pg_0001

ppraisers operate on the

presumption that however

different the individual

business is from all others, busi-

nesses within a specific industry

nonetheless share certain charac-

teristics that make it possible to

compare one to another and thus

derive a value.

Franchise operations, however,

are a breed unto themselves, and this

makes the valuation of these enter-

prises a unique process. The chief

reason for this is the fact that the

relationship between franchisors and

franchisees is a business partnership

in which each party owns and

derives value from different forms

of property. Typically, the fran-

chisor owns and manages only the

intellectual property involved in the

relationship, such as goodwill,

logos, brands, trademarks, advertis-

ing slogans, and business systems

and processes (for example, recipes

in the case of the fast food franchisor). The franchisor generally

does not engage in the delivery of products or services to the con-

sumer unless, of course, it operates company-owned stores or

manufactures or sells products to its franchisees.

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 sup-

plies. 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 rela-

tionship as defined in state law. Under the laws of many states,

franchise relationship exists when the following occurs:

Nevin Sanli (nsanli@sphvalue.com) is president and cofounder of Sanli

Pastore & Hill, Inc., and an Accredited Senior Appraiser (ASA), Busi-

ness Valuation Discipline, of the American Society of Appraisers.

Barry Kurtz (bkurtz@barrykurtzpc.com.), a specialist in franchise law,

is of counsel to the Encino, California, law firm Greenberg & Bass.

Appraisal of Franchises Requires the Use of

Unique Valuation Procedures

EVIN

ANLI

, ASA,

AND

ARRY

URTZ

• The franchisee offers, sells, or distributes goods or services

under a marketing plan or system “prescribed in substantial

part” by the franchisor. This means that the franchisor pro-

vides the franchisee with advice and training, retains signifi-

cant control over the conduct of the franchisee’s business,

grants the franchisee exclusive rights to operate in a given

territory, or requires the franchisee to purchase or sell a

specified quantity of the franchisor’s goods or services.

• The franchisee’s business is “substantially associated” with the

franchisor, meaning that the franchisee uses the franchisor’s

trademark and advertising slogans to identify its business.

• The franchisee pays a franchise fee to the franchisor to

engage in business, plus royalties on sales and possibly pay-

ments for inventory, supplies, training, and assistance.

As these terms suggest, the relationship between the fran-

chisor 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 managers of

intellectual property, franchisors generally do not earn profits

directly from the sale of the products or services bearing their

names at all. Hence, the value of the franchisor’s business

operation derives mainly from the skill with which the fran-

chisor manages its intellectual property and, importantly, the

relationships with its franchisees.

This skill can create substantial value in franchise versus non-

franchise operations. For example, assume two restaurant com-

panies selling the same fast food products and generating equal

revenues and profits. The first is a franchisor owning no tangible

assets (that is, no real estate, no equipment, no outlets, etc.), and

the second is a chain operation owning all of its outlets. In a sale,

the franchisor might command a multiple of six to eight times

EBITDA (Earnings Before Interest, Taxes, Depreciation, and

Amortization), and the nonfranchisor a multiple of only four to

five times EBITDA. It should be noted, however, that skill in

managing intellectual property is not the only factor in creating

this difference (see sidebar on page 68).

Thus, given the importance of intellectual assets in a well-man-

aged franchise operation, the process of valuing the business begins

with an assessment of the premium commanded by the franchisor’s

brand over similar generic brand products, and it continues with a

step-by-step calculation of the values associated with every other

item in the franchisor’s inventory of intellectual property.

Nevin Sanli

Barry Kurtz

or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.

pg_0002

and risk their own capital only if they are confident that they have

the managerial skill and market knowledge to succeed.

It is also true that successful franchisors, keenly aware that

their intellectual property is their core asset, develop substan-

tial skill in managing it, thereby adding to the inherent value

of a franchised business.

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 nonfran-

chised businesses. Thus, when a franchised business goes on the

block, potential buyers gain increased confidence that the num-

bers they see on the franchisor’s financial statements represent

the true state of the business.

The accompanying charts bear this out. We analyzed trans-

action data reflecting sales of 77 franchised and 356 nonfran-

chised 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 mul-

tiple 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 com-

mand 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 increasingly important role in the U.S. economy, as

borne out by the University of New Hampshire study.

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 equip-

ment, wood products, and instruments of all kinds, according to

the study.

In addition, franchised businesses met payrolls exceed-

ing $229 billion and generated nearly $625 billion of output, con-

stituting nearly 4 percent of all private-sector output.

EVIN

ANLI AND

ARRY

URTZ

Endnotes

1.Available at www.unh.edu/news/docs/franchisingvaluereport.pdf.

2. E

CONOMIC

MPACT OF

RANCHISED

USINESSES IN THE

NITED

TATES

1 (IFA 2004) (comprehensive study conducted by

PricewaterhouseCoopers for the International Franchise Association

Educational Foundation), available at www.franchise.org/files/-

EIS6_2.pdf

There is no doubt that, comparing apples to apples, a fran-

chised business is likely to be more valuable than a nonfran-

chised 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 direc-

tor, 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.

Franchised businesses minimize agency problems (that is, the

problems facing any principal who delegates decision-making

authority to an agent hired to provide a service) by giving the

agent/franchisee powerful incentives to do well, according to the

researchers. Franchised businesses gain access to cheaper capital

by requiring new franchisees to front certain start-up costs, in

essence requiring new franchisees to become suppliers of expan-

sion capital for the franchisor. And franchised businesses gain

access to motivated managerial expertise and local market knowl-

edge because it is a good bet that new franchisees will sign on

Why Are Franchises Worth More?

or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.

pg_0003

The franchisor’s growth prospects are also important in deriv-

ing value. How large is the universe of possible buyers for the

franchisor’s product or service? Where are these buyers? How

many more territories must the franchisor open up to reach these

buyers? How long will it take the franchisor to do this? What will

this effort cost? What revenues and profits will it produce?

Franchise Agreements Drive Value

The agreements between franchisors and franchisees are also

important in driving value, particularly those governing the

rights of each party when renewing the arrangement. These

may permit the franchisor, for example, to increase royalties,

fees, or rents, or require franchisees to remodel their outlets,

upgrade their equipment, etc. The more these terms favor the

franchisor, the more value they yield for that party—and,

often, the less for the franchisee.

Although franchisors derive much value from the management

of their intellectual property, such items as real estate and equip-

ment must also be considered. The more of these assets the fran-

chisor owns, the better. They generate rental income for the

franchisor in addition to the royalty and fee income from fran-

chisees with relatively predictable increases over time.

Royalties reflect the marketplace value of the franchisor’s

intellectual property, and because competition is extensive in

many franchising niches, royalties are also relatively pre-

dictable. In most cases, data are readily available on royalty

rates, making it possible to judge their impact on the value of a

franchise operation. In the fast food industry, for example,

royalty rates typically range between 3 and 8 percent, with

most franchisors charging 6 percent or less.

Up-front franchise fees paid by new franchisees reflect mar-

ketplace value as well. Some top-tier franchisors charge as

much as $1 million per store and sometimes more, with an obvi-

ous impact on value.

Don’t Try This at Home

Clearly, these factors make for a complex valuation process

best left to professionals who understand how to give proper

weight to each of the factors in question.

The process begins

with an assessment of the franchisee’s hard assets, including

plant, equipment, supplies, and inventory. In addition, it is

necessary to judge how much value the franchisee derives

from its association with the franchisor. It is also important to

judge the franchisee’s production capacity and its right to

expand into new territories. Local economic and social condi-

tions may enhance or diminish profitability and hence value.

When valuing a master franchisee, the questions begin with

whether state law gives the master franchisee the right to bargain

over royalties, fees, territories, and other factors. If so, what value

does the master franchisee derive from this right? Does the master

franchisee achieve economies of scale by operating its own train-

ing program, by reducing the cost of supplies through bulk pur-

chases, or by negotiating special real estate leasing terms?

The Internet

In recent years, the Internet has become another source of

value for both franchisors and franchisees, and sometimes a

point of contention between them. Does the franchisor possess

the sole right to sell to catalog or Internet customers within the

territories of its franchisees? If so, this may increase value for

the franchisor and decrease it for the franchisees. Conversely,

if the franchisees have the right to sell to catalog or Internet

customers irrespective of territory, the impact on value for the

franchisor is obvious.

To avoid conflict over Internet sales, many franchise agree-

ments give franchisors sole right to such sales but require

them to funnel orders to franchisees in whose territories the

sales originate, thus enhancing value for both enterprises.

Nevertheless, the remaining gray areas give rise to a good deal

of litigation between franchisors and franchisees over the

value of intellectual and other items of property that are held

by each party, with consequent impact on value for each. Most

franchise agreements specify that goodwill, for example, is the

sole property of the franchisor as an item of intellectual prop-

erty, but case law shows that a franchisee’s specific goodwill

can become an item of community property in a divorce

action.

In addition, under certain circumstances a franchisee

may generate goodwill specific to its own operations and

hence lay claim to compensation for its loss when a local gov-

erning body condemns the property on which the franchisee

operates in an eminent domain action.

Terms of Agreement?

Franchisors and franchisees frequently contest other terms in

their legal arrangements, including those that permit fran-

chisors to terminate agreements with undesirable franchisees.

Hence, it is necessary to step carefully when judging the

impact of such terms on valuation. Not surprisingly, many

such terms affect franchisors and franchisees in opposite ways.

If the franchisor, for example, has ample leeway to terminate

undesirable franchisees, this will tend to enhance the valuation

of the franchisor and depress that of the individual franchisee.

Conversely, an agreement giving the franchisee solid renewal

or territorial rights favors the franchisee but may reduce the

growth prospects and hence the value of the franchisor.

Impact of Liability on the Franchise

Liability can also affect valuation. Most franchise agreements

specify that franchisors are not liable for the debts or torts of

franchisees and vice versa. Even so, plaintiffs commonly try to

involve franchisors in any liability action against franchisees

on the theory that the franchisor is likely to have the deeper

pockets.

The courts may side with plaintiffs where the fran-

chisor exercises enough control over the franchisee to trigger

vicarious liability, for example, when the franchisor requires

the franchisee to follow an employee manual produced by the

franchisor.

Endnotes

1. Fifteen states have franchise registration and disclosure statutes.

See C

. C

ORP

. C

ODE

. § 31110 (Deering Supp. 2004); H

. R

TAT

. A

. § 482E-3(b) (Michie 2004); 815 I

. C

OMP

. S

TAT

. 705/10

(2004); I

. C

ODE

. § 23-2-2.5-9(1) (Michie 2004); M

. C

ODE

., B

. R

. § 14-214 (2004); M

ICH

. C

OMP

. L

AWS

§ 445.1507a

(2004); M

INN

. S

TAT

. A

. § 80C.02 (West 2003); N.Y. G

. B

. L

§ 683 (McKinney 2004); N.D. C

ENT

. C

ODE

§ 51-19-03 (2003); O

KLA

TAT

. A

. tit. 71, § 806 (West 2004); R.I. G

. L

AWS

§ 19-28.1-5

(2004); S.D. C

ODIFIED

AWS

§ 37-5A-6 (Michie 2004); V

. C

ODE

or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.

pg_0004

§ 13.1-560 (Michie 2004); W

ASH

. R

. C

ODE

. § 19.100.020

(West 2004); W

. S

TAT

. A

. § 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

. R

. S

TAT

. § 650.010 (2003). See also Mark Miller, Unintentional

Franchising, 36:2 S

. M

ARY

’

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 relation-

ship laws on the books. Id. Even business arrangements that are drafted

to avoid regulation as a franchise may fall under the FTC Rule (see end-

note 2) and state business opportunity laws. Twenty-three states have

enacted business opportunity laws. See also P

HILIP

F. Z

EIDMAN

, F

RAN

CHISING AND

THER

ETHODS OF

ISTRIBUTION

, 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 F

RANCHISE

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 pro-

vided by the franchisee’s accountant rather than that offered by the

franchisor’s expert witnesses, one of them an expert in the commer-

cial 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 witness-

es, on the other hand, showed the accountant’s valuation to be sub-

stantially inflated by presenting detailed figures representing typical

costs in these and other categories among commercial cleaning fran-

chisees nationwide.

4. See B

ARTH

H. G

OLDBERG

, V

ALUATION OF

IVORCE

SSETS

§ 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 hus-

band, subject to a lien of 40 percent of the net income from the

patents in favor of the wife); 2 R

UTKIN

, V

ALUATION AND

ISTRIBU

TION OF

ARITAL

ROPERTY

, 23.07 [1], 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 fran-

chisee, 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 F

RANCHISE

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).

or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.