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How To Value a Franchise Business

The word 'value' written with a blue marker on a transparent board.

Valuing a franchise business is not a task that can be undertaken lightly. Unlike standalone businesses, franchise valuations are often more complex with various unique factors that can add to or diminish the value. Here's a step-by-step guide to provide a clear understanding of the valuation process for a franchise business.

Business Valuation Methods

There are several ways to assess the value of any business. It’s helpful to have multiple ways of evaluating a business to price the asset intelligently. And while one may be more suitable than another for valuing a franchise business, the appropriate method will depend on a variety of factors, including industry, size, and the circumstances of the sale.

Market-Based Valuation

The Market Approach focuses on external market factors and draws comparisons with similar businesses:

Using Multiples

Using multiples in a market-based valuation requires understanding various factors, such as industry standards, economic conditions, and historical data of similar franchise sales. By analyzing the market value of comparable businesses, one can derive various multiples of different financial metrics. For example, a franchise selling for $5M with EBITDA of $1M can be said to have a 5X EBITDA multiple.You can find national average valuation multiples for a variety of types of businesses in our Industry Valuation Multiple Charts.

Benchmark Analysis

Benchmark analysis is a process of comparing the franchise with similar businesses that have been sold recently. It considers location, size, market presence, and more factors to establish a selling price benchmark.

Resale Comparisons

Resale comparisons are especially relevant for established franchises like McDonald's, where resale data might be available. Analyzing the resale value of similar franchises within the same brand or industry can offer a tangible reference point, thus adding credibility to the valuation.

Asset-Based Valuation

The Asset approach takes a tangible perspective by looking at the “Book Value” of the business:

Book Value

The book value considers the franchise's physical and intangible assets and liabilities, including real estate, machinery, intellectual property, debts, and more. Analyzing the difference between the total assets and liabilities provides a grounded value, particularly relevant for franchises with significant real estate holdings or valuable intellectual properties.

Income-Based Valuation

The income approach to valuing a franchise is centered on the expected economic benefits that the franchise is likely to generate in the future. This method primarily breaks down into two facets:

Discounted Cash Flow

Discounted cash flow analysis involves thoroughly examining a franchise's projected cash flow, and discounting that amount for risk using the weighted average cost of capital. This adjusted cash flow presents a more accurate picture of the franchise's financial health and is usually calculated for one year and then assumes professional growth.

The capitalization of earnings method involves assessing the past cash flow generated by an asset and then dividing it by its cap rate, which stands for capitalization rate. This method helps to identify risks and quantify the potential return on investment. A higher cap rate signifies a more significant return on investment, albeit at a heightened level of risk.

Correctly valuing a franchise involves a multifaceted approach, combining the intricacies of income projections, market comparisons, and asset evaluation. These elements woven together provide a comprehensive view of the franchise's worth that’s tailored to its unique characteristics and the industry it operates within.

Valuation May Be More Complex Than Valuing Standalone Businesses

Valuing a franchise business is more complex than appraising a traditional standalone enterprise. The difference lies in the unique dynamics that govern franchise operations, involving multi-layered and often nuanced considerations. A franchise is not merely a business, but a partnership governed by a legal framework. The Franchise Disclosure Document (FDD) and Franchise Agreement are fundamental legal constructs laying down the rules of thumb, responsibilities, and obligations for the franchisor and franchisee.

FDD: The FDD, a comprehensive and legally mandated document, must be provided to prospective franchisees. It includes details on the franchise system, fees, intellectual property, and more. A close examination of the FDD is essential for an accurate valuation, as hidden costs or liabilities could affect the franchise’s true value.

Franchise Agreement: This binding contract spells out the obligations and rights of both parties. The franchise agreement might include restrictions, such as geographic limitations or specific performance benchmarks, that could affect the franchise’s value. Due diligence in understanding these terms is paramount.

The franchisor's influence goes beyond mere guidelines; it often extends into various aspects of the business, including:

Ability to Sell or Transfer Business: The franchisor's rules and restrictions might impact the franchisee's ability to sell or transfer the business, limiting the franchise's liquidity and potentially its value.

Compliance and Control: The franchisor’s control over the business model, marketing, supply chain, and daily operations can significantly impact the value. The franchisor's success or failure in these areas can either enhance or diminish the value of individual franchises within the system.

Unique Considerations for Franchise Valuations and Factors That Add or Diminish Value

There are a variety of factors that impact the valuation of a franchise. Below are a few of the factors that may add value to a franchise, as well as factors that may diminish value.

Factors that Add Value to a Franchise

Franchising offers a variety of benefits. One of the advantages of becoming a franchisee is that you can leverage an established business model with brand recognition, purchasing power, and supply chain management, among other benefits.

Established Brand Awareness

The advantage of an established brand, as exemplified by franchises like McDonald's, cannot be overstated. A franchise of a recognized brand inherently possesses credibility and customer loyalty. This brand awareness translates into a tangible asset that adds significant value to the business. The marketing efforts, brand reputation, and existing customer base with a well-known brand can drastically reduce the time and resources needed to establish a presence in the market.

Proven Business Model

For potential buyers, a proven business model represents reduced risk and uncertainty. Franchise owners buy into a model that has been tested, refined, and succeeded elsewhere. This means that much of the trial and error accompanying a new independent business has already been tackled. The franchisor provides a blueprint for success, complete with operational guidelines, marketing strategies, and support systems. This proven pathway to profitability enhances the franchise’s value, assuring both current owners and potential buyers.

Supply Chain/Purchasing Power

Franchises often benefit from the established contracts and volume purchasing power that comes with being part of a larger network. This means access to preferred suppliers, negotiated pricing, and economies of scale that independent businesses might struggle to achieve. Capitalizing on these established relationships can significantly reduce costs and enhance profitability, thereby adding value to the franchise.

Factors that Diminish Value

There are various factors that may have the potential to diminish the value of a franchise. There are various factors that may have the potential to diminish the value of a franchise. Before entering an agreement, make sure to review the FDD and franchise agreement to understand the geographic restrictions and any limitations on selling or transferring the business, as these may impact its valuation.

Geographic Restrictions

The value of a franchise can be constrained by geographic restrictions that limit expansion opportunities. Whether through franchise agreements or market saturation by the franchisor, the inability to grow beyond certain territories can hamper a franchise's potential. These limitations could deter potential buyers looking for growth opportunities, thus diminishing the franchise’s value.

Restrictions on Franchisee’s Ability to Sell or Transfer Business

A franchise often comes with certain constraints concerning its sale or transfer. Transfer fees, the need for franchisor's consent, or other restrictions can make selling or transferring the franchise more complicated and costly. These constraints can devalue the franchise in the eyes of potential buyers, reducing its market attractiveness.

Franchise Agreement

The terms and conditions laid out in the franchise agreement can sometimes be stringent. These may include compliance with specific operational standards, marketing guidelines, or other obligations that limit the franchise owner's flexibility and autonomy. While these terms often serve to maintain brand consistency, they can also be perceived as restrictive. A potential buyer might see these as limitations on innovation or customization, thus reducing the perceived value of the franchise.

Final Thoughts

The valuation of a franchise business is a detailed and complex process that requires proper diligence and a significant understanding of various factors. Whether capitalizing on a small business's franchise opportunities or considering new franchise agreements, franchise valuation can be multifaceted.

Additionally, the value of a business, especially a franchise, is not static. Market conditions, franchisor rules, and the franchisee's adherence to the model can impact the value of your franchise. Stay informed of these factors, and you'll be well on your way to understanding your franchise's worth.

BizBuySell has many tools and resources to help you get started on valuing your franchise, whether you're buying, selling, or just looking for a valuation: