Valuing a Franchise Business
The intangible value
or “goodwill” of a franchise depends largely on the terms of the franchise
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.
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
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
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
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
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. ■