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What To Consider When Valuing Franchises

Posted in Business Valuation, on May 2019, By: Mark S. Gottlieb

 

A number of years ago I went on a short vacation to Ottawa, Canada.  We stayed at the Fairmont Hotel, which is known for its elegance and convenient locale. Between the hotel and the town center was what we New Yorker’s call a coffee shop or diner.  The storefront was brightly lit, clean, and had a menu the size of a small phone book.  FYI, I grew up in a similar family business, so it was no surprise to my wife that I was drawn to this familiar scene. 

As I often do, I excused myself from the table and walked around to inspect the restaurant while my breakfast was being prepared.  To my delight, the restaurant had an open kitchen and I was able to park myself in a corner and watch the kitchen staff dance with one another between the grill, sandwich board, and refrigeration units.  I was in heaven.  In case you are interested, I was a short-order cook, or what my Pop called a “griddle man”, way before business school.

While returning to my table I observed a series of laminated colored pictures of the most common dishes ordered taped to the exhaust units. I quickly understood they were there so the kitchen staff would know exactly how the food should look.  My immediate reaction was, why didn’t I ever think of that?  What a good idea, especially if you had a number of shifts or stores and wanted everything to look the same.  Upon paying for our meal I noticed a small sign, “Contact Us For Franchising Opportunities”.  It would have never occurred to me that a business of this type is franchised.  After all, most similar businesses, like my Pop’s, were often staffed with family and long-time employees.

Today, there’s more to franchising than fast food restaurants and auto dealerships. Franchising opportunities exist in many different industry segments, including retail, health care, professional services, real estate, education, child care, fitness, and hospitality to name a few. With so many franchising options, one thing is clear: Not all franchises are created equal.

Over the years our firm has been asked to value franchised businesses for a variety of purposes.  In this blog we address some of the items to be considered.

Weigh The Pros & Cons

The nature of franchising may lead you to believe that a franchise is significantly more valuable than an otherwise identical standalone business. But that’s not always the case.

As with any business, the value of a franchise is a function of risk and return. A franchised business may seem to carry little risk because its brand is established and the franchisor provides administrative support, including marketing programs, accounting systems, operating manuals, and training. The franchisor also may pass along volume purchasing discounts from suppliers to its franchisees.

EvaluateThe Return

The franchisor’s support comes at a substantial cost, however, which can vary substantially depending on the franchise you’re investing in. Those costs typically include:

Franchise fee. This upfront charge can generally range from about $50,000 to $200,000.  Though some franchise fees may be higher or lower depending on the brand and geographic market. Additionally, the franchisee must pay professional fees and build-out costs to get started.

Royalties. Once open, the franchisee must pay ongoing royalties to the franchisor that typically range from 4% to 8% of gross revenues and include an ongoing assessment for a joint marketing and advertising fund. The franchisee also may be required to purchase uniforms, inventory and other supplies from the franchisor, as well as update the facilities to comply with the franchisor’s appearance standards.

As a result of these costs, most franchisees don’t report positive operating cash flow until they’ve been in business for several years. To help forecast revenue and costs, a business valuation expert will ask for a copy of the franchise disclosure document. Required by the Federal Trade Commission, this document provides insight into start-up costs and fees, average monthly sales, and projected revenue growth.

Beware Of Restrictions

A franchised business may look even less attractive to investors if the franchisor restricts the owner’s actions. Examples include covenants that restrict independent marketing efforts, relocation and ownership transfers.

Business valuation professionals review the franchise agreement to get a handle on these restrictions. A discount may be warranted if the agreement limits the franchisee’s rights to expand, sell to a third party, or respond to changing trends and market demographics.

Consider Market Trends

When valuing a franchise, experts typically evaluate how the brand and the industry measure up to others. Franchisees are most satisfied when franchisors continually reinvent their brands and offerings, invest in training programs, support customer retention efforts and grant flexibility to respond to changing market conditions. Strong franchisors also adapt to regulatory changes, such as emerging tax laws, health care reporting requirements, and minimum wage and overtime rules.

Each year, the Franchise Business Review surveys franchisee satisfaction for hundreds of brands. Valuation experts may be able to download a free satisfaction “snapshot” from this source when considering how a particular brand ranks among its comparables.

Need Help?

When valuing a franchise, it’s important to understand the relationship between the franchisee and its franchisor. Risk and control are considerations when valuing any business. On the one hand, franchisors may lower risk by providing support and brand recognition. On the other, franchisors may exercise control over a franchisee, detracting from the value of a franchise. A business valuation expert can help you evaluate the upsides and downsides of investing in a franchise.

If you have questions about this or any other valuation issues feel free to contact me at the above phone numbers.  I can also be reached via email at msgcpa@msgcpa.com

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