There comes a time in every franchisor’s business lifecycle when they start contemplating their next opportunity. You have worked hard to develop the business and are most likely curious about what it’s worth.
The first thing you must recognise is that price and value are two very different concepts. Price is affected by timing, opportunity, various emotional factors and therefore the reasons for selling and the purchaser’s reasons for buying often impact price.
Conducting a valuation is an essential first step in the planning process. A robust valuation provides an assessment of the key value drivers and prepares the vendor for discussions with potential purchasers.
A useful negotiating tool is a robust and defendable valuation assessment (including reasonable forecasts and assumptions that can be backed up with convincing data).
Ultimately the deal (including price) needs to be at a level, which the vendor and purchaser both feel comfortable (or it is destined to fail).
Deal structures may include safety nets, which assist the vendor in maximising price and at the same time protect the purchaser eg: earn outs, restrictive covenants (such as non-competes) and specific warranties.
Conducting a valuation of a franchisor business
No two businesses are alike. Valuers examine the interplay of the following factors to develop an accurate picture of what a business is worth:
- Operating earnings streams
- Operating costs and capital expenditure
- Risk profile of existing cash flows
- Specific risks in relation to litigation, brand/reputation, regulation and competition
- Impact of expansion (timing, scale and cash flow impact)
- Net assets invested in the business, including the value attributable to intellectual property and real estate (if any)
- Market multiples and capitalisation rates.
An assessment of value includes reviewing:
- Franchise agreements containing the rights and obligations governing the franchisor and franchisee relationship (eg. rights to income streams and obligations to incur costs)
- Franchisor’s disclosure document (outlined in the Franchising Code of Conduct) and inherent characteristics of the franchise network
- Franchisor’s strategic plan and projections
- Historical financial statements.
Understanding the above is key to the valuer’s assessment.
Which valuation methodology works best?
Discounted Cash Flow (DCF) is theoretically the most appropriate methodology, however, DCF requires robust long-term projections of potential cash inflows and outflows and this is rarely available. In the absence of robust cash flows, capitalisation of Future Maintainable Earnings (FME) may be appropriate.
The main indicator of earnings is the previous 12 months. However, FME can look very different to reported earnings as FME should reflect the expected earnings associated with the nature and scale of the franchisor’s business at the valuation date. Noting arrivals, departures, increases in royalty rates and movements in operating costs can have a significant impact. FME also involves adjusting for abnormal income and expense items and or restating related party transactions.
Expansion can significantly impact value and therefore a valuation assessment of a franchisor’s business should consider both DCF methodology and capitalised FME methodology. Therefore, it is in the franchisor’s best interests to prepare robust cash flow projections.
It’s important to develop a forecast model that can be easily updated. Where specific purchaser(s) have been identified, it’s reasonable to prepare a valuation model which allows for synergies that may flow to the purchaser and will increase the price they are willing to pay.
Setting yourself up for success
It pays to invest the time upfront to prepare for a valuation of your business and learn about the assessment process.
Here are our top tips for franchisors:
1. Ensure your forecasts are rigorously prepared and supportable by convincing data. This will help mitigate the risk that the valuer places an over reliance on past performance,ignoring projected growth or assuming that the earnings multiple adequately allows for growth.
2. Clearly identify recurring and non-recurring items and the risk profile associated with each stream.
3. Spend time and identify potential purchasers for the franchise business and how the franchise business can deliver benefits to these purchasers.This is important as the value will differ depending on the perceived benefits to these purchasers.
Finally, the commissioning of an independent valuation assessment provides objectivity and is essential for strategic planning, but be aware that the value of a business evolves and assessment of value needs to be regularly updated as time progresses.
Authors: Ian Diepenhorst, Tony Natoli and John-Henry Eversgerd at PPB Advisory.