What You Need To Know About Franchise Value

People frequently ask me for help in valuing an interest in a franchise business location, or a franchisor. The concern is that a franchise means special issues are present and added considerations arise. In truth, however, franchisors and franchisees are valued using common appraisal theory, approaches, and methods. What is different how one approaches an understanding of the perceived level of risk associated with franchising, and the earnings capacity a buyer or seller might realize.

The Big Picture

The issues of risk and economic benefits will vary between franchisors and franchisee. But several unique factors in franchising materially affect risk and benefits streams. First, franchising is not an industry. It’s a capital formation model. Appraisers need an understanding of the underlying business related to the subject’s business model.

Franchising is a contract-driven business. Far more than most businesses, the existence, applicability, legitimacy, and enforceability of the contracts will impact value.

Finally in my experience franchisors and brands are either growing or shrinking. Growing franchisors, and franchisees within these systems, tend to be priced at a premium. Shrinking or stable franchise systems are understandably perceived as less valuable. Therefore, a clear understanding of the future direction and strategy of the brand is critical.

The Players

Franchising is a business and capital markets concept. While the original franchise systems focused on largely on lodging (e.g., HOJOs, Holiday Inn) and food (e.g., McDonald’s, Pizza Hut), the business model today is used in a wide range of industries.

The investor’s motivation for using the franchise business model will vary depending upon whether the subject is a franchisor, a franchisee, or a multi-unit franchisee (a “MUF” owns a number of franchise locations, sometimes in multiple brands or segments).

Franchisors seek the opportunity to more rapidly expand their brand footprint using other people’s money – that is the franchisee’s. Most new franchise concepts will eventually fail. All brands reach tipping points during their growth where they run out of money and talent. Some of the concepts will find solutions as they emerge, most do not.

Franchisees seek to operate a proven business concept requiring a known and controllable investment. Most brands today try to limit the initial all-in investment to less than $150,000 to attract people changing career paths in the face of the lingering doldrums from the great recession. Many of these more affordable brands are focused on personal services, human body brands, and business services. Food and beverage and lodging brands, while still very active segments, require much higher investments ($400,000 and up), and the pool of potential franchisees is far more shallow.

Multi-unit franchisees are a breed to themselves. They see the franchise model as a good way to develop a larger business, seeking quick scale and much higher returns than a single franchisee will achieve. MUFs operate franchise business enterprises, and reap all the synergies one might expect in marketing, management, operations, and cost of capital. Franchisors today seek out MUFs or potential MUFs since they allow faster expansion of brands with reduced development costs, and, since MUFs tend to be seasoned business people, they are far more likely to be successful.

As a complicating appraisal issue, most franchisors will have “owned stores” in addition to franchise locations. The owned stores were necessary initially to start the brand and demonstrate proof of concept and market. These stores continue to be important for brand R&D, training, and franchise development. The mix of owned and franchised locations often results in a need to value the owned stores separately from the franchise system.

Although most brands require some physical “space”, such as food and retail brands, franchisees today, unlike the legacy brands, will lease real estate rather than own property. However, if the franchisor or franchisee owns operating real property, that asset needs to be appraised separately.

Impact of Risk, Cash Flow on Value

There are a number of key contracts an appraiser must digest in developing a value for in franchise. The impact of the contracts may vary depending upon whether the subject is a franchisor, a franchisee, or a MUF.

1. Appraisers must read the current Franchise Disclosure Document, or “FDD.”

Franchising is a regulated industry. At the Federal level, the FTC has developed extensive franchise rules and regulations. The disclosure requirements are well known to seasoned franchise players. The FDD tells the story of the brand, as well as the nature and extent of each party’s obligations and rewards. The quantity and quality of disclosure is up to the franchisor, but the public may seek redress if the information in the FDD is insufficient or misleading. New entrants with untrained legal and financial advisors often provide FDDs with weak, incomplete, and inaccurate disclosure, all of which lead to false expectations, disputes, and ultimately poor operating performance.

2. The appraiser should learn about Area Development Agreements (ADAs) and Master Agreements (MAs) which are used to execute rapid growth strategies.

The franchisor has additional tools in the quiver to accelerate growth. ADAs and MAs are executed between a franchisor and a suitable partner to build out a brand in a specified area. ADAs usually require the developer to be in charge of brand development within the area of protection (AOP), and provide on-going training, opening assistance, and QC support. The franchisor and the developer normally split the up-front franchise fee, and the periodic royalties. The developer normally pays a significant six figure fee for the right to control a territory.

ADAs often fail to accomplish the desired outcome. The usual causes are that the ADAs lack the necessary financial resources, they lack the business acumen needed, and are unwilling, or unable to acquire the talent needed, the target market for the brand may never have existed or is poorly developed, and the quality of the franchisees under an ADA fail because of the lack of skill and support from the ADA. The failure of an ADA is a serious constraint on earnings and value since it may take years to terminate an underperforming developer, and in the meantime the franchisor has lost access to the market.

MAs can be used to cover any geographic territory, but they often appear where the franchisor simply cannot reach to manage the brand, execute franchise development, and collect fees. While masters can be found in the USA, they are frequently used to develop brands in distant foreign countries of divergent cultures where a local “partner” is needed to develop and maintain the brand. The MA becomes the subfranchisor and executes all franchisor functions. The MA pays the franchisor a small share of the franchise fee and royalty for the sublicense, but it will pay a material fee to the franchisor for the master rights, often exceeding $1MM. Major risks exist – if the MA fails to execute, the franchisor is often without timely recourse to enforce the agreement or insert a replacement MA, and markets and revenues are meanwhile lost.

3. Accounting for franchising may not follow the dollars – cash flow and earnings are divergent concepts.

The FASB and the IASB have done their best to complicate revenue recognition for franchisors. Appraisers need to follow the cash.

New franchisees pay an initial “franchise fee” that can amount to $20-100,000, and even more in some cases. The accounting rules require that the fee be brought into income only to the extent that the franchisor’s obligations to the franchisee are met. Accordingly, recognition of franchise fees may be deferred for financial reporting until the required tasks are completed. But the franchisor has the cash and rarely is it ever returned.

4. What is the franchisee’s AOP? The lack of an AOP means the franchisees are not protected from same brand encroachment and competition.

Franchisees are normally contractually provided an AOP as part of the license agreement. That’s one of the features of the brand, one of the reasons a person owns a franchise. The lack of an AOP is a weakness for the franchisee and thereby a collective weakness for the brand.

5. What are the franchisee Unit Economics (UE)?

If the franhisees are not making money, or not sufficiently to provide a return on the capital invested, the brand will likely fail.  What are the UEs for the franchisees?  Does the franchisor even know or have a system to collect this data?  What are the comments from franchisees?  Does the franchisor even collect comments from franchisees?

6. It’s a litigious business.

Enforceability of the contracts lends itself to litigation flash points. It is common for franchisors to have one or more legal matters in process dealing with enforcement of agreements and collection of fees. Some states are distinctly more favorable to one party or the other. The current political “we versus they” environment in the US encourages litigation concerning the fairness of agreement terms. One leading issue today that is especially troublesome is the classification of the franchisor vis-a-vis the franchisee operations and employees of franchisees. These cases are having a chilling effect on the franchise business model.

Specific Value Issues for Franchisors

Franchise brand investors enjoy the annuity nature of the business model, combined with the use of other people’s money to grow the investment, and the ability to rapidly increase value by expanding the number of franchisees. EBITDA multiples for brands can easily reach over 10 for strategic oriented or platform add-on deals.

For Fair Market Value, developing the cost of capital should take into account your understanding of the risk factors noted above. Lower risks are associated with a well-documented brand, a seasoned franchise platform, good unit economics, and expansion. The tools we commonly use to develop a cost of capital for any situation – CAPM, BU Method, D&P, Butler Pinkerton – are used here as well. The critical judgment the appraiser needs to make is the specific company risk factor given the status of the risks mentioned previously.

Keep in mind that the franchisor is a participant in some industry. The capital model is franchising. The appraiser needs to digest the body of knowledge of the economics of the industry. A franchisor cannot make a successful business out of an industry that is failing.

Market comparables can be obtained from both public and private transactions in the industry segment. NAICS also has a code for franchising – 533110 Lessors of Nonfinancial Intangible Assets (except Copyrighted Works) that may be used as well, but the utility of the information can be limited since this data will not focus on industry.

Obviously larger franchisors are more comparable to public companies – size adjustments are critical in any event. But private company data bases such as Pratt’s Stats, BizComps, and MergerStat will yield useful information. Keep in mind that most brand owners’ exit planning consists of a sale to strategic player or platform buyer, similar to what one sees in technology subjects. Do not overlook the possibility that the hypothetical buyer is a strategic buyer.

I mentioned before that brands are either growing or contracting. They are adding units or losing units, sometimes losing them intentionally. If a system is growing, substantial franchise fee revenue is being earned, and development costs will increase. System revenues (that is, the gross revenues generated by all franchised locations), which drive royalties, are changing as well. Revenue streams and operating performance can be materially impacted if the brand decides to build more or fewer owned operations versus franchised. There may be ancillary revenue streams that are changing as well, or being added or deleted. Franchisors often separately charge for support functions, such as technology platforms, additional training, and arbitrage earned on special financing programs for franchisees. And most franchisors sell forms of proprietary property to franchisees that are required to buy from the franchisor. Another interesting revenue source that is evolving is the licensing of the brand name to other retail consumer products and distribution channels (Cinnabon™, Carvelle™, and Back Yard Burger™ are but three good examples, but there are many).

Consequently, it is important and frequently necessary to consider forecasts of future operations and reliance on discounted cash flow. I often use the Market Approach method to determine the terminal value.

[Most franchise systems charge a national, and even regional and local marketing fee. These fees can run up to 10% of franchisee revenues. The franchisor’s responsibility for these funds is stated in the FDD and license agreement, but generally the funds must be used for the exclusive benefit of brand marketing and on behalf of the franchisees, taking on an actual or practical trust relationship. The franchisor must use the funds for the intended purpose, and the fee is not considered income to the franchisor. Brand marketing costs incurred by a franchisor in excess of the marketing fee revenues are normally considered a period cost to the franchisor, since few franchisors ever recover the excess marketing costs incurred. Some brands will regard these excess costs as a receivable from the franchisees, but experience shows that collection is illusory.]

Special considerations are often necessary when a franchisor is also an operator of its own stores. I normally exclude special consideration if a franchisor owns a small number of stores permanently (say one to three stores in a system of 100 units) for R&D, training, and marketing. But if the brand includes a large number of owned stores in addition to franchised locations, you may need to consider parallel value analyses – one for franchising, one for operating locations. And it is also possible that there is owned real property, in which case one needs to account for real estate value in addition to normal enterprise value.

Specific Value Issues for Franchisees

There is a perception that a franchise operation is more valuable than an equivalent unaffiliated operation. That perception comes from a belief that franchise operations have higher cash flow and lower risk. There is some truth to this perception.

If the franchisees are not making money, or not sufficiently to provide a return on the capital invested, the brand will ultimately fail. Franchisee financial performance is globally referred to as “unit economics”. Appraisers need to understand the unit economics of the franchisees. Does the franchisor monitor performance? Does the franchisor even have a system to collect this data? What are the comments from franchisees? Does the franchisor even collect comments from franchisees?

We find that market multiples and the cost of capital are normally more generous to franchisees than similar unaffiliated operations. To prove out the extent of the price premium in any particular case, one only needs to compare the market multiples from Pratt’s Stats and BizComps for sales of franchise operations versus unaffiliated operations. In most cases, the multiples for franchise companies are materially higher than for unaffiliated. How you incorporate these premiums into your case requires some study and judgment, including but not limited to how similar your subject is to the comparative population.

As for benefit streams, it is not uncommon for franchise locations to have higher average unit volumes (“AUV”) than unaffiliated, but to also have higher costs. Royalties and marketing fees alone can add 8-15% to costs in a franchise location. Operating costs may be higher in a franchise due to product or service quality issues. Consequently, it is not uncommon for a franchise location to generate less operating cash than a similar unaffiliated operation. Notwithstanding this comment, the ultimate value may benefit from a lower cost of capital. And the DLOM may be lower for a franchise operation since these businesses tend to be the first to sell within a trade area. After all, better access to markets at exit time is one of the reasons a person buys a franchise.

As you work through the study of a subject franchisee, keep these additional issues in mind:

• Is there an AOP that is appropriate for the brand and the subject location? There is nothing worse than another franchisee of the brand coming into the subject’s trade area. Revenues may not be sustainable. This is a highly litigated area.
• How does the revenue trend compare to the market trade area?
• Is there physical obsolescence even if the facilities are well maintained? The franchisor has “prototypes” and often will issue “property improvement plans” (“PIP”) which may require the franchisee to take action to update the facilities. The cost may be burdensome or even prohibitive.
• Is the franchisee’s AUV similar to other franchisees in the system? How about competitors in the trade area? Is this a leader or laggard? Is the AUV trend driven by the brand, or the national and local marketing, or franchisee skill, or something else? And to what extent are these features transferable?

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