not

outright ownership

– The full bundle of rights attributable to

owning an asset is absent in the franchise

agreement

– Whatever benefits exist are found in the

franchise agreement

69

Franchise Agreements Need to

Be Evaluated Like All Other

Contracts• Advantageous to franchisee?

– What is gained?

• Disadvantageous to franchisee?

– Costs or requirements outside of the

franchisees best interests?

70

Franchise Agreements Need to

Be Evaluated Like All Other

Contracts• Does the franchisor have history of

premature termination of franchise

agreements?

• Does the franchisor have any history

regarding breach of contract claims

and litigation?

72

Opportunity Cost for

Franchisee• Even large, established franchisees are

not expecting to get rich – it’s a job

• Franchisors worry more about their

stock price and the top-line than

franchisee profitability and actively

manage franchises this way

73

The Threat of Non-Renewal

• Franchisors keep franchisees “in line” with renewals. Franchises are renewed every 10 to 15 years. Franchisors use the threat of non-renewal to keep franchisees in line with their business plans.

Significant Training Time

• Franchisee training time

– New franchisees must undergo significant

amounts of training prior to running the

business

– This is time for which they are not

compensated

75

Training Time Impact on

Valuation• Increases the initial investment

required

– Franchisee must have sufficient ability to

support themselves while not being

compensated

• Also increases required total return for

franchisee

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What Does this all mean to your Valuation?

Using Rules of Thumb?

• Rules of Thumb can be

problematic, but they

address key valuation

considerations that

need to be addressed

78

Inherent or Implied in Rules of

Thumb

• A cost of capital

• Ratio based on operating costs or net

profit

• Expectation of future growth

• An assessment of brand strength or risk

• An assumption about the scale of the

enterprise

• Other things necessary to complete

the valuation 79

Why Are Rules Of Thumb

Problematic?

• They miss:

– Changes in brand strength or weakness

– Location factors

– Changes in the franchise relationship or

agreement

80

Using Rules of Thumb

• Rules of thumb are best used by

individuals with very deep knowledge

of the industry, company and area

– They may be best to use as a check or to

corroborate a value conclusion achieved

via other methods rather than relying

on them

81

Three Approaches to Value

65

Market

ApproachAsset

Approach

Income

Approach

Value Conclusion

Market Approach

66

Market Approach

• Market Approach: Comparable Sales

– The best comparable transactions are

sales of franchises with the same

franchisor

82

Market Approach


– Franchisors usually won’t share this data

(remember they usually have a right to

approve all transfers so they have this

data)

83

Market Approach

• Market Approach: Comparable

Sales

– This data, searchable by franchisor, is

generally not available in any of our

typical transaction databases

• There are sales of franchise locations in

the databases but not comparison to

other sales within the same franchise

system/subject to the same franchise

agreement

84

Market Approach


– Can you just uses sales in the subject

company’s industry and market?

• Franchises can have significantly different deal

multiples than non-franchise businesses that

are otherwise similar

• In some industries, the multiples are higher for

franchises, in some industries, the multiples are

lower for franchises

85

Market Approach

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SIC Code Industry

Franchise

Transaction

Count

Non-Franchise

Transaction

Count

Franchise Average

MVIC to Sales

Non-Franchise

Average MVIC to

Sales

Franchise %

Non-Franchise

5812 Eating Places 272 1,783 0.46 0.41 113%

7231 Beauty Shops 3 351 0.28 0.40 70%

7349 Building Cleaning and Maintenance Services 20 209 0.58 0.66 88%

7389 Business Services, Not Elsewhere Classified 26 383 0.48 0.97 49%

7538 General Automotive Repair 21 204 0.33 0.44 76%

7991 Physical Fitness Facilities 18 95 0.68 0.67 101%

8299 Schools and Education Services, NEC 68 50 0.72 0.96 75%

Data: Pratt's Stats 1/1/03 through 11/24/14

Transaction Multiples: Franchised Businesses Compared With Non-Franchised Businesses

Asset Approach

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Cost Approach

• Recall that the cost approach is

predicated on the assumption that no

rational buyer would pay more for a

company or asset than it could be re-

created for

89

Cost Approach

• The Cost Approach needs to consider

not only the cost of the assets on the

balance sheet, but also the franchise-

specific start-up costs

– Recall: training time isn’t compensated for

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Income Approach

75

Income Approach

• More than the impact of the franchise

on the top line needs to be considered

• Costs can be different in a franchised

business

– Advertising expenditure is outside the

control of the business owner

– Will royalty payments change?

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Evaluating Royalty Payments

• Knowing whether or not the company

is paying a reasonable royalty rate

can be important to the valuation

• Compare to royalty rates paid to

similar franchisors

– This can be tricky because it

depends on other factors in the franchise

agreement

88

Summary

• Valuing franchised businesses is similar

to valuing any other small business in

many ways

• However, there are a number of

franchise specific benefits and risks

that need to be considered in coming

to your

conclusion of value

92

Questions?

79

Theresa Zeidler-Shonat

Director of Valuation Services

Smith & Gesteland, LLP

608.828.3154

[email protected]

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Franchise valuation asa feb 2015 v2-20-15

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