By Nevin Sanli, ASA and Barry Kurtz
Printed in Franchise Law Journal – Fall 2006
Through its relationship with the franchisor, the franchisee, on the other hand, possesses the right to use these assets in its business but usually owns only the tangible assets it needs to conduct business, including equipment, inventory, and supplies. The franchisor may own or lease real estate, leases, and equipment and subleases these items to the franchisee, or the franchisee may own or lease these items directly.
What Is a Franchise?
Whatever the details of the particular arrangement, the task for the appraiser is to discover the degree to which each asset contributes to the success of the operation as a whole—a job that is more easily said than done.
The process begins with an understanding of the franchise relationship as defined in state law. Under the laws of many states,1 a franchise relationship exists when the following occurs:
As these terms suggest, the relationship between the franchisor and the franchisee is intimate and ongoing. But since each party owns different assets but puts them to use in a joint effort, it is often not readily apparent exactly how much each asset contributes to the value of any given enterprise. Indeed, given the differences in the assets owned by the parties in the enterprise, franchisors and franchisees in many ways engage in different businesses that create value when joined together.
Appraising the Franchisor’s Value
Consider the franchisor first. As owners and
This skill can create substantial value in
Thus, given the importance of intellectual assets in a well-managed franchise operation, the process of valuing the business begins with an assessment of the premium commanded by the franchisor’s brand
The franchisor’s growth prospects are also important in
Franchise Agreements Drive Value
The agreements between franchisors and franchisees are also important in
Although franchisors derive much value from the management of their intellectual property, such items as real estate and equipment must also be considered. The more of these assets the franchisor owns, the better. They generate rental income for the franchisor in addition to the royalty and fee income from franchisees with relatively predictable
Royalties reflect the marketplace value of the franchisor’s intellectual
Up-front franchise fees paid by new franchisees reflect marketplace value as well. Some top-tier franchisors charge as much as $1 million per store and sometimes more, with an obvious impact on value.
Don’t Try This at Home
Why Are Franchises Worth More?
There is no doubt that, comparing apples to apples, a franchised business is likely to be more valuable than a nonfranchised business. But no one factor accounts for this truth, according to researchers at the University of New Hampshire.
“Franchising firms minimize agency problems and have access to cheaper capital, motivated managerial expertise, and better local market knowledge,” according to E. Hachemi Aliouche and Udo Schlentrich, senior research fellow and director, respectively, of the William Rosenberg International Center of Franchising at the University of New Hampshire, in their 2005 study Does Franchising Create Value? An Analysis of the Financial Performance of U.S. Public Restaurant Firms.1
Franchised businesses minimize agency problems (that is, the
It is also true that successful franchisors, keenly aware that their
Last, but not least, because of the maze of federal and state laws, statutes, and regulations that require franchisors to treat franchisees fairly and openly, franchisors tend to keep better books, i.e., audited financial statements, than do many nonfranchised businesses. Thus, when a franchised business goes on the block, potential buyers gain increased confidence that the numbers they see on the franchisor’s financial statements represent the true state of the business.
The accompanying charts bear this out. We analyzed transaction data reflecting sales of 77 franchised and 356 nonfranchised restaurant companies over five years beginning January 2001, showing clearly that franchised restaurant companies command higher prices when they are offered for sale.
As chart A shows, over the five-year period the mean multiple of deal price to EBITDA was 4.11 among franchised restaurants versus 3.30 for nonfranchised restaurants. It was not uncommon for successful franchised restaurants to command multiples of eight times EBITDA. The mean multiples of deal price to EBIT were 4.68 and 2.94, respectively, and the mean multiples of deal price to discretionary cash flow were 2.93 versus 2.29.
Meanwhile, as chart B shows, the median multiple of deal price to EBITDA was 3.80 for franchised restaurants versus 2.58 for nonfranchised restaurants. The median multiples of deal prices to EBIT were 3.47 versus 2.19, respectively, and those of deal price to discretionary cash flow were 2.66 versus 1.84.
Thus, it is not surprising that franchised businesses as a whole play an
In 2001, the most recent year for which data were available, franchised businesses provided jobs for nearly 9.8 million people, or 7.4 percent of all private-sector jobs—about the same number of jobs attributable to all U.S. manufacturers of durable goods, including cars, trucks, aircraft, computers, communications equipment, wood products, and instruments of all kinds, according to the study.2 In addition,
NEVIN SANLI AND
Terms of Agreement?
Franchisors and franchisees frequently contest other terms in their legal
1. Fifteen states have franchise registration and disclosure statutes. See CAL. CORP. CODE ANN. § 31110 (Deering Supp. 2004); HAW. REV. STAT. ANN. § 482E-3(b) (Michie 2004); 815 ILL. COMP. STAT. 705/10 (2004); IND. CODE ANN. § 23-2-2.5-9(1) (Michie 2004); MD. CODE ANN., BUS. REG. § 14-214 (2004); MICH. COMP. LAWS § 445.1507a (2004); MINN. STAT. ANN. § 80C.02 (West 2003); N.Y. GEN. BUS. LAW § 683 (McKinney 2004); N.D. CENT. CODE § 51-19-03 (2003); OKLA. STAT. ANN. tit. 71, § 806 (West 2004); R.I. GEN. LAWS § 19-28.1-5 (2004); S.D. CODIFIED LAWS § 37-5A-6 (Michie 2004); VA. CODE ANN.
§ 13.1-560 (Michie 2004); WASH. REV. CODE ANN. § 19.100.020 (West 2004); WIS. STAT. ANN. § 553.21 (West 2003). Oregon law does not require a franchisor to register but is considered to be a registration state because it does require proper disclosure by the franchisor. See OR. REV. STAT. § 650.010 (2003). See also Mark Miller, Unintentional Franchising, 36:2 ST. MARY’S L.J. 331 nn.27, 28 (2005).
In addition, nineteen states—Arkansas, California, Connecticut, Delaware, Florida, Hawaii, Illinois, Indiana, Iowa, Kentucky, Michigan, Minnesota, Mississippi, Missouri, Nebraska, New Jersey, Virginia, Washington, and Wisconsin—have franchise and distribution relationship laws on the books. Id. Even business arrangements that are drafted to avoid regulation as a franchise may fall under the FTC Rule (see endnote 2) and state business opportunity laws. Twenty-three states have enacted business opportunity laws. See also PHILIP F. ZEIDMAN, FRANCHISING AND OTHER METHODS OF DISTRIBUTION, 1526 PLI/Corp 461 (Practising Law Inst. 2006); Leonard D. Vines, Gina D. Bishop & Rupert M. Barkoff, Damage Control for Violations of Registration and Disclosure Obligations, 24:4 FRANCHISE L.J. 191, 199 n.1 (2005).
2. Fed. Trade Comm’n, Disclosure Requirements and Prohibitions Concerning Franchise and Business Opportunity Ventures, 16 C.F.R. § 436.2(a)(1)(i) (FTC Rule).
3. A Rhode Island case, Guzman v. Jan-Pro Cleaning Systems, Inc., 839 A.2d 504, Bus. Franchise Guide (CCH) ¶ 12,695 (R.I. 2003) shows what can go wrong when the right factors do not receive the proper weighting. In Guzman, the Rhode Island Supreme Court ruled that the trial court had erred in accepting a valuation provided by the franchisee’s accountant rather than that offered by the franchisor’s expert witnesses, one of them an expert in the commercial cleaning business and the other a professional business valuator. The accountant relied on generally accepted accounting principles in deriving a valuation but did not factor labor, payroll taxes, or other operating costs into his calculations. The franchisor’s expert witnesses, on the other hand, showed the accountant’s valuation to be substantially inflated by presenting detailed figures representing typical costs in these and other categories among commercial cleaning franchisees nationwide.
4. See BARTH H. GOLDBERG, VALUATION OF DIVORCE ASSETS § 12.6, at 315 (1984):
Obviously, each attorney knows that during the past 25 years this nation has seen a vast rise in the number and types of franchises granted to individuals, whether in the hotel industry, the fast food industry, or otherwise. Thus it has become commonplace for many spouses to have franchises, the rights to which must be fully explored and their valuation determined; e. g., a husband may be a franchisee of a McDonald’s hamburger restaurant.
At time of dissolution, both community property and equitable distribution must value marital assets. Generally, these assets are easily valued, though some are more difficult than others.Yet one group of assets invariably causes great difficulty at the time of dissolution when valuations are requisite: the intangible assets, and the like.
See also, with respect to intangible property treated as community property, In re the Marriage of Hewitson, 191 Cal. Rptr. 392 (Cal. Ct. App. 1983); In re the Marriage of Monslow, 912 P.2d 735 (Kan. 1996) (affirming lower court decisions that awarded patents to husband, subject to a lien of 40 percent of the net income from the patents in favor of the wife); 2 RUTKIN, VALUATION AND DISTRIBUTION OF MARITAL PROPERTY, 23.07 , at 23-133-35 (1995).
5. In Redevelopment Agency of the City of Concord v. International House of Pancakes, Inc., 12 Cal. Rptr. 2d 358 (Cal. Ct. App. 1992), the California Court of Appeal ruled that state law specifically precluded a franchisor from obtaining compensation for loss of goodwill in a condemnation proceeding. The ruling noted that under the terms of most franchise agreements, no partnership, joint venture, or agency relationship exists between franchisor and franchisee, which the court characterized as “independent contractors,” and that compensation for loss of goodwill should flow exclusively to the franchisee.
6. See William L. Killion, Franchisor Vicarious Liability—The Proverbial Assault on the Citadel, 24:4 FRANCHISE L.J. 162 (2005).
7. Uneven application of vicarious liability demonstrates “how different courts evaluating the very same franchisor controls reach opposite conclusions about the vicarious liability of a franchisor.” Id. at 165. Compare Hoffnagle v. McDonald’s Corp., 522 N.W.2d 808, Bus. Franchise Guide (CCH) ¶ 10,570 (Iowa 1994) (franchisor not liable for third-party assault of franchisee’s employee because it did not control day-to-day operations), with Miller v. McDonald’s, 945 P.2d 1107, Bus. Franchise Guide (CCH) ¶ 11,248 (Or. Ct. App. 1997) (franchisor found liable when franchisee’s customer bit into a gemstone that had fallen into a Big Mac).
Published in Franchise Law Journal, Volume 26, Number 2, Fall 2006. © 2006 by the American
Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.