Beware of hidden risks when valuing a franchise

BVWireIssue #139-4
April 23, 2014

Most valuation analysts might think that a franchise probably would be more valuable than an otherwise comparable independent business with similar revenues or cash flow. However, franchises can have a much greater degree of risk than an independent, which affects value. The franchising industry has a checkered history that includes fraud and misleading statistics. Plus, there’s a huge imbalance of power between the franchisor and franchisee. A recent lawsuit illustrates some of the trouble in this industry.

New lawsuit: A group of Papa Murphy’s franchisees have filed a lawsuit against the chain, accusing the company of misleading them about the financial results they could expect and forcing them to pay more for advertising than they were told. The franchisor—a take-and-bake pizza chain with over 1,400 stores—ranked No. 5 on Forbes magazine’s list of the top 20 restaurant franchises to buy in 2011. The lawsuit comes at an awkward time for the franchisor as it prepares for an IPO.

Valuation analysts need to understand the unique characteristics of the franchising industry. One is the significant control the franchisor exercises over the franchisee’s operations. This control can extend to many details of the operation, including location, suppliers, hours of operation, signage, and so on. The franchisee must also make required payments during the year. Another characteristic is that there is a wide disparity of relationships between franchisees and franchisors.

What to do: When valuing a franchise, carefully examine the franchise agreement because it “really drives the risk and the value of the business,” says Theresa Zeidler-Shonat (Smith & Gesteland). Speaking during a recent webinar on valuing franchises, she also advises that you look closely at the franchise disclosure documents. “These documents are incredibly important to understand because the provisions within them can significantly impact company value.”

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