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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 busine...
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 t...
Franchises and the Economy
Sources of Franchise
Information
• U.S. Census Bureau
• IHS Global Insight & IFA Franchise
Business Economic Outlook for 2...
Franchises in the U.S.
• IHS and the IFA estimate that in 2013 there
were:
• 757,453 franchised businesses in the United S...
Franchises in the U.S.
• IHS IFA estimates for all of 2014:
– Quick-Service Restaurants, sometimes
called fast food restau...
Franchises in the U.S.
• IHS IFA estimates for all of 2014:
– Quick Service Restaurants also led in
number of employees ac...
Franchises in the U.S.
• IHS IFA estimates for all of 2014
that in terms of output:
– Quick Services led the franchise
bus...
Franchise Output Per Worker
• For 2013 according to IHS and IFA:
– Automotive franchise employees had
the most output per ...
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...
Significant Control
• The franchisor exercises significant
control over the franchisees’
operations
• This typically inclu...
Required Payment
• In return for the use of the
trademarked product or service and
other benefits of being part of the
fra...
The Documents that Govern the
Franchise Relationship
30
Franchise Disclosure
Document
• The Franchise Disclosure
• The Franchise Agreement
31
Franchise Disclosure
Document
• The Exhibits
– Guarantees
– General Release
– Confidentiality Agreement
32
Franchise Disclosure
Document
• The Exhibits (cont.)
– Consent to Transfer
– Financial Statements
– State Addenda to the D...
Franchise Agreement
• A Franchise Agreement is a legal,
binding contract
between a franchisor and franchisee
• Prior to a ...
Franchise Agreement
• The Franchise Rule requires a
franchisee be supplied a Uniform
Franchise Offering Circular (UFOC) or...
Franchise Agreement
• Once the Federal fourteen-day
waiting period has passed, the
Franchise Agreement becomes a
State lev...
Key Components of Franchise
Agreements
• Training and/or support provided by
the franchisor
• Assigned Territory and Right...
Key Components of Franchise
Agreements
• Duration of the franchise agreement
• Franchise fee and total anticipated
investm...
Key Components of Franchise
Agreements
• Franchisor constrains advertising or
manages advertising
• Amount franchisees are...
Key Components of Franchise
Agreements
• Operating Protocol
• Renewal rights and franchise
termination/
cancellation polic...
Examples of Business Format
Franchises
• Automotive
• Commercial and Residential Services
• Quick Service Restaurants
• Ta...
Examples of Product Distribution
(Trademark) Franchises
• Automotive and Truck Dealers
• Gasoline Service Stations without...
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 c...
Sources of Business Value
• The growth option for that brand, or
variants of that brand, that may be
offered in the future...
Sources of Business Value
• The value that arises from the future
stream of expected profits on the
current brand in the c...
Sources of Business Value
• The growth option for that brand, or
variants of that brand, that may be
offered in the future...
Sources of Business Value
• A reduction in value for the risk that
the brand itself may decline or the
manufacturer may ce...
Sources of Business Value
• A reduction in value for the risk that
the brand itself may decline or the
manufacturer may ce...
Valuation Considerations
• Determinants of value
• Demand for the product provided by the business?
• Industry growth
• Co...
Franchise-Specific
Marketability Considerations
Marketability
• Well established franchises/brands
– There are known players – franchisees that
have a relatively large nu...
Franchises Can Impede
Marketability
• Franchisors typically have the Right of
First Refusal on any sale of the business
– ...
Franchises Can Impede
Marketability
– Without that knowledge, the outside
bidder may bid too low and lose out
to the franc...
Market Considerations: Buying a
Franchise
• Acquiring an Existing Franchise
Location
– Same process as buying any other
bu...
Franchised Business Risks
Sources of Risk to Franchise
Businesses
• Variety of different sources of risk to a
franchise business
– Normal business a...
Franchise Disputes
• Franchise disputes can represent a
significant risk to franchisee
– One potential outcome is the loss...
Franchise Disputes
• What drives disputes?
– Business issues (cash flow issues, lack of
profitability)
– Differing expecta...
Impact on Business Value
• When circumstances exist that could
trigger a franchise dispute, there is a
negative impact on ...
Rules Change Quickly
• Rules can change very quickly –
franchisees have no control over
changes
– Restaurant makes $300k i...
Impact on Valuation
• Request or research information on
how often the franchisor changes
requirements or if franchisee is...
Franchises Are Contract
Rights
• Franchises are contract rights, not
outright ownership
– The full bundle of rights attrib...
Franchise Agreements Need to
Be Evaluated Like All Other
Contracts
• Advantageous to franchisee?
– What is gained?
• Disad...
Franchise Agreements Need to
Be Evaluated Like All Other
Contracts
• Does the franchisor have history of
premature termina...
Opportunity Cost for
Franchisee
• Even large, established franchisees are
not expecting to get rich – it’s a job
• Franchi...
The Threat of Non-Renewal
• Franchisors keep
franchisees “in line”
with renewals.
Franchises are
renewed every 10
to 15 ye...
Significant Training Time
• Franchisee training time
– New franchisees must undergo significant
amounts of training prior ...
Training Time Impact on
Valuation
• Increases the initial investment
required
– Franchisee must have sufficient ability to...
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 a...
Inherent or Implied in Rules of
Thumb
• A cost of capital
• Ratio based on operating costs or net
profit
• Expectation of ...
Why Are Rules Of Thumb
Problematic?
• They miss:
– Changes in brand strength or weakness
– Location factors
– Changes in t...
Using Rules of Thumb
• Rules of thumb are best used by
individuals with very deep knowledge
of the industry, company and a...
Three Approaches to Value
65
Market
Approach
Asset
Approach
Income
Approach
Value Conclusion
Market Approach
66
Market Approach
• Market Approach: Comparable Sales
– The best comparable transactions are
sales of franchises with the sa...
Market Approach
• Market Approach: Comparable Sales
– Franchisors usually won’t share this data
(remember they usually hav...
Market Approach
• Market Approach: Comparable
Sales
– This data, searchable by franchisor, is
generally not available in a...
Market Approach
• Market Approach: Comparable Sales
– Can you just uses sales in the subject
company’s industry and market...
Market Approach
86
SIC Code Industry
Franchise
Transaction
Count
Non-Franchise
Transaction
Count
Franchise Average
MVIC to...
Asset Approach
72
Cost Approach
• Recall that the cost approach is
predicated on the assumption that no
rational buyer would pay more for a
...
Cost Approach
• The Cost Approach needs to consider
not only the cost of the assets on the
balance sheet, but also the fra...
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...
Evaluating Royalty Payments
• Knowing whether or not the company
is paying a reasonable royalty rate
can be important to t...
Summary
• Valuing franchised businesses is similar
to valuing any other small business in
many ways
• However, there are a...
Questions?
79
Theresa Zeidler-Shonat
Director of Valuation Services
Smith & Gesteland, LLP
608.828.3154
theresa.zeidler-shonat@sgcpa.com...
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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. 1. The Impact of Franchise Agreements on Small Business Valuation Theresa Zeidler- Shonat Director of Valuation Service
  2. 2. Content Overview Today’s Mission
  3. 3. Franchise Rights and Organization
  4. 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. 5. Forms of Franchising • Single Unit Model • Master Franchising Model • Regional Developer 14
  6. 6. Single Unit Model Franchisor Franchisee Franchisee Franchisee Franchisee 15
  7. 7. Master Franchising Model Franchisor Master Franchisee Franchisee Franchisee Master Franchisee Franchisee Franchisee 16
  8. 8. Regional Developer • Has the rights to market and award franchises within a defined region • Acts like franchisor within that region 17
  9. 9. Franchises and the Economy
  10. 10. Sources of Franchise Information • U.S. Census Bureau • IHS Global Insight & IFA Franchise Business Economic Outlook for 2014 • IFA (International Franchise Association)
  11. 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. 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. 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. 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. 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. 16. Three Essential Characteristics of a Franchise System 26 Trademar k Significan t Control Required Payment
  17. 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. 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. 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. 20. The Documents that Govern the Franchise Relationship 30
  21. 21. Franchise Disclosure Document • The Franchise Disclosure • The Franchise Agreement 31
  22. 22. Franchise Disclosure Document • The Exhibits – Guarantees – General Release – Confidentiality Agreement 32
  23. 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. 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. 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. 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. 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. 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. 29. Key Components of Franchise Agreements • Franchisor constrains advertising or manages advertising • Amount franchisees are expected to pay toward franchisor advertising costs 43
  30. 30. Key Components of Franchise Agreements • Operating Protocol • Renewal rights and franchise termination/ cancellation policies • Resale rights – Buyback or first refusal clauses 44
  31. 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. 32. Examples of Product Distribution (Trademark) Franchises • Automotive and Truck Dealers • Gasoline Service Stations without Convenience Stores • Beverage Bottling
  33. 33. Sources of Franchise Business Value
  34. 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. 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. 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. 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. 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. 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. 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
  41. 41. Franchise-Specific Marketability Considerations
  42. 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. 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. 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. 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
  46. 46. Franchised Business Risks
  47. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 60. What Does this all mean to your Valuation?
  61. 61. Using Rules of Thumb? • Rules of Thumb can be problematic, but they address key valuation considerations that need to be addressed 78
  62. 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. 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. 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. 65. Three Approaches to Value 65 Market Approach Asset Approach Income Approach Value Conclusion
  66. 66. Market Approach 66
  67. 67. Market Approach • Market Approach: Comparable Sales – The best comparable transactions are sales of franchises with the same franchisor 82
  68. 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. 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. 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. 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
  72. 72. Asset Approach 72
  73. 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. 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
  75. 75. Income Approach 75
  76. 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. 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. 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. 79. Questions? 79
  80. 80. Theresa Zeidler-Shonat Director of Valuation Services Smith & Gesteland, LLP 608.828.3154 theresa.zeidler-shonat@sgcpa.com 80

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