May 8, 2023
Franchisees may need to conduct a valuation of their franchise business for a number of reasons. Whether that’s to secure a bank loan for the business or for personal purposes, it is relevant for tax and estate planning. And of course, it is critical to know the value of a franchise business when looking to put it on the market. There are several ways of determining what a franchise is worth and ways of going about it. Many individuals ask, “How do you appraise a franchise business?”
While we do not provide formal valuations, let’s cover the principal methods of valuation of a franchise business, the essential determining elements of franchise appraisal, and some of the pluses and minuses of a high or low value.
INITIATING A VALUATION OF YOUR FRANCHISE BUSINESS
As is true in many walks of life, there are both formal and informal ways of determining the sale price for your franchise business. Just as a real estate broker might give you a “drive-by” estimate of the value of your house, you might have a business broker give you a “drive-by” estimate of the value of your business. On the other hand, a formal appraisal of your house might cost several hundred dollars and involve considerable research by an appraising firm but produces a more reliable result.
Either way, there are some determining elements that factor into franchise appraisal and continue to remain consistent across the board. Working with the right franchise lawyers will help assist with which step you should take and further assist you in determining the elements for franchise appraisal.
The Benchmarks of Value
In many industries, there are benchmarks available to provide a rough estimate of the value of a business. These benchmarks are usually expressed in terms of multiples of the revenue, or top-line income of the business, or multiples of EBIDTA (earnings before interest, depreciation, taxes and amortization)—a rough shorthand for the owner’s discretionary income discussed below. You should inquire as to whether there are such benchmarks in your industry as they will give you a short-form estimate of the value of your business and are good to be aware of before you go through with franchise appraisal.
THE 3 DETERMINING ELEMENTS OF FRANCHISE APPRAISAL
If you want a formal valuation of your franchise business, you would go to a certified appraiser. An appraiser would use a combination of three methods to come up with a value:
- The value of your hard assets is determined by a review of your books and records.
- The value of the business is determined by sales of comparable businesses.
- A value is related to the capitalized value of the future income of the business.
The appraiser then combines these three figures to come up with a number. Let us take a look at each one of these elements.
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1. The Book Value of Your Business
A common franchisee question is, “What’s the book value of my business?” The book value of your business is typically the value of your assets as shown on your financial statements. Because hard assets are depreciable, however, the value of them may be quite low. Real estate, buildings and vehicles, as well as specialized equipment, may have a greater value in determining the appraised worth of your franchise. Generally, book value is going to result in a very low figure because it does not reflect the valuation of your franchise business as a going concern—i.e., its ability to generate revenue and income. For that reason, book value is of academic interest to an official appraiser rather than a real-world estimate of value.
2. The Sales of Comparable Businesses
The second element of the valuation of your franchise business looks at sales of comparable businesses. In a popular franchise system with many franchisees, it may be easy to determine and find comparable sales. Many franchisors, for example, assist franchisees with sales of their businesses and may have information on comparables. Similarly, business brokers may be a good source of information about the sale price for a franchise business. However, this is not always the case. In some industries, finding comparable sales may be difficult because of the nature of the business or the marketplace. An appraiser may have to do extensive research in order to find similar businesses that have been sold within a reasonable timeframe.
Once comparable sales have been found as a part of the franchise appraisal, adjustments have to be made to account for differences in geography, the businesses, the brands under consideration and other factors. Industry benchmarks, discussed above, may be of significant assistance in franchise appraisal.
3. The Value of Income Generated
The third element for franchise appraisal looks at the value of the income generated by the business. In simple terms, the “capitalization of income” approach asks this question: “What would a reasonable buyer pay to obtain a yearly income of x dollars?” An official appraiser will look to alternative investments such as U.S. Treasury Bills, the stock market, and other businesses to answer this question. But with a franchise appraiser, there are a number of preliminary issues that need to be addressed. Among the most important of these preliminary issues for the valuation of your franchise business is determining what the actual income of the business is.
Owners of small businesses typically push income down in order to minimize taxes by turning benefits into business expenses. Thus, for example, the business may supply its owner with a company car which is a business expense. The economic reality, however, is that the car is income to the owner. Such expenses, as well as depreciation and amortization, need to be added back into income in order to arrive at a realistic figure, often called the “owner’s discretionary income.” Once the appraiser knows that amount, he or she can then ask the question of what a willing buyer would pay to obtain that return on their investment. A number of additional factors need to be considered within the franchise appraisal, such as the risk that is associated with that particular business, economic conditions, and the time value of money. Typical valuations of income range from three to seven times the owner’s discretionary income, but lower or higher values may be achieved.
SETTLING ON A LOW VS. HIGH VALUE
In a formal franchise appraisal, the appraiser will combine the three valuations to come to a final figure. The valuation of your franchise business may be affected by other factors, as well. One factor is the purpose of the franchise appraisal. For example, if you are trying to determine the value in order to avoid estate taxes, you will want a low value. On the other hand, if you are looking to sell, you will want a higher value. We have seen instances in which franchisees looking to sell their business have been haunted by a low valuation made as part of an estate-planning process.
Another factor that may affect the valuation of your franchise business is who the buyer is. If the buyer is a franchisor, purchasing a franchised business, the value of the franchise may be higher. A franchisor is known as a “strategic” buyer because it can realize certain economies of scale and efficiencies in running a franchise that a third-party buyer cannot.
LEVERAGE YOUR FRANCHISE APPRAISAL WITH LEGAL ADVICE
Determining the value of your business requires considerable thought and input if you are doing it for a serious purpose. Before going through with the appraisal for your franchise business, it is best to sit back and consider your current circumstances while understanding the key determinants of business value so you end up right where you want to be. The tiniest of business elements can change the value of your franchise appraisal tenfold.
Make sure you’re reaping all of the benefits of your appraisal with the advice of a good franchise lawyer, accountant or appraiser before diving too deep.