franchise valuation asa feb 2015 v2-20-15
TRANSCRIPT
The Impact of Franchise Agreements on Small Business
Valuation
Theresa Zeidler-
Shonat
Director of
Valuation
Service
Content Overview
Today’s Mission
Franchise Rights and Organization
What is a Franchise?
• Simply put: : the right to sell a
company's goods or services in a
particular area; also : a business that is
given such a right
13
Forms of Franchising
• Single Unit Model
• Master Franchising Model
• Regional Developer
14
Single Unit Model
Franchisor
Franchisee Franchisee Franchisee Franchisee
15
Master Franchising Model
Franchisor
Master Franchisee
Franchisee Franchisee
Master Franchisee
Franchisee Franchisee
16
Regional Developer
• Has the rights to market and award
franchises within a defined region
• Acts like franchisor within that region
17
Franchises and the Economy
Sources of Franchise
Information• U.S. Census Bureau
• IHS Global Insight & IFA Franchise
Business Economic Outlook for 2014
• IFA (International Franchise
Association)
Franchises in the U.S.
• IHS and the IFA estimate that in 2013 there
were:
• 757,453 franchised businesses in the United States
• employing 8.3 million people
• with an output of $801 billion.
18
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)
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.
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.
Franchise Output Per Worker
• For 2013 according to IHS and IFA:
– Automotive franchise employees had
the most output per employee with
$212,301,
– Real Estate had the second highest
output at $161,022 per worker,
– Business Services had the third highest
output with $159,439 per worker.
Three Essential Characteristics of
a Franchise System
26
Trademar
k
Significan
t
Control
Required
Payment
Trademark
• A franchisor creates a brand identity
for a product or service
• The brand identity normally includes
products or services that bear a
trademarked symbol or name
27
Significant Control
• The franchisor exercises significant
control over the franchisees’
operations
• This typically includes following certain
standards for representing the brand
and for service and product delivery
28
Required Payment
• In return for the use of the
trademarked product or service and
other benefits of being part of the
franchise system, the franchisee pays a
fee, royalty, or other amount to the
franchisor
29
The Documents that Govern the
Franchise Relationship
30
Franchise Disclosure
Document• The Franchise Disclosure
• The Franchise Agreement
31
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 Disclosure
Statement Document
– Operations Manual Table of Contents
33
Franchise Agreement
• A Franchise Agreement is a legal, binding contract
between a franchisor and franchisee
• Prior to a franchisee signing a contract, the U.S. Federal
Trade Commission regulates information disclosures under
the authority of The Franchise Rule
• .
34
Franchise Agreement
• The Franchise Rule requires a
franchisee be supplied a Uniform
Franchise Offering Circular (UFOC) or
Franchise Disclosure Document (FDD)
prior to signing a franchise agreement
a minimum of fourteen days before
signing a franchise agreement
35
Franchise Agreement
• Once the Federal fourteen-day
waiting period has passed, the
Franchise Agreement becomes a
State level jurisdiction document. Each
state has unique laws regarding
franchise agreements.
36
Key Components of Franchise
Agreements
• Training and/or support provided by
the franchisor
• Assigned Territory and Rights
– Can be exclusive or non-exclusive
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
Key Components of Franchise
Agreements
• Franchisor constrains advertising or
manages advertising
• Amount franchisees are expected to
pay toward franchisor advertising costs
43
Key Components of Franchise
Agreements
• Operating Protocol
• Renewal rights and franchise
termination/
cancellation policies
• Resale rights
– Buyback or first refusal clauses
44
Examples of Business Format
Franchises• Automotive
• Commercial and Residential Services
• Quick Service Restaurants
• Table/Full Service Restaurants
• Retail Food
• Lodging
• Real Estate
• Retail Products and Services
• Business Services
• Personal Services
47
Examples of Product Distribution
(Trademark) Franchises
• Automotive and Truck Dealers
• Gasoline Service Stations without
Convenience Stores
• Beverage Bottling
Sources of Franchise Business Value
Sources of Business Value
• The value that arises from the future
stream of expected profits on the
current brand in the current market
area
50
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
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
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
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
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
Valuation Considerations
• Determinants of value
• Demand for the product provided by the business?
• Industry growth
• Competition
• Business lifecycle
• Seasonality• Location
• Amount of capital required to run the business
• Management team
• Franchise Specific– Royalties
– Limits on Expansion
– Restricted ability to make business decisions (menu offerings, services, etc.)
– What is buried in the franchise agreement
Franchise-Specific
Marketability Considerations
Marketability
• Well established franchises/brands
– There are known players – franchisees that
have a relatively large number of
locations that are likely interested in
buying franchises that become available
– It’s almost like an exchange for
established businesses
• Less well established brands don’t
have this
56
Franchises Can Impede
Marketability
• Franchisors typically have the Right of
First Refusal on any sale of the business
– Franchisor is always a potential bidder
– Franchisor knows more about an
available franchise than any other
potential bidder
– Any outside bidder would have to expend
a great deal of money and effort to even
approach the franchisor’s knowledge of
the available franchise57
Franchises Can Impede
Marketability– Without that knowledge, the outside
bidder may bid too low and lose out to the franchisor or bid too high and make a bad deal
– Because the franchisor may have special interest in expanding its position, it might have the tendency to drive up the price beyond what a potential buyer might be willing to pay based on the present value of the cash flows
• These factors can act as a significant deterrent to would-be bidders
58
Market Considerations: Buying a
Franchise
• Acquiring an Existing Franchise
Location
– Same process as buying any other
business with addition of
• Approval of franchisor
• Starting a new franchise location
– Same as any other start-up decision with
the addition of
• Evaluation of franchise-specific costs,
risks rewards61
Franchised Business Risks
Sources of Risk to Franchise
Businesses
• Variety of different sources of risk to a
franchise business
– Normal business and industry risk
– Risk associated with terms and conditions
of franchise agreement
– Risk associated with risk of franchisor
– Risk associated with being unable to
manage brand
63
Franchise Disputes
• Franchise disputes can represent a
significant risk to franchisee
– One potential outcome is the loss of
ability to continue doing business
64
Franchise Disputes
• What drives disputes?
– Business issues (cash flow issues, lack of
profitability)
– Differing expectations
– Changes in the relationship
– Market- or competition-driven changes
– Inconsistencies in treatment, including
means of dispute resolution
– Lack of clarity in franchisor
communications 65
Impact on Business Value
• When circumstances exist that could
trigger a franchise dispute, there is a
negative impact on business value
– Either take a probabilistic approach to
cash flows or account for extra risk in
discount rate
66
Rules Change Quickly
• Rules can change very quickly –
franchisees have no control over
changes
– Restaurant makes $300k in improvements
to dining area
– Franchisor changes restaurant
design/layout and franchisee is required
to make changes despite recent
improvements
67
Impact on Valuation
• Request or research information on
how often the franchisor changes
requirements or if franchisee is aware
of planned changes
– If the franchisor has the tendency to
make changes, include adjustments for
this risk in the cash flows or discount rate
68
Franchises Are Contract
Rights• Franchises are contract rights, not
outright ownership
– The full bundle of rights attributable to
owning an asset is absent in the franchise
agreement
– Whatever benefits exist are found in the
franchise agreement
69
Franchise Agreements Need to
Be Evaluated Like All Other
Contracts• Advantageous to franchisee?
– What is gained?
• Disadvantageous to franchisee?
– Costs or requirements outside of the
franchisees best interests?
70
Franchise Agreements Need to
Be Evaluated Like All Other
Contracts• Does the franchisor have history of
premature termination of franchise
agreements?
• Does the franchisor have any history
regarding breach of contract claims
and litigation?
72
Opportunity Cost for
Franchisee• Even large, established franchisees are
not expecting to get rich – it’s a job
• Franchisors worry more about their
stock price and the top-line than
franchisee profitability and actively
manage franchises this way
73
The Threat of Non-Renewal
• Franchisors keep franchisees “in line” with renewals. Franchises are renewed every 10 to 15 years. Franchisors use the threat of non-renewal to keep franchisees in line with their business plans.
Significant Training Time
• Franchisee training time
– New franchisees must undergo significant
amounts of training prior to running the
business
– This is time for which they are not
compensated
75
Training Time Impact on
Valuation• Increases the initial investment
required
– Franchisee must have sufficient ability to
support themselves while not being
compensated
• Also increases required total return for
franchisee
76
What Does this all mean to your Valuation?
Using Rules of Thumb?
• Rules of Thumb can be
problematic, but they
address key valuation
considerations that
need to be addressed
78
Inherent or Implied in Rules of
Thumb
• A cost of capital
• Ratio based on operating costs or net
profit
• Expectation of future growth
• An assessment of brand strength or risk
• An assumption about the scale of the
enterprise
• Other things necessary to complete
the valuation 79
Why Are Rules Of Thumb
Problematic?
• They miss:
– Changes in brand strength or weakness
– Location factors
– Changes in the franchise relationship or
agreement
80
Using Rules of Thumb
• Rules of thumb are best used by
individuals with very deep knowledge
of the industry, company and area
– They may be best to use as a check or to
corroborate a value conclusion achieved
via other methods rather than relying
on them
81
Three Approaches to Value
65
Market
ApproachAsset
Approach
Income
Approach
Value Conclusion
Market Approach
66
Market Approach
• Market Approach: Comparable Sales
– The best comparable transactions are
sales of franchises with the same
franchisor
82
Market Approach
• 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
Market Approach
• Market Approach: Comparable
Sales
– This data, searchable by franchisor, is
generally not available in any of our
typical transaction databases
• There are sales of franchise locations in
the databases but not comparison to
other sales within the same franchise
system/subject to the same franchise
agreement
84
Market Approach
• 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
Market Approach
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SIC Code Industry
Franchise
Transaction
Count
Non-Franchise
Transaction
Count
Franchise Average
MVIC to Sales
Non-Franchise
Average MVIC to
Sales
Franchise %
Non-Franchise
5812 Eating Places 272 1,783 0.46 0.41 113%
7231 Beauty Shops 3 351 0.28 0.40 70%
7349 Building Cleaning and Maintenance Services 20 209 0.58 0.66 88%
7389 Business Services, Not Elsewhere Classified 26 383 0.48 0.97 49%
7538 General Automotive Repair 21 204 0.33 0.44 76%
7991 Physical Fitness Facilities 18 95 0.68 0.67 101%
8299 Schools and Education Services, NEC 68 50 0.72 0.96 75%
Data: Pratt's Stats 1/1/03 through 11/24/14
Transaction Multiples: Franchised Businesses Compared With Non-Franchised Businesses
Asset Approach
72
Cost Approach
• Recall that the cost approach is
predicated on the assumption that no
rational buyer would pay more for a
company or asset than it could be re-
created for
89
Cost Approach
• The Cost Approach needs to consider
not only the cost of the assets on the
balance sheet, but also the franchise-
specific start-up costs
– Recall: training time isn’t compensated for
90
Income Approach
75
Income Approach
• More than the impact of the franchise
on the top line needs to be considered
• Costs can be different in a franchised
business
– Advertising expenditure is outside the
control of the business owner
– Will royalty payments change?
87
Evaluating Royalty Payments
• Knowing whether or not the company
is paying a reasonable royalty rate
can be important to the valuation
• Compare to royalty rates paid to
similar franchisors
– This can be tricky because it
depends on other factors in the franchise
agreement
88
Summary
• Valuing franchised businesses is similar
to valuing any other small business in
many ways
• However, there are a number of
franchise specific benefits and risks
that need to be considered in coming
to your
conclusion of value
92
Questions?
79
Theresa Zeidler-Shonat
Director of Valuation Services
Smith & Gesteland, LLP
608.828.3154
80