“How Much Are Your Franchise Developments Worth”		«BACK
	by Dennis L. Monroe
	from November/December 2004Franchise Times

The value at which franchisee businesses are sold is normally a multiple of unit level cash flow, less a reasonable general and administrative allocation and certain annual capital expenditures. Even with lower multiples for unit level cash flow, today’s market conditions are supporting increased valuations attributable to development rights (particularly exclusive development rights). Development rights, with reasonable exclusivity, have the potential to contribute tremendous revenue growth, thus increasing the earnings and value of the franchise business.

A franchise that is not growing is only going to be valued at a conservative multiple of current cash flow without the consideration of future growth. The potential buyers for this class of business are limited. You need buyers that, in effect, can gain something through scale by spreading out general and administrative expenses over a larger number of operating units or by enhancing diversification in concept and/or territory. In terms of actual multiples, it is very difficult to gain a top valuation for a franchisee, unless they have development rights.

The question that comes up is, “How do you value development rights?” There are four factors in valuing development rights:

• 1. Basic unit economics characterized by proven unit-level financial performance. Can the profitability and leadership the franchisee demonstrates for existing units translate into newly developed stores?
•  
• 2. Development schedule supported by reasonable financing. How many stores can be developed, and what is the period required for such development?
•  
• 3. Development territory and the availability of quality real estate. Can profitable growth be accomplished based on the available development market?
• 4. Various restrictions and transfer rights associated with the development agreement. How liquid is the implied value of the development rights?

Since the value of development rights is based on future potential, it is basically an intangible asset. An accepted method of determining this intangible asset value is the capitalization of ‘super-profits’ or discounted cash flow analysis. Super-profits is defined as a new unit’s projected ability to contribute incremental operating profit, over and above required operating costs.

• 1. Assessing the monetary value of the super-profits (excess earnings);
• 2. Determining the appropriate market-derived capitalization or [discount] rate;
• 3. Applying the capitalization or [discount] rate to the super-profits to derive the total value of the [intangible assets].

Super-profits (new unit forecasted earnings), based on both proven unit economics and the scope and timing of the development rights, are discounted to net-present-value (NPV) by using a discounted cash flow method (DCF) to determine the value. In order to determine the most accurate value, the analysis requires the determination of a risk factor or discount rate that appropriately reflects relative performance risk.

J. H. Schilt published a widely regarded guideline for the determination of risk factors in Financial Planner that provides a description of franchisee characteristics that can be used to determine the appropriate capitalization or discount rate [Risk Premium] (see Figure 1):

Figure 1 – Risk Premiums

Source: J.H. Schilt, A Rational Approach to Capitalization Rates for Discounting the Future Income Stream of a Closely Held Company, Financial Planner (January 1982), 20.

There are specific development area characteristics that may necessitate a higher risk premium, including the following:

• 1. Development territory is new with no existing franchise or corporate locations;
• 2. High site costs, either real estate or lease rates (e.g., Northeast and Pacific);
• 3. Time required to develop is impacted by unique circumstances like heavy local governmental constraints or availability of raw materials.
• 4. Seasonality and demographic issues, such as weather, consumer traffic at various times of the year, and population changes, among others.
• 5. Franchisor support, including help in marketing a new area to advance consumer acceptance and demand.
• 6. Ramp up time - How long does it take to get a unit up to full sustainable profitability?

It is critical to understand and apply the risk premiums consistently. Much of this application is subjective, so let’s look at an example:

An experienced franchisee has secured a development agreement with a national/regional-tier concept that allows and/or requires the franchisee to open 5 additional units at the beginning of each of the next five years at a rate of one per year. The concept and franchisee have established reputations and a proven ability to deliver earnings in the target market. To simplify the example, new unit comparable sales growth is held flat. (A detailed analysis should include a consideration for comparable growth, where applicable, typically after 18 months of operation.) A calendar fiscal year is also assumed.

Additionally, based on the franchisee’s proven experience, new units are expected to produce $1.25 MM in Annual Sales resulting in a 12.5% Annual adjusted EBITDA contribution or $156,250 per new unit (see Figure 2).

Using these simplified assumptions, total annual EBITDA contribution is forecasted and thus the “Super-Profits” contributed by units developed in accordance with the development agreement are determined (see Figure 3).

The application of the discounted cash flow is a science. Forecasting the numbers and determining the appropriate risk factor is an art. Franchisors should be encouraged to track successful developers to provide an effective template for applying the valuation model.

Fully understanding the value of your franchise business is important in effectively managing your investment and operation. Development rights can contribute a substantial increase in franchisee business valuation. Good unit economics characterized by proven unit-level financial performance, a reasonable development schedule, a growing and target-rich development territory and limited development agreement restrictions will add incremental value to your operating enterprise and tangible operating assets enriching the value of your business.