Valuation of Franchise Companies

AuthorRichard Greenstein and Richard Morey
A. Key Definitions
As a starting point, it is helpful to dene some of the terms and con
cepts that are commonly used when discussing franchise company
valuations. EBITDA, or earnings before interest, taxes, depreciation, and
amortization, is a commonly used metric for valuing both franchise and
non‑franchise companies. Deal prices are often reported as a multiple of
the target company’s EBITDA. The more general terms “earnings” and
“cash ow” are also often used to mean EBITDA, although technically
they are not the same.
EBITDA is not a concept that is dened in generally accepted account
ing principles (GAAP) or another standardized manner. As a result,
determining EBITDA is often a very subjective process. For example,
the owner of a business might decide to take $10,000 in salary from the
business, and that salary would be a business expense deducted from
EBITDA. In the alternative, that owner could decide to take that $10,000
as a dividend or other return on capital, and that return would not be
deducted from EBITDA. Of course, this decision has tax and other impli
cations as well, but it demonstrates how transactions with the same
economic effect can nevertheless impact EBITDA in different ways.
The goal in any valuation process is to determine a normalized EBITDA,
or EBITDA that has been adjusted for certain nonrecurring income or
expenses. Because there is no one standard way to calculate EBITDA,
evaluators of franchise and other types of companies will use their own
Valuation of Franchise Companies
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calculation of normalized EBITDA. In some cases a potential acquirer will modify
the target’s EBITDA calculation to reect the changes that it intends to make, in
order to estimate what the target’s EBITDA would have been if it had owned the
target. This calculation is often referred to as “pro forma EBITDA.” For example, the
acquirer may remove the salaries of some management positions that it intends
to eliminate or, referring specically to a franchise company, remove the revenue
associated with a franchise developer who it knows will not be in the franchise
system for long after the acquisition. This pro forma EBITDA is typically not shared
with the seller, but can be useful to the buyer in analyzing the target’s valuation.
While EBITDA is a relatively common metric used across industries, many indus
tries have developed specic metrics used to assess valuation for businesses in
those industries. For example, hotels and other companies in the lodging and
hospitality industry often report RevPAR, or revenue per available room, in order
to assess a hotel’s protability. Some retail chains have historically valued busi‑
nesses using annual revenue rather than EBITDA, particularly when the costs
can vary signicantly from operator‑to‑operator and from year‑to‑year. Another
metric often used for retail and multi‑unit concepts is EBITDAR, which is EBITDA
adjusted for rent expense. Free cash ow (EBITDA less capital expenditures) is
another term commonly used in valuations of companies. Free cash ow signi
es the true amount of cash generated by a company to pay down debt or pay
out dividends to shareholders.
B. Internal Rate of Return
Finally, in addition to valuing a target’s earnings, the buyer and seller will need
to understand the investment’s past and projected internal rates of return, or
IRRs. IRR is commonly used by private equity rms and others to understand
not only how much value has been created by the company after the acquisi
tion, but also how quickly it was created. For a simple example, assume a buyer
acquired a franchise company using $10 million in equity (plus debt, which is
not relevant for this simple calculation). Further assume that the buyer does not
contribute any additional capital to, nor take any returns on equity from, the
franchise company during its ownership. When it sells the franchise company
ten years later, the buyer receives $15 million. While a $5 million prot on a $10
million investment might at rst glance seem like a good return, it took the buyer
ten years to realize that $5 million. The IRR on that investment was only four per
cent. Most private equity rms typically search for investments with an IRR of at
least 20 percent. In assessing a nancial seller’s willingness to sell (and how low
the purchase price can go), the buyer should try to gain some understanding of
the seller’s IRR on the investment. In determining the IRR, it is also important to
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