April 2004

Valuing a Franchise Business

The intangible value or “goodwill” of a franchise depends largely on the terms of the franchise agreement

A large number of businesses operate as franchises, in which a separate entity (the franchisor) creates a brand identity for a product that is sold through a system of franchised retailers (the franchisees).

Typically, the franchisor has a contractual right to specify certain marketing and operational practices and define franchisees’ geographic territories. The franchisee generally pays a royalty and advertising allowance to the franchisor in return for the exclusive right to sell a product or service within the defined geographic area. A typical franchise agreement sets forth the provisions under which the franchisee may utilize the franchisor’s trade name and trademark; it also specifies the term, required marketing assistance, method of product distribution, and other factors that define the legal relationship between the two parties.

Valuation Peculiarities

Because many franchise agreements prohibit the franchisee from selling his business to a third party or require approval by the franchisor, the purposes for business valuation in a franchise setting are narrower than those involving an independent company.

Still, for a variety of reasons – marital dissolution, estate planning, taxation, etc. – the value of a franchise may need to be determined. In the process, it is usually necessary to determine the intangible value or goodwill of the business.

The intangible value of any business is the difference between the total value of the business as a going concern and the total value of the business’s tangible assets. The difference arises because the earnings of a business depend not only on its tangible assets (e.g., cash, inventory, and fixed assets) but also on such intangible factors as location, customer relationships, and reputation. When those factors are transferable to a third-party buyer, they take on value that drives up the purchase price.

Fast food restaurants such as McDonald’s, Subway or Burger King operate using a franchise system in which the franchisees concede varying amounts of autonomy to the franchisor in exchange for the right to use the brand name and benefit from the franchisor’s extensive marketing. The profits of each franchise location result from the combined efforts of the franchisor and franchisee.

The franchisor-franchisee relationship creates special nuances for the valuation of intangible value. When a non-franchised business has a fair market value in excess of its tangible assets, it can be assumed that the difference is due to factors created or controlled by the owner of the business. That conclusion may not hold true, however, in the setting of a franchise, since the income of a franchise business results from the efforts of two different entities: the franchisor and the franchisee.

To classify and value the intangible assets of a franchise business, the valuation professional must distinguish between the intangible value of the franchisor, embodied in the franchise agreement, and the intangible value of the franchisee.

The relevant question: In the event of a loss of the franchisor brand name, would customers continue to patronize the business to such an extent that there would still be goodwill in the business?

Allocation of Goodwill

In allocating the intangible value between the franchisor and the franchisee, the valuation professional must determine the extent to which each party’s actions created the intangible value at issue. However, in the great majority of cases, earnings probably result from the conduct of both parties to the franchise agreement.

There are at least three chief variables in allocating goodwill between the parties.

• Control. Where the franchisee’s operations are heavily regulated by the franchisor, the intangible value is more likely to come from the franchisor. Conversely, loosely regulated franchisees have considerable opportunity to acquire their own intangible value.

• Advertising and Brand Recognition. In many businesses, advertising is essential to the development of a loyal customer base. Most franchise businesses concentrate advertising activity at the national or regional levels; therefore, that factor most often favors the franchisor.

• Location. Just as advertising often favors the franchisor in allocating value, location generally favors the franchisee. Location is obviously a factor where, such as in the fast food industry, a particular desirable location is key to the earnings of the business. Where location is a factor, it should logically favor the party who has the right to use the location in the future.

If the franchisee retains the right to operate a restaurant in its present desirable location while switching franchisors or even becoming independent, location-based intangible value would obviously survive the transfer. In this case, location favors the franchisee. If the right to operate a location-dependent business at a particular location resides with the franchisor, not a great deal of intangible value would be allocated to the franchisee.

In our opinion, one of the best methods of allocating the intangible value between the franchisee and franchisor is to compare how the business ranks relative to other franchisees operating under the same franchise system. Where the earnings are all in line with or below the concept averages, the individual franchisee intangible value is probably not present. Where earnings are above the relevant concept averages, allocation of some portion of the intangible value to the franchisee would seem to be appropriate.

Summary

In the end, the intangible value that is allocable to the franchisee will be determined largely by the franchise agreement. If the intangible value specific to the franchisee must be determined separate from the intangible value attributable to the franchisor, the valuation professional should review the franchise agreement thoroughly so that the prerogatives of each party, as well as the transferability of the franchise, are well understood.

The franchise agreement will also allow the valuation professional to gauge the risks of the franchisee losing the franchise relationship and to factor that risk factor into the valuation process.

In the end, if it is determined that some of the intangible value is due to the attributes of the specific franchisee, the allocation should compare the franchisee’s earnings to the typical earnings of others in the same franchise system. ■