Franchise valuation asa feb 2015 v2-20-15
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The impact of franchises on small business valuation. Presented to the Wisconsin Chapter of the American Society of Appraisers on 2-20-15
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Franchise valuation asa feb 2015 v2-20-15
- 1. The Impact of Franchise Agreements on Small Business Valuation Theresa Zeidler- Shonat Director of Valuation Service
- 3. Franchise Rights and Organization
- 4. 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
- 5. Forms of Franchising • Single Unit Model • Master Franchising Model • Regional Developer 14
- 6. Single Unit Model Franchisor Franchisee Franchisee Franchisee Franchisee 15
- 7. Master Franchising Model Franchisor Master Franchisee Franchisee Franchisee Master Franchisee Franchisee Franchisee 16
- 8. Regional Developer • Has the rights to market and award franchises within a defined region • Acts like franchisor within that region 17
- 9. Franchises and the Economy
- 10. Sources of Franchise Information • U.S. Census Bureau • IHS Global Insight & IFA Franchise Business Economic Outlook for 2014 • IFA (International Franchise Association)
- 11. 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
- 12. Franchises in the U.S. • 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)
- 13. Franchises in the U.S. • 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.
- 14. Franchises in the U.S. • 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.
- 15. 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.
- 16. Three Essential Characteristics of a Franchise System 26 Trademar k Significan t Control Required Payment
- 17. 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
- 18. 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
- 19. 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
- 20. The Documents that Govern the Franchise Relationship 30
- 21. Franchise Disclosure Document • The Franchise Disclosure • The Franchise Agreement 31
- 22. Franchise Disclosure Document • The Exhibits – Guarantees – General Release – Confidentiality Agreement 32
- 23. Franchise Disclosure Document • The Exhibits (cont.) – Consent to Transfer – Financial Statements – State Addenda to the Disclosure Statement Document – Operations Manual Table of Contents 33
- 24. 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
- 25. 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
- 26. 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
- 27. Key Components of Franchise Agreements • Training and/or support provided by the franchisor • Assigned Territory and Rights – Can be exclusive or non-exclusive
- 28. Key Components of Franchise 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
- 29. Key Components of Franchise Agreements • Franchisor constrains advertising or manages advertising • Amount franchisees are expected to pay toward franchisor advertising costs 43
- 30. Key Components of Franchise Agreements • Operating Protocol • Renewal rights and franchise termination/ cancellation policies • Resale rights – Buyback or first refusal clauses 44
- 31. 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
- 32. Examples of Product Distribution (Trademark) Franchises • Automotive and Truck Dealers • Gasoline Service Stations without Convenience Stores • Beverage Bottling
- 33. Sources of Franchise Business Value
- 34. 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
- 35. Sources of Business Value • 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
- 36. Sources of Business Value • 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
- 37. Sources of Business Value • 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
- 38. Sources of Business Value • A reduction in value for the risk that the brand itself may decline or the manufacturer may cease to do business 54
- 39. Sources of Business Value • 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
- 40. 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
- 42. 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
- 43. 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 franchise 57
- 44. 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 58
- 45. 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 rewards 61
- 47. 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
- 48. Franchise Disputes • Franchise disputes can represent a significant risk to franchisee – One potential outcome is the loss of ability to continue doing business 64
- 49. 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
- 50. 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
- 51. 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
- 52. 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
- 53. 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
- 54. 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
- 55. 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
- 56. 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
- 57. 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.
- 58. 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
- 59. 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 76
- 60. What Does this all mean to your Valuation?
- 61. Using Rules of Thumb? • Rules of Thumb can be problematic, but they address key valuation considerations that need to be addressed 78
- 62. 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
- 63. Why Are Rules Of Thumb Problematic? • They miss: – Changes in brand strength or weakness – Location factors – Changes in the franchise relationship or agreement 80
- 64. 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
- 65. Three Approaches to Value 65 Market Approach Asset Approach Income Approach Value Conclusion
- 67. Market Approach • Market Approach: Comparable Sales – The best comparable transactions are sales of franchises with the same franchisor 82
- 68. Market Approach • Market Approach: Comparable Sales – Franchisors usually won’t share this data (remember they usually have a right to approve all transfers so they have this data) 83
- 69. 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
- 70. Market Approach • Market Approach: Comparable Sales – 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
- 71. Market Approach 86 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
- 73. 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
- 74. 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 90
- 76. 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? 87
- 77. 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
- 78. 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
- 79. Questions? 79
- 80. Theresa Zeidler-Shonat Director of Valuation Services Smith & Gesteland, LLP 608.828.3154 theresa.zeidler-shonat@sgcpa.com 80
Editor's Notes
- Thanks, Steve, and thank you to everyone attending, both in-person and online. For online attendees, please use the chat function in gotowebinar if you have any comments or questions. It is a pleasure to be here today to talk to you about valuation considerations related to valuing small businesses with franchise agreements Valuing a business that is subject to a franchise agreement is more of an exercise in critical thinking and less of an exercise in franchise-specific valuation methodology. Therefore, much of what we will be talking about today will be the things that you need to take a good hard look at, and understand and consider the implications of in order to frame your critical thinking process. To that end, we will discuss how franchising works in the context of the small business, and how franchise agreements impact small business. No franchised business exists in a vacuum, and so the conditions impacting all franchised businesses need to be considered. There are a number of different types of franchise relationships. We will discuss the structure of various types of franchise relationships and considerations related to them. In order to value a franchise business, you need to understand the market for such businesses. This means that it is important to understand why small businesses chose to be part of a franchise, and to understand the specific characteristics that are unique to franchises. We will take a look at franchise-specific factors that must be considered when valuing a business operating under a franchise agreement – things that not only frame the critical thinking process, but things which can directly impact value. We will cover the value that franchise relationships add to small businesses. We will also discuss the risks that are associated with a franchise relationship, and ways that franchises can detract from value. We will take a look at franchise-specific factors that must be considered when valuing a business operating under a franchise agreement – things that not only frame the critical thinking process, but things which can directly impact value. Finally, once we have gotten the critical thinking component out of the way, we will take a look at valuation-specific challenges when using the three approaches to value.
- So, we will begin at the beginning, with a look at what franchises are and how they operate.
- So, what is a franchise? The word franchise can be used to mean several different things: The right to sell a company’s goods or services in a specific area A business given that right, or The intangible asset that consists of that right and the brand, business processes, and other things that combine to make it recognizable Franchising is a way of organizing and developing (or growing) a business. Most Corporations are organized such that every “branch” of the business is owned by the company and is operated by its employees. In Franchising, the ownership and operations of each “branch” is distributed to Franchisees who are independent business owners rather than employees of the Corporation. As you are likely well-aware, a Franchisor is the Company that offers or awards Franchises to Franchisees A Franchisee (also called “a Franchise” or a “Franchise Business“) is an individual or group of individuals or a Corporation that is licensed to use the brand name, the logos, the business systems, products or other things that the Franchisor provides. In most cases, a Franchisee is given this license for renewable periods up to 20 years, but 10 to 15 year licenses are more common.
- There are three ( or more) ways to refer to franchising arrangements that you are likely to run into: the single unit model, the master franchising model, and regional developers. In order to understand these arrangements, note that the word “unit” often refers to a single location, or a single store. It more specifically refers to the location or territory in which the franchisee is allowed to operate.
- Under the single-unit model, or the direct franchise model, the franchisee makes an investment in one unit, and this is the full extent of the initial agreement. The franchisee typically has a particular territory that is covered by the unit. Usually the franchisor assigns a number of miles to be covered by each unit in operation. Some franchises give you a protected territory, while others do not. If the franchisee is successful, they may be offered the opportunity to invest in additional units at a later stage. Each of these additional units are typically governed by individual agreements – that is, a franchisee can operate with many “single unit” agreements. AREA DEVELOPMENT FRANCHISES also fall under the direct franchise model Under an area development franchise, a franchisee has the right to open more than one unit during a specific time, within a specified area. For example, a franchisee may agree to open 5 units over a five year period in a specified territory. The franchisor grants the franchisee exclusive rights for the development of that territory.
- The master franchising model is a structure in which the franchisee has contracted with a person or entity to provide services to single-unit franchisees in a specified territory (typically a major market or even one or more states). The master franchisee typically pays the franchise company a significant initial fee for the rights to develop the territory and then retains most or all the initial fees and royalty fees paid over time by the individual franchisees in the territory. That master is usually responsible for recruiting the individual franchisees and providing all training and support they need, both initially and on an ongoing basis. Franchise companies often select the master approach in the belief it will result in more rapid system growth with less initial capital risk for the company.
- I tossed this in because you will occasionally see it referred to. Regional developer, or area developer is another term used to refer to master franchisee – depending on the franchise, you will see differing terminology.
- What impact do franchise businesses have on the economy – and how likely are we to have to value one?
- To answer that question – and to value franchises, you need to know where to find data
- There are three characteristics that exist in every franchise system. These are the presence of a trademark or brand, significant control at the franchisor level, and required payments from the franchisee to the franchisor.
- 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. Most of the most-recognized restaurant brands in the US are franchises, as are many of the hotels, real estate brokerages, and the like. It is important to note that the franchisee does not take ownership of the trademark. The trademark – and all other marketing intangibles – are held at the franchisor level. Valuing a franchise location does not involve a valuation of the marketing intangibles held by the franchisor.
- To ensure uniformity, franchisors usually control how franchisees conduct business. These controls may significantly restrict a franchisee’s ability to exercise their own business judgment. Many franchisors pre-approve sites for outlets, which, in turn, may increase the likelihood that a franchised outlet will attract customers. At the same time, the franchisor may not approve the site a franchisee prefers. Franchisors may impose design or appearance standards to ensure a uniform look among the various outlets. Some franchisors require periodic renovations or seasonal design changes; complying with these standards may increase franchisee operating costs. Franchisors may restrict the goods and services a franchisee sells. For example, if a restaurant franchisee not be able to make any changes to the menu. An automobile transmission repair franchisee may not be able to perform other types of automotive work, like brake or electrical system repairs. Franchisors may require that franchisees operate in a particular way: they may dictate hours; pre-approve signs, employee uniforms, and advertisements; or demand that Franchisees use certain accounting or bookkeeping procedures. In some cases, the franchisor may require that franchisees sell goods or services at specific prices, restricting franchisee ability to offer discounts, or require that franchisees buy supplies only from an approved supplier even if they can buy similar goods elsewhere for less. A franchisor may limit your business to a specific territory. While territorial restrictions may ensure that you will not compete with other franchisees for the same customers, they also could hurt your ability to open additional outlets or to move to a more profitable location. In addition, a franchisor may limit your ability to have your own website, which could restrict your ability to have online customers. Moreover, the franchisor itself may have the right to offer goods or services in your sales area through its own website or through catalogs or telemarketing campaigns.
- In exchange for the right to use the franchisor’s name and for the franchisor’s assistance, Franchisees a number of different fees to the franchisor. The franchisee pays an initial franchise fee, which can range from several thousand dollars to several hundred thousand dollars, and which may be non-refundable. Franchisees may incur significant costs to rent, build, and equip an outlet and to buy initial inventory. Franchisees also may have to pay for operating licenses and insurance, and a “grand opening” fee to the franchisor to promote the new business. Franchisees may have to pay the franchisor royalties based on a percentage of their weekly or monthly gross income. Often, they must pay royalties even if their outlet isn’t earning significant income. As a rule, franchisees have to pay royalties for the right to use the franchisor’s name. Even if the franchisor doesn’t provide the services they promised, the franchisee still may have to pay royalties for the duration of their franchise agreement. Indeed, even if a franchisee voluntarily terminates their franchisee agreement early, they may owe royalties for the remainder of their agreement. Franchisees also may have to pay into an advertising fund. Some portion of the advertising fees may be allocated to national advertising or to attract new franchise owners, rather than to promote their particular business.
- Franchise relationships are governed by legal documents. These documents are important to understand because the provisions within them can significantly impact company value.
- The primary documents that govern the franchise relationship are the franchise disclosure document and the franchise agreement. A franchise disclosure document (FDD) is a legal document which is presented to prospective buyers of franchises in the pre-sale disclosure process in the United States. It was originally known as the Uniform Franchise Offering Circular (UFOC) (or uniform franchise disclosure document), prior to revisions made by the Federal Trade Commission in July 2007. The Federal Trade Commission Rule of 1979, which governs disclosure of essential information in the sale of franchises to the public, underlies the state FDD's and prohibits any private right of action for the violation of the mandated disclosure provisions of the FDDs
- One of the regulations requires every franchise to publish a Franchise Disclosure Document (FDD) every year. Every year the document must be updated with current information. The FTC dictates what information must be included in the FDD. The FTC actually writes the table of contents. They ensure that each franchise company provides the same kinds of information, usually called “items.” There are 23 sections in the FDD. There will be information on the senior managers of the company. The success of senior managers will be a key factor in the success of the franchisee. Has there been an ownership change? If so, do the new owners have a background in the industry? Have the owners ever filed bankruptcy? This is the kind of information that will be included on the ownership, in items number one, two, and four. Has this company ever had a major law suit? If so, it will be detailed in the FDD.
- Item 19 is the one that is often talked about. This is the only optional part of the FDD. In this section, the franchisor is permitted to share the financial results that existing franchisees have. Unfortunately, only about one-third of franchisors provide this in the FDD. However, if it is not there, it is still possible to get this information. In Item 20, the franchisor must disclose you how many franchises they have, as well as how many have opened and closed for the past two years. They also have to provide phone numbers for every last franchisee. Because those franchisees can be a very good source of information on the business, you can pick up the phone and call as many of the existing franchisees as you like to request information. They are, however, under no obligation to answer your questions.
- The franchise agreement is the written contract between the franchisor and franchisee. It is the fundamental legal document upon which the franchisor-franchisee relationship is based. The franchise agreement details the conditions that both the franchisee and franchisor must understand and accept. It also specifies the precise obligations, responsibilities and rights of each party to the contract, as well as the actions that the franchisee and franchisor are prohibited from engaging in.
- Under the Franchise Rule, which is enforced by the FTC, potential franchisees must receive the document at least 14 days before you are asked to sign any contract or pay any money to the franchisor or an affiliate of the franchisor. Potential franchisees have the right to ask for—and get—a copy of the disclosure document once the franchisor has received your application and agreed to consider it. Including the FDD that your subject company received prior to entering into the franchise agreement in your information request is a good idea.
- 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.
- There are some key components of franchise agreements, most of which has some impact on business value, either directly or indirectly. Some of these components include: who is eligible for training whether new employees are eligible for training and, if so, at what cost. Who pays? how long the training sessions take. How much time is spent on technical training, business management training, and marketing? who conducts the training and their qualifications whether the company offers ongoing training and at what cost support staff available for trouble-shooting: Are they assigned to your area and how many franchisees they are responsible for? whether on-site individual assistance is available and at what cost
- be sure that the duration of the Franchise Agreement is clearly stipulated. How long does it last – five, ten, or twenty years? Is it renewable when the initial contract expires? If the contract is renewable, how much will you have to pay? Is it the full franchise fee or is it discounted for a renewal?
- Advertising Fees You also may have to pay into an advertising fund. Some portion of the advertising fees may be allocated to national advertising or to attract new franchise owners, rather than to promote your particular outlet. The agreement has information on advertising costs. Franchisees often are required to contribute a percentage of their income to an advertising fund. Find out: what part of the advertising fund is devoted to administrative costs what other expenses are paid from the advertising fund whether franchisees have any control over how the advertising dollars are spent what advertising promotions the company has already engaged in and what’s on the drawing board what percentage of the fund is spent on national advertising what percentage of the fund is spent on advertising in your area what percentage is devoted to selling more franchises whether all franchisees contribute equally to the advertising fund whether you need the franchisor’s consent to develop and buy your own advertising whether there are rebates or advertising contribution discounts if you do your own advertising whether the franchisor gets any commissions or rebates when it places advertisements, and who benefits from those—you or the franchisor
- FRANCHISING, IN GENERAL, AFFORDS franchiors the capacity to replicate time and again the system and services that are the core components of their brand. The protocol for the franchise is typical communicated through the use of an operations manual. The operating manual furnished by most companies will provide you with the knowledge you need to operate that business. It’s a good reference book for you as it establishes the rules, standards and specifications regarding what has to be done to accomplish a task, or to present a certain product or service. Essentially an operations manual is an expansion of the relevant material contained in the franchise agreement. It is actually possible to have more than one manual for a franchise. Separate manuals for training, cooking instructions, dress standards, cleaning requirements and other elements are often issued. The core of an operations manual will deal with all procedural requirements that are standard across all franchise outlets, which may include the following: • Legal requirements - such as business registration, council permits and signage limitations. • Opening and closing procedures – hours of operation, routines. • Accounting – correct procedures for record keeping techniques such as budgeting, profit & loss, cash flow, petty cash reimbursement, payroll, bank reconciliation, invoicing, sales and accounts control. • Stock – suppliers of stock, maximum and minimum amounts, ordering, etc. • Security procedure – locking doors, windows, alarm system, and so forth. • Cleaning and hygiene matters – cleaning particulars and routine hygiene checks. • Occupational Health and Safety routines • Personnel – recruitment, interviewing and selection techniques, training, wages and evaluation. • Telephone manner – correct greetings, how to take orders over the phone, etc. • Dress standards – correct uniform and appearance. • Emergency procedures – course of action in case of fire or other emergency. • Liaison with franchisor - how often to contact franchisor, key points to pass on, etc. • System of operation – cooking, preparation, job time, customer service, general day-to-day matters. BILL – MENU EXAMPLE – BREAKFAST AT SUBWAY
- Business format franchising is an arrangement where a franchisee receives (in addition to the right to sell goods or services) the franchiser's designs, quality control and accounting systems, operating procedures, group advertising and promotions, training, and (in case of hotels and travel agencies) worldwide reservation system.
- Product distribution franchises simply sell the franchisor’s products and are supplier-dealer relationships. In product distribution franchising, the franchisor licenses its trademark and logo to the franchisees but typically does not provide them with an entire system for running their business. The industries where you most often find this type of franchising are soft drinks, automobiles and gasoline. Product distribution franchises are more like a non-franchised business. Less risk related to outside control, but potentially very significant capital expenditure on start-up.
- So now that we have taken a look at how franchises are structured, let’s dive into what franchise-specific factors impact business value.
- With a franchise, as with any business, the value of the business is that which arises from the future stream of expected profits of the company. In franchises, this is closely tied to the performance of the brand in the market area. Don’t lose sight of the fact that, in many ways, this is like valuing any other business.
- The value of the company is further tied to the growth option for the brand – how will the brand be developed? What are the future offerings of the brand, assuming that the company would be reasonably expected to be a distributor of these future offerings?
- Of these two items, the expected profits are substantially under the control of the current managers of the company.
- The growth options for the brand and the performance of the future options are only partially under the control of the current business managers
- However, not all influences on the company are positive ones. There is a risk that the brand may decline, or that the franchisor may cease to do business.
- This is almost completely outside the control of the managers of the franchise. KRISPY KREME example
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- Purchasing a franchise is like any other investment: it comes with risk. When you think about a particular franchise, think about the demand for the products or services it offers, competitors that offer similar products or services, the franchisor’s background, and the level of support you will receive. Demand Our value definition is very often “fair market value.” This means we need to consider the market for franchises, and what the participants in that market would consider when acquiring a franchier. Is there a demand for the franchisor’s products or services in your community? Is it seasonal or ever- green? Could you be dealing with a fad? Does the product or service generate repeat business? Competition What’s the level of competition—nationally, regionally, and locally? How many franchised and company-owned outlets are in your area? Does the franchise sell products or services that are easily available online or through a catalog? How many competing companies sell similar products or services? Are they well-established or widely recognized by name in your community? Do they offer a similar product at a similar price? Your Ability to Operate the Business Sometimes, franchise systems fail. What will happen to your business if the franchisor closes up shop? Will you need the franchisor’s ongoing training, advertising, or other help to succeed? Will you have access to the same suppliers? Could you conduct the business alone if you have to cut costs or lay anyone off? Before you invest in a particular franchise system, think about how much money you have to invest, your abilities, and your goals. Be brutally honest. Name Recognition Buying a franchise gives you the right to associate with the company’s name or brand. The more widely recognized the name, the more likely it is to draw in customers. Consider: name and brand recognition for the company and its product or service whether the company has a registered trademark how long the franchisor has been in business whether the company’s reputation is for quality products or services whether consumers have filed complaints against the franchise with the Better Business Bureau or a local consumer protection agency Training and Support Services What training and continuing support does the franchisor provide? Does the franchisor’s training measure up to the training for workers in the particular industry? Can you compete with others who have more formal training? What backgrounds do the current franchise owners have? Is your education, experience, or training similar? Franchisor’s Experience Many franchisors operate well-established companies with years of experience both in selling goods or services and managing a franchise system. Some franchisors started by operating their own business. There is no guarantee, however, that a successful entrepreneur can successfully manage a franchise system. Find out: how long the franchisor has managed a franchise system whether the franchisor has enough expertise to make you feel comfortable. If the franchisor has little experience managing a chain of franchises, take any promises about guidance, training, and other support with the proverbial grain of salt. Growth A growing franchise system increases the franchisor’s name and brand recognition and may enable you to attract customers. But growth alone doesn’t ensure successful franchisees. Indeed, a company that grows too quickly may not be able to support its franchisees with the support services it promises them. Investigate the franchisor’s financial assets and resources; are they sufficient to support the franchisees
- BILL – risk ejection – what is your ejection point if this doesn’t work? Goes back to elements of control
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- TZ BILL – color commentary – like 20% control situation
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- BILL 23 franchise store anecdote Deferred maintainence & significant valuation adjustment
- BILL Comes down to “do your homework”
- BILL “at participating stores” – bring in atny – plan for divorce
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- BILL – data below for my color commentary Terminations and renewal You can lose the right to your franchise if you breach the franchise contract. Franchise contracts are for a limited time; your right to renew is not guaranteed. Franchise Terminations A franchisor can end your franchise agreement for a variety of reasons, including your failure to pay royalties or abide by performance standards and sales restrictions. If your franchise is terminated, you may lose your investment. Renewals Franchise agreements may run for as long as 20 years. At the end of the contract, the franchisor may decline to renew. Renewals are not automatic, and they may not have the original terms and conditions. Indeed, the franchisor may raise the royalty payments, impose new design standards and sales restrictions, or reduce your territory. Any of these changes may result in more competition from company-owned outlets or other franchisees.
- BILL – Discuss TZ – follow-on comments One key element of almost all franchise training programs involves training at the franchisor's headquarters. a tour of the prototype operation, corporate headquarters and an introduction of staff. Once the formal training session begins, most franchisors focus on subjects best taught in a "classroom" setting. address corporate history and philosophy, pre-opening procedures, daily operations, insurance requirements, vendor relationships and reporting requirements. This segment of training often involves hands-on training within a franchise prototype Onsite Training a franchise training program can also involve several days to a few weeks (depending on the complexity operations) assisting franchisees and their staff at the franchisee's location.
- So putting this all together and getting down to actual analysis - what does it mean to your valuation?
- Often times you will catch industry participants referencing rules of thumb. You will never catch me advocating relying on rules of thumb. They are problematic - but they can address key valuation considerations.
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- Guy who buys and sells many restaurants a year – his rule of thumb is probably pretty close to a true market multiple. You and I? We don’t do that, and any published rules of thumb will be stale data.
- Instead, it’s best to rely on your good old, trusty, approaches to value. There are a couple of franchise-specific things you need to consider, and some challenges to be aware of. Image: © dvarg - Fotolia.com
- Guideline method—difficult to find real comps. Lots of information available on public companies but they tend not to be very similar to most closely held companies. They should be similar in: Revenues, earnings, assets, capital structure, dividend payout ratio or other measures. Adjustments may be necessary to make them more similar. Produces a marketable minority value that needs to be adjusted for the fact that our subject company is not freely traded on a public exchange or over the counter. Transaction method is more of a statistical approach that uses averages of many similar transactions Not much information about companies or the transactions. Must have sufficient transactions to be statistically significant—usually more than 10 but it depends on how “similar” and relevant the transactions are. Often used to support other approaches; as a sanity check. May also look at actual transactions in the subject company’s stock if they are at arm’s length—to 3rd parties.
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- TZ Discuss differences – and how data was derived
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- All cost approach valuation methods are based on the economics principle of substitution. In the Cost Approach, the aggregate value of the company’s assets is netted against the estimated value of all existing and potential liabilities, resulting in an indication of the value of the business enterprise. The resulting indication of value often represents a minimum, or floor value that a company may reasonably expect to realize, often through the liquidation of its assets. In some cases, can be the most reliable approach: Franchisors stipulate the cost to enter the business - $2.0 mil to get into Krispy Kreme, for example
- Intangible assets aren’t on the balance sheet either, so the value of the contractual relationship - that is, the franchise agreement - also needs to to be considered. Therefore, when using the cost approach to value a franchise, you not only need to make adjustments to bring the book value of the assets in line with your value definition - and how often is the book value of a company’s fixed assets the fair market value of those same fixed assets? - but you also need to make adjustments for those assets which exist, but which are not on the balance sheet.
- Imagine: © denisismagilov - Fotolia.com
- BILL Rents/lease rates Franchisor often stipulates suppliers – inability to adjust cost of goods Some flexibility in pricing
- Where can you find other royalty rates? A database like ktmine or royalty source - both have franchise agreements in them. Alternetly, you can look to franchise disclosure documents for this info. comparison can be tricky - a royalty rate may be impacted by levels of other fees, for example, or by whether the agreement is for an exclusive or non-exclusive territory. As with all comparables, the better you can match on all points, the more you can rely on the data. Adjustments for royalty payments? possibly. or a difference in the cost of capital compared with other market participants.
- At this point, you should have a much clearer picture of the things you need to consider when valuing a franchise. There are a lot of components to the franchise agreement and in the franchise’s relationship with the franchisor that can have a large impact on the value of the company. While no valuation should ever be a simply mechanical exercise, the valuation of franchises certainly should never be - the franchise agreement should be reviewed the provisions of the agreement should be carefully considered for their impact on the company, and adjustments should be made in each of the valuation approaches for franchise-related considerations.
- Image: © spinetta - Fotolia.com
- Image: © Sasajo - Fotolia.com