Tuesday, April 15, 2008

How to Value a Franchise Depends on Why You’re Valuing It

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

Valuation of a franchise is an issue in many franchise disputes. It is calculated in several different ways, but usually is defined as what a hypothetical buyer would pay for it.

In such situations, an expert's valuation of a franchise generally takes into account many things such as the balance sheet, the cash flow, license rights, and the covenants and other restrictions on transfer placed on franchises such as the right of first refusal.

Business Valuation Concepts

Generally, the major terms used in business valuations are “fair market value,” which is a legal term, and “fair value,” which is an accounting term and both generally mean the same thing.

"Fair market value" is a term of art which has been the subject of court decisions in the gift and estate tax area since the 1930s and has developed a formidable body of law to refine its meaning. The basic definition is found in the Internal Revenue Code and in Revenue Ruling 59-60 where the Internal Revenue Service defined "Fair Market Value" as

the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

The hypothetical buyer and seller are assumed to be able, as well as willing, to trade.

Under this concept, there are three (and really only three) general methods that are acceptable for determining business value. These are—in legal terms—book value, capitalization of earnings, and comparable sales.

Context of Valuation: Divorce

However, in some cases all this theory may be superceded by the question: why are you valuing the franchise? For example, in divorce cases the judge may ignore the concept of “fair market value.”

The recent Tennessee case of Bertuca v. Bertuca is such a situation where the court specifically dismissed the concept of a sale. In that case the husband was the owner of several McDonald’s and the appellate court held the franchises should be valued simply as follows:

Cash Flow (per expert)................................$ 412,663
Capitalized at 12%....................................$ 3,438,858
Add: Current Assets...................................$ 1,016,829
Less: Current Liabilities..............................($ 525,891)
Less: Notes Payable 6/30/2005.....................($ 2,199,028)
Less: Rebuild Note...................................($ 950,000)
[An obligation to refurbish one of the units.]

VALUE....................................................$ 780,768

The husband had appealed the trial court’s ruling as to valuation but the appellate tribunal held:

Mr. Bertuca next complains that the trial court failed to consider the non-marketability of his interest in [the franchises]. Since our determination as to value is based upon the earnings value of the partnership, that value would not be impacted by the lack of marketability of Mr. Bertuca's interest unless it appeared from the record that his needs or situation were such that a sale of his interest would be necessary or desirable. The trial court very carefully drafted its ruling in the case allowing Mr. Bertuca to pay the amount awarded over time so that he would not [*21] have to sell his partnership interest in order to satisfy the award. Since the partnership indebtedness is serviced by the income derived from the business and will be paid in seven years, the value of the business significantly increases with time and we are satisfied it is in Mr. Bertuca's best interest to maintain his interest in the partnership. There is no indication in the record that Mr. Bertuca has any intention of selling his interest in [the franchises]. Thus the value of the business is not affected by the lack of marketability and discounting the value for non-marketability in such a situation would be improper. Anderson, 2006Tenn. App. LEXIS 592, 2006 WL 2535393, at*4.

And the court went on to add:

Mr. Bertuca makes a similar argument with regard to the trial court's failure to reduce the value due to the buy-sell agreement applicable to his ninety percent partnership interest. He correctly points out that a trial court should consider such an agreement when determining the value of a business. See, Harmon v. Harmon, No. W1998-00841-COA-R3-CV, 2000 Tenn. App. LEXIS 137, 2000 WL 286718, at *9-10 (Tenn.Ct.App. March 2, 2000). As with Mr. Bertuca's lack of marketability argument, such a provision only affects the value if he plans to sell his interest [*22] in the partnership and the record is devoid of any suggestion that he intends to do so. The buy-sell provision, therefore, does not affect the value of his interest in the partnership determined on a value of earnings basis.

So much for the concept of “fair market value” in divorce proceedings! It appears that if there is to be no sale, some courts will not use a hypothetical sale as a basis for valuation.

Bertuca v. Bertuca, 2007 Tenn. App. LEXIS 690, (filed November 14, 2007) will appear in the CCH Business Franchise Guide.This decision was provided by David Beyer, Esq. of DLA Piper, for which the author expresses special gratitude.

Additional information on franchise valuation issues appears in CCH Franchise Regulation and Damages by Byron E. Fox and Bruce S. Schaeffer.

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