Knowing the worth of your business is always given priority by entrepreneurs for prevalent reasons like to identify growth trajectory of business, to obtain financing or alternative investment, to track your goals, or curious to know the true worth of your business for deciding what kind of strategic plans to be taken up, or planning for an exit etc. as mentioned in my another article on “Why your business needs a business valuation”.
A very strong brand identity is the dream of every entrepreneur. To make this possible, one has to derive strategies and this differs from one to another. One of the most popular strategy for brand establishment is to spread awareness by opening retail outlets. If you are looking for a strategic plan for expansion with low investment, then going for franchising the business is always in top of the list. Few of the successful players in this line are:
McDonald’s is an American company and is found in 120 countries with nearly 37,855 restaurants globally by 2018. Dominos is an Indian company with 1250+ stores all over India. Burger king is an American company having nearly 17,796 stores world-wide by 2018. Pizza hut is also an American company with 18,431 outlets internationally by 2018.
What is franchising all about?
Basically two parties, Franchisor and Franchisee come to an agreement. The franchisor is the business owner who sells the right to operate stores using its brand, expertise & intellectual property and the franchisee is an independent party who purchases those rights from franchisor and in exchange of the rights, he pays a lump sum license fee and an ongoing franchisee fee, commonly known as Royalty fee either on a monthly, quarterly, or annual basis to franchisor. Here, Franchisee operates a business that replicates franchisor’s business under franchisor’s brand and operational manual bound by an agreement.
Areas of focus for a franchisee are mainly actively replenished inventory, profit margins, marketing support from franchisor and for a Franchisor it is expertise of franchisee, possibility of increased brand visibility and growth potential in market.
This model of franchise management began in 1990s in India with the start of liberalization era with few educational institutions and IT companies. Now it’s been following by many industries, majorly food & beverages, Beauty & health care, retail, education, medical services etc.
What is this Franchise agreement?
A franchise agreement is a legal document between franchisor and franchisee that details the expectations from both the parties by this contract and outlines the rights and obligations for one another. There is no specific standard format since the terms and conditions vary widely depending on the type of business. Most commonly, it contains provisions regarding location, operations, duration of agreement, renewal and cancellation rights, ongoing assistance from franchisor, initial license fee, ongoing royalty fee, terms regarding advertisement and marketing.
Unlike other business valuations, franchise valuation can be taken up either by franchisor or franchisee involving in the agreement and the factors that need to be considered differs from franchisor to franchisee.
Valuation by Franchisor:
Franchisor is the owner who is in possession of brand. It is easier for franchisor to value his franchised business and he may do it by taking the following into consideration under DCF method:
- Current Cash flows:
Firstly, consider the cash inflows of the franchisor from franchised business which may typically include initial licence fee, ongoing royalty income, and renewal fee (if any) etc. Cash outflows from franchisor includes cost of goods sold or services provided at franchised business, advertisement and sales promotion expenses incurred, training expense, employee cost if employed by franchisor, cost of setting up operations initially like ERP software, interiors etc., apportioned head office expenses pertaining to franchised business etc.
This is inclusive which varies and largely depends upon the terms & conditions of franchise agreement and the industry in which business is being operated.
Before stepping into the computation of growth rate, franchisor has to determine the expected life of business which largely depends on the nature of product and the stage in which his product is, in the product life cycle.
Growth essentially is in two ways for a franchisor a) Growth in number of franchisees b) Growth in cash flows from/to existing franchisees. Based on expected business life, growth rate should be determined and given effect in either ways to the projected cash inflows as well as outflows and the same should be discounted at Cost of capital rate to arrive at the present of value of business.
One interesting area of focus for a franchisor is goodwill and this arises due to the ability of the business to generate higher cash flows than industry average. This goodwill can be quantified using methods like profit capitalization method. However, this goodwill gets factored in the projected cash flows when DCF methodology is followed and separate valuation can be used when business is valued using techniques other than DCF.
Valuation by Franchisee:
As is true in many walks of life, there are both detailed scientific ways and simple relative methods of determining the value of business.
For a franchisee to value his business, the most common practice is to base the value of a business on a multiple of future maintainable earnings or on multiple of franchise revenue. The computation of future maintainable earnings is as simple as EBIDTA (Earnings before Interest Depreciation Tax Amortisation) adjusted with one-time / abnormal gains as well as losses. These normalized earnings has to be computed for previous 3 years and the same has to be weighted based on seasonality, market risks and various other business related factors. And the appropriate multiple is derived based on comparable deals adjusted with internal factors like degree of risk involved in generating cash flows etc.
As a matter of fact, a franchisee who have devoted time and efforts to build, may seek something a bit more thorough than a back-of-the-envelope calculation. The more detailed methodical valuation of business can be done in below two methods apart from the above Multiple method.
(a) Net assets valuation:
Arrives at valuation in terms of stated net worth of the company
Variations of this method use depreciated replacement cost of fixed assets or net realizable value (break-up or asset-by-asset sale basis). These methods are used mostly in cases where the business is asset – rich and those tangible assets dominantly drive its earnings capability
Although an important premise of franchising is that goodwill remains vested in the franchisor, franchise value should include the value added to the franchise business by the franchisee that is often referred to as goodwill. This can be explicitly seen when franchise revenue is over and above the similar franchise stores average revenue and a franchisee shall therefore expect to be compensated for the value he has added to the franchise business on any sale. This Goodwill as a multiple of earnings may be considered for the establishment of the business and derive its value.
(b) DCF – Free cash flow:
Sole focus on EBIDTA or revenue as in case of multiples method may not show true worth since they may appear rosier than they are. In any business, it’s not either revenue or EBIDTA that matters but cash flows from it which indicates the health of business in real sense.
The value of franchise business can be determined using Discounted Cash Flow (DCF) method which is one of the most scientific among all the valuation methods in terms of conceptual framework. As per the method, value is defined as follows:
The revenues for a future period of time are projected along with expenses and a free cash flow is derived based on expected life of business which might depend on licence period of agreement. The projected cash flows should be discounted i.e., deriving its present value using discount rate. This discount rate is cost of capital rate computed using different methods and the most used one is capital asset pricing model in which various factors like beta of the company, risk free rate and risk premium are considered.
This methodology is superior because the value derived using this is not impacted by accounting practices (which are many a times non-uniform across companies/ time), as it is based on cash flows and not book profits. The method incorporates all factors relevant to business (e.g. tangible and intangible assets, current and future competitive position, financial and business risks, etc.).
Valuation is both an art and science. But the weightage of art would be higher because the value of a business depends on numerous variables, it can typically be assessed only within a range. The art lies in the subjective judgement that a valuer makes, having considered the research/evidence carried out, in actually putting a figure against asset or revenue or expenses and in making appropriate adjustments.
A Valuation analyst does sound valuation by relying on multiple factors, all vetted to the extent possible and use combination of above methods to arrive at a Fair value of the Business.