Thursday, June 21, 2007

Why Valuing Franchise Businesses Is Different from Valuing Other Businesses

This posting was written by Bruce S. Schaeffer of Franchise Valuations, Ltd., co-author of CCH Franchise Regulation and Damages.

The issue of what a franchise business is worth has become ubiquitous. It comes up in areas like estate and succession planning, annual valuations for ESOPs (or buy/sell purposes), or establishment and justification of an asking price for potential buyers. And it comes up in more contentious areas like the damages aspects of franchise litigation and arbitration or in divorces. Basically, the issue arises whenever there is a dispute about money.

Acceptable Methods of Valuation

There are really only three recognized methods for determining the value of a business—franchise or otherwise. The Financial Accounting Standards Board (FASB) has said, "Although many valuation methods are used in practice, all such methods can be classified as variations of one of the three approaches . . ."

In fact, under the Uniform Standards of Professional Appraisal Practice, a valuation specialist is required to consider all three approaches ("cost," "income," "market," in accounting nomenclature; "book value," "capitalization of earnings," and "comparable sales" in legal terminology). If one or more is not used, the valuation specialist must explain why.

Will Any Valuation Do?

In the June/July 2006 issue of Franchise Times, there was a column about franchise valuations by Dennis Monroe, Esq., entitled, "Know Your Worth --All Company Valuations are Not Created Equal." In it, the author, describing his search for expertise, wrote:

"There are a number of valuation firms in the country. I wanted to speak with someone who is known for valuing businesses of all kinds and for various purposes, not just someone who values franchise businesses, because they can be formulaic in their approach."

Generalist v. Franchise Expert

I'm all for avoiding a formulaic approach, but I must take issue with Mr. Monroe's implication that a generalist is better than a franchise expert. Franchise businesses are not the same for valuation purposes as other businesses. As a matter of fact, this was recently proven, empirically (with more data and graphs than one can easily digest) in two scholarly publications:

 Nevin Sanli and Barry Kurtz, "Appraisal of Franchises Requires the Use of Unique Valuation Procedures," Franchise Law Journal, Vol. 26, Number 2, Fall 2006, p. 67; and

 E. Hachemi Aliouche and Udo Schlentrich, "Does Franchising Create Value? An Analysis of the Financial Performance of US Public Restaurant Firms" from the William Rosenburg International Center of Franchising at the University of New Hampshire.

Franchise Valuations Are Not the Same

There are at least half a dozen good and sufficient reasons why the valuation of a franchise business is different from valuing other businesses and should be done by an expert in franchising:

(1) Contract Right, Not Outright Ownership. --First and foremost, ownership of a franchise is not the same as outright ownership. The full bundle of rights attributable to owning something outright is absent in a franchise agreement and all rights to own and/or alienate the property are determined by the contract. The asset is merely a contract right. That is not the case with a family farm.

(2) Management Analysis. --Although any sensible valuation of a business takes into account the strengths and weaknesses of management, in the franchise context this is a two-tier analysis. The valuation must focus on the management skills of both the franchisor and the franchisee. Again, that is not the case with a business owned outright.

(3) Franchisor/Franchisee Relationship. --In no other business context is the value of the enterprise so dependent on one relationship. In any other context, such complete dependency with one other entity would be considered an inordinate business risk, like a dependency on a single customer. But in the franchise situation it is more often a strength than a weakness.

(4) Regulation. --No other business (other than the securities industry) is as highly regulated in as many areas and separate jurisdictions as franchising. This alone makes it wholly unlike any other form of business.

(5) System-wide Goodwill. --In no other type of business would a tainted hamburger or scallions sold in an eatery in Washington or New Jersey so heavily impact or affect other businesses in states across the country (for example, Jack in the Box, Taco Bell, etc.). Also, franchisors, almost uniquely, have the ability to exploit their intangible assets by licensing in other venues and for other purposes. This is an attribute to consider in the valuation of a franchisor, unlike most other businesses.

(6) Restrictions on Transferability. --Usually a franchise is not freely alienable. Customarily there are conditions in franchise agreements that impact the valuation, such as the risk of non-renewal, the risk of non-approval of a proposed transferee, and the presence of rights of first refusal (ROFRs) in the franchisor. The U.S. Tax Court has characterized ROFRs as difficult to value but probably causing a 10% to 15% discount from the total enterprise value. This too is not an ordinary aspect in the valuation of a business.

Accordingly, just as one would not want proctologists doing brain surgery, one should also avoid using valuation experts who specialize in dental practices, gas stations or real estate to do franchise valuations.

Additional information on valuation of franchises and dealerships is available in CCH Franchise Regulation and Damages by Byron E. Fox and Bruce S. Schaeffer.

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