Many aspire to build their own start-up that could help then leave the rat race and one of the options of the general public is to open a franchise. An easier alternative than opening your own start up. In this article we explore how to value a franchise business and see if they are worth the money.
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 the franchise 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.