There’s more to franchising than fast food restaurants and auto dealerships. Today, franchising opportunities exist in many different industry segments, including retail, health care, professional services, real estate, education and child care, fitness, and hospitality. With so many franchising options, one thing is clear: Not all franchises are created equal. Here’s a look at the special considerations that factor into a franchise business valuation.
Weigh the pros and cons
The nature of franchising may lead you to believe that a franchise is significantly more valuable than an otherwise identical standalone business. But that’s not always the case for a variety of reasons.
As with any business, the value of a franchise is a function of risk and return. A franchised business may seem to carry little risk because its brand is established and the franchisor provides administrative support, including marketing programs, accounting systems, operating manuals and training. The franchisor also may pass along volume purchasing discounts from suppliers to its franchisees.
Evaluate the return
The franchisor’s support comes at a substantial cost, however, which can vary substantially depending on the franchise you’re investing in. Those costs typically include:
Franchise fee. This upfront charge generally ranges from about $50,000 to $200,000, though some franchise fees may be higher or lower depending on the brand and geographic market. Additionally, the franchisee must pay professional fees and build-out costs to get started.
Royalties. Once open, the franchisee must pay ongoing royalties to the franchisor that typically range from 4% to 8% of gross revenues and include an ongoing assessment for a joint marketing and advertising fund. The franchisee also may be required to purchase uniforms, inventory and other supplies from the franchisor, as well as update the facilities to comply with the franchisor’s appearance standards.
As a result of these costs, most franchisees don’t report positive operating cash flow until they’ve been in business for several years. To help forecast revenue and costs, a business valuation expert will ask for a copy of the franchise disclosure document. Required by the Federal Trade Commission, this document provides insight into start-up costs and fees, average monthly sales, and projected revenue growth.
Beware of restrictions
A franchised business may look even less attractive to investors if the franchisor restricts the owner’s actions. Examples include covenants that restrict independent marketing efforts, relocation and ownership transfers.
Business valuation professionals review the franchise agreement to get a handle on these restrictions. A discount may be warranted if the agreement limits the franchisee’s rights to expand, sell to a third party, or respond to changing trends and market demographics.
Consider market trends
When valuing a franchise, experts typically evaluate how the brand and the industry measure up to others. Franchisees are most satisfied when franchisors continually reinvent their brands and offerings, invest in training programs, support customer retention efforts and grant flexibility to respond to changing market conditions. Strong franchisors also adapt to regulatory changes, such as emerging tax laws, health care reporting requirements, and minimum wage and overtime rules.
Each year, the Franchise Business Review surveys franchisee satisfaction for hundreds of brands. Valuation experts may be able to download a free satisfaction “snapshot” from this source when considering how a particular brand ranks among its comparables.
When valuing a franchise, it’s important to understand the relationship between the franchisee and its franchisor. Risk and control are considerations when valuing any business. On the one hand, franchisors may lower risk by providing support and brand recognition. On the other, franchisors may exercise control over a franchisee, detracting from the value of a franchise. A business valuation expert can help you evaluate the upsides and downsides of investing in a franchise.
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.