FRANCHISORS AND FRANCHISEES: UNIQUE PARTNERS, UNIQUE VALUES
By: Nevin Sanli and Barry Kurtz - Written for Valorem Principia
In the broad spectrum of business enterprises, franchise operations – meaning both franchisors and franchisees – are a breed unto themselves, requiring unique valuation approaches.
Chief among the reasons for this is the fact that the relationship between franchisor and franchisee creates a hybrid partnership. The franchisor owns and manages certain items of intellectual property but does not deliver goods or services to the consumer. That job belongs to the franchisee, which as a rule owns only certain hard assets used in carrying out this task.
Looked at from this standpoint, the valuation consists more of discovering to what degree each asset contributes to the success of the business enterprise – a task more easily said than done.
Under common provisions of state law, a franchise relationship exists when:
The franchisee engages in offering, selling or distributing goods or services under a marketing plan or system “prescribed in substantial part” by the franchisor; The franchisee’s business is “substantially associated” with the franchisor; and The franchisee pays a fee to the franchisor in order to engage in business.
Taking these one by one, the franchisee operates under a plan or system “prescribed in substantial part” by the franchisor when the latter provides the franchisee with advice and training, retains significant 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.
Similarly, the franchisee’s business is “substantially associated” with the franchisor if the former uses the latter’s trademark and advertising slogans to identify its business.
As for fees, they may include franchise fees, royalties on sales, and payments for training and assistance or for inventory and supplies.
Mergers and acquisitions involving franchise operations are commonly asset sales, not stock sales, so franchisors and franchisees alike can organize their companies under the legal structure that best suits their respective tax needs, largely without regard to valuation.
Different Businesses and Different Assets
Whatever the legal structure of their companies, franchisors and franchisees own different assets. In general, the franchisor owns intangible assets including goodwill, logos, brands, trademarks, advertising slogans, and business systems and processes – for example, recipes in the case of the fast-food franchisor. The franchisee gains the right to use these assets in the conduct of its business but as a rule owns only some or all of the tangible assets it needs to conduct business, including equipment, inventory and supplies. Sometimes the franchisor owns or leases real estate and equipment and leases or subleases them to the franchisee. Sometimes the franchisee owns or leases these items directly.
As these considerations make clear, in many ways franchisors and franchisees are in different businesses. Franchisors do not earn profits directly from the sale of products or services at all. Instead, they are repositories of intellectual property, and their value derives in great measure from their skill in managing both that property and their relationships with franchisees.
Impact on Value
The impact of this skill on value can be substantial. Assume, for example, two operations generating equal revenues and profits, one a pure franchisor owning none of its outlets and the other a non-franchisor selling the same product – say, fast food – through a chain of wholly owned outlets. The franchisor might command a multiple of six to eight times earnings before interest, taxes, depreciation and amortization (EBITDA), or cash flow, and the non-franchisor a multiple of four to five. This results in part from the fact that the non-franchisor faces more operating risk in its day-to-day operations compared to the franchisor, who has shifted some of that risk to its franchisees.
Where the franchisor sells a brand-name product, the steps involved in deriving value begin with determining what premium the brand-name product commands over generic products and then, through a series of calculations, isolating values for every other item in the franchisor’s “inventory” of intellectual property.
The next step is to gauge the franchisor’s growth prospects – and here consumer demand is paramount. How many more buyers of the franchisor’s products or services are there? Where are they? How many more territories might the franchisor establish over the next five years to reach these buyers? Over the next ten years? What will this effort cost?
The terms governing what franchisors can do when renewing agreements with their franchisees are also important in valuation. For one thing, these terms may permit a franchisor to increase royalties, fees or rents. For another, they may require franchisees to remodel their premises, upgrade equipment, etc. Taken all in all, the more these terms favor franchisors, the more value they generate for the franchisor.
The same holds true for the franchisor as lessor of real estate or equipment. In general, the more of these assets the franchisor has, the better, since they give the franchisor rental income in addition to royalties and fees, along with possibly regular and predictable increases. The management of such assets, however, can become a business in itself, possibly distracting the franchisor from its primary mission, with negative impact on valuation.
A good deal of data is available on royalty rates, making it relatively easy to judge their impact on the value of franchisor and franchisee operations. Overall, royalties reflect the marketplace value of the intellectual property created by the franchisor and made use of by the franchisee. But because competition is extensive in many areas of franchising, royalties are also more or less predictable, depending of course on the product or service in question. In the fast food industry, for example, royalty rates range from 3 to 8 percent, with most franchisors charging 6 percent or less.
Upfront franchise fees reflect the same factors, with some top-tier franchisors charging as much as $1 million per store, sometimes more. Here, too, the impact on valuation is obvious.
In the case of the individual franchisee, the key is to gauge the value of its hard assets – plant, equipment, inventory, etc. – in generating the franchisee’s profits. But there are additional factors to consider as well: How much value does the franchisee derive from being part of the franchisor’s system? To what degree does the franchisee gain or lose value because of economic and social conditions in its territory? Because of capacity? Because of its hours of operation? Does the franchisee have first right of refusal to expand into new territories?
When valuing a master franchisee, other questions arise: assuming that state law permits the practice, does the master franchisee bargain over royalties, fees, territories, and other factors? If so, what value does the master franchisee derive from this power? Does the master franchisee achieve economies of scale by operating its own training program, by wringing costs from the supply chain, by negotiating special real estate leasing terms?
The right to sell products and services through catalogs or over the internet can become a point of contention between franchisor and franchisee. If the franchisor retains the right to sell to catalog or internet customers residing within the exclusive territory of the franchisee, this can diminish the value of the territory. If, on the other hand, the franchisee has the right to sell to catalog or internet customers irrespective of its own territory, this diminishes the value of the franchisor’s business, not to mention the businesses of other franchisees.
To avoid this, many franchisors, recognizing that they are in the intellectual property business, not the business of delivering goods or services, retain control of catalog and internet sales but funnel orders through franchisees in whose territories the orders originate. From the standpoint of valuation, such franchisors, by striving to increase the commerce of their franchisees, enhance their own value.
Most franchise agreements attempt to make these matters explicit, but gray areas persist and give rise to much litigation, with significant impact on valuation. Goodwill, for example, is the property of the franchisor, but the franchisee may create goodwill specific to its own operations and become entitled to compensation in the event that a local governing body condemns the business under eminent domain. This specific goodwill can become an item of community property in divorce proceedings as well.
With respect to both franchisors and franchisees, certain terms in the franchise agreement also affect valuation – for example, terms permitting franchisors to terminate agreements with undesirable franchisees. These, too, can give rise to litigation, making it necessary to step carefully when judging the efficacy of the terms in any particular franchising agreement.
Not surprisingly, the impact of many such terms is not the same on franchisors as on franchisees. An agreement giving the franchisor ample leeway in terminating undesirable franchisees will tend to enhance the valuation of the franchisor and depress that of the individual franchisee. Conversely, a solid, locked-in territory favors the franchisee but may depress the valuation of the franchisor. Either way, the key to the result, whether favorable or unfavorable to the one party or the other, lies in the strength and clarity of the terms of the franchise agreement – or the lack thereof.
One final factor, liability, can affect valuation. Most franchise agreements specify that franchisors are not liable for the debts or torts of franchisees, and vice versa. Even so, litigants 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 litigants in cases where the franchisor exercises such control over the actions of the franchisee as to trigger vicarious liability – as, for example, when a franchisor requires the franchisee to follow an employee manual produced by the franchisor. Hence here, too, it is necessary to step carefully when deriving valuation.
Barry Kurtz, a specialist in franchise law, is of counsel to the Encino, Calif., law firm Greenberg & Bass. He may be reached at (818) 728-9979 or firstname.lastname@example.org. Nevin Sanli is president and co-founder of Sanli Pastore & Hill. He may be reached at (310) 571-3400 or email@example.com.