| “How Much is My Franchisee Company Worth” |
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by Dennis
L. Monroe - Krass Monroe, P.A. |
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from Franchise Times, November - December 2002 Issue |
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You, as a franchisee business owner, are always interested in the value of your business. As has often been said, the value of a franchisee business is directly related to the ability to finance that business. We have recently seen an erosion of this concept, although this axiom has held true for many years. This article will provide you, the owner or franchisor, with some thoughts on (i) what a multi-unit franchisee business is worth; (ii) ways to look at its economic value; and (iii) a new paradigm on valuation and exit strategy.
valuing a business, the following factors have changed:
1. The high multiples of cash flow that determined sales prices for franchisee businesses have declined, whether it is a quick serve restaurant (QSR) or an auto-aftermarket business.
2. Buyers no longer look at cash flow and assume sales increases or lower proforma operating expenses.
3. Buyers look for a substantial return on their equity investment, knowing they can only leverage a franchisee business somewhere between two and four times the historic free cash flow from the businesses. A buyer usually looks at an equity return in the 30%+ range.
4. Public multiples are no longer relevant since the public market for franchisee businesses has drastically deteriorated.
5. The types of valuations applied by lenders in the late 1990s are irrelevant.
6. The number of franchisee to franchisee transactions has greatly diminished over the past several years; therefore, the market data for comparable transactions is very thin and much of the information as it relates to value is anecdotal.
7. Most franchisors are reluctant to buy franchisees; therefore, this portion of the market is less available to a potential franchisee seller.
8. Cash flow is all that matters. Other types of intrinsic values are, by in large, just an add-on with little value.
Given the above backdrop of new factors and paradigms in valuation, how should you as an owner look at the value of your company?
1. The value is most likely backed into. You, the seller, should assume a buyer is going to look at the transaction as follows:
a. The buyer, at best, will assume flat sales. If there has been a decline in sales over the last few years (as there has been with many of the QSR concepts), the buyer will use a declining sales assumption.
b. The buyer will use the greater of their general administrative expense factor or the general administrative expense factor of the seller. There may be some exceptions if the buyer is a large franchisee and is absorbing a smaller franchisee. In this case, the buyer may only look at the incremental general administrative cost. However, in most cases it is difficult to get a buyer to assume they can run the business better than the seller.
c. Historic numbers are the only numbers used. Proforma numbers are problematic.
d. Operating leases and capitalized real estate leases are offsets to purchase price.
e. Most buyers will not assume current liabilities, only operating leases and capitalized real estate leases.
f. Most buyers seek to negotiate above market leases.
Once a preliminary value is determined, the buyer will assess its ability to leverage the transaction. Currently buyers can expect to be able to borrow approximately 2.5 times free cash flow with a minimum fixed charge coverage ratio (that is the amount of available cash to pay the fixed charges including debt service and rent) of between 1.4 - 1.5 to 1. Once this debt level is determined, the buyer will look at the cash flow after debt service and determine what, on an annual basis, will be the return on invested equity. The expected return determines the appropriate level of equity investment. The combination of this equity component and available senior debt is the purchase price. If there seems to be a gap between seller and buyer, this gap may be bridged by the seller agreeing to carry paper at an interest rate below market.
The above analysis determines the offer price of the business. The real estate component is valued differently and may be purchased separately. Real estate is priced based on a multiple (cap rate) times a normalized rental rate for each piece of real estate. Cap rates at present are ranging from a low of 8% in the case of like kind exchange buyers to a high of 12%. In most cases, a buyer may be able to effectively leverage this real estate value between 70% to 85% of the purchase price.
The real estate component will indirectly increase the business value. Real estate is king. The combined value of the real estate and the enterprise is added together which gives the gross value of the company. From this gross value the seller will subtract the selling costs and all debt (whether it is assumed or not, including capitalized leases, operating leases and current liabilities). Normally the buyer will pay cash for inventory, prepaids and other current assets that have a useful value to the buyer.
In summary, the overall multiples of cash flow are determined by a return on equity with a moderate amount of leverage. The multiples we are seeing for franchisee businesses range from a low of 2 to 2.5 to a high of 4.5 to 5. Obviously, there are aberrations and exceptions to this range. A buyer may pay more for an emerging concept or units with significant development rights, but the days of speculative prices based on proforma analysis and aggressive sales trends are gone. Valuations are now on a very static, historic cash flow approach, with a focus on moderate leverage and substantial return on equity.
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