The franchise restaurant industry has seen an increasing number of transactions in recent years. Corporate owners have sold franchises to private equity firms or other buyers, with many transactions taking the form of roll ups. Despite the volume and diversity of these deals, there are a number of common valuation issues that apply to restaurant franchise transactions. This article will explore several issues from the perspective of both Buyers and Sellers in these transactions.
It is not uncommon for private companies to accumulate nonbusiness and personal assets on their balance sheets including vehicles and vacant land held for future restaurant locations. These assets do not contribute to the current operations of the business, but may have significant value in their own right. If the nonbusiness real estate is to be included in the sale, the Seller should have a valuation done in order to receive proper compensation for these assets, in addition to the business value.
If the transaction is structured as a sale of assets, the gain on the sale of the equipment may be taxable to the Seller at ordinary income rates rather than at capital gains rates. This recapture tax can significantly increase the cash tax liability of the Seller. The Seller therefore will want a low value assigned to equipment in order to minimize this tax. (It is worth noting that the buyer will benefit from having a high value assigned to the equipment, as described in more detail below.)
In our experience, the fixed asset records of franchise restaurants often include double and triple counting of assets. As older assets components are retired from service, it is typical for the new replacement to be entered on the asset file. However, the cost and net book value for the retired component is often not removed from the fixed asset file. The use of net book value or other simplistic valuation methods, based on the fixed asset record, can therefore result in an overstatement of value and higher recapture taxes. The Seller should insist on a proper valuation of the equipment prior to the close of the transaction so that the purchase price can be adjusted for the Seller’s tax liability.
The sale of most franchises includes a non-compete agreement which prohibits the Seller from competing with the Buyer within the franchise territory for a specified number of years. The value of the non-compete agreement is taxable to the Seller at the ordinary income rate rather than the lower capital gains rate. Therefore, it is again important for the Seller to have a third-party valuation of the non-compete agreement, before the transaction closes, in order to avoid any tax surprises after the fact.
The structure of the real estate holdings can create complexities for the Buyer, even in the smallest transaction. Often the Seller owns the real estate in a separate corporation and leases it to the operating company. These related party lease agreements are often at rates different from current third party market lease rates. It is important for the Buyer to understand the terms of the leases (including all option periods) and to explore comparable market rates. A real estate valuation professional can be helpful in this review, prior to the transaction.
Many owners of franchise restaurant businesses do not want to tie up their operating capital in owned real estate. If owned real estate is included in the transaction, the Buyer may want to explore the sale-leaseback market. For a variety of reasons, it is important that both the sales price and lease rate be set at market rates. The valuation of these assets should again be performed prior to finalization of the sale-leaseback transaction.
If a franchise transaction is structured as a sale of assets, the Buyer will establish a new depreciable basis in the assets for tax purposes, based on their value. As mentioned above, the Seller may incur recapture tax liability as a result of a high value placed on the fixed assets. The Buyers interests here run contrary to the Sellers. Because the equipment will be depreciated for tax purposes over a three to seven year life, versus 15 years or longer, the Buyer is best advantaged by a higher value being assigned to the equipment. Because the Buyer and Seller must use the same values for tax reporting and the values used must be supportable, it is advisable to have a valuation of the assets performed before the transaction closes, in order to sort out the differences between the parties.
The Buyer will be required to record the value of the intangible assets on the balance sheet and to amortize these assets over their useful lives. These assets may include non-compete agreements, franchise agreements and brand names. The amortization of these intangibles will have a negative impact on the Buyer’s income statements. This may be a concern to the Buyer, if for example, there are profit benchmarks the company is required to… meet under the terms of a bank loan agreement. Understanding the value and amortization of the intangible assets, prior to the close of the transaction, will eliminate these types of unforeseen problems.
It is also important for the Buyer to be aware of the remaining term on the franchise agreement and determine the length of time that cash flow will be available. The remaining term defines where the franchise is in its physical life cycle. It isn’t uncommon for major capital improvements to be required toward the end of the franchise term or on renewal.
Most franchise agreements require significant upgrades or renovations more than once during the term. It is important to understand where the restaurant is physically under the franchise agreement and what type of capital investment may be required as part of the franchise agreement. Also, franchisors may change the form of the franchise agreement on renewal, including adjustments to the economic terms. Buyers should be aware that a franchise agreement with a short remaining term may contain provisions that have a serious impact on profits.
Both the Buyer and Seller should review the franchise income statement and identify expenses which are either above or below third party market rates. For example, the selling owners may have paid themselves above-market salaries for managing the business. This makes the franchise appear less profitable, and therefore less valuable, than it would otherwise be to a third party. Other items to review include charitable contributions, entertainment expenses and lease terms. Adjusting for these expenses will provide both Buyer and Seller with a better understanding of the value of the business.
As restaurant franchise transactions continue to increase, it is important for Buyers and Sellers to obtain independent and experienced legal and valuation advice. The challenges in valuing these businesses and the unique nature of franchise agreements make restaurant transactions complex. Taking steps to identify and address issues prior to close can help expedite the transaction and avoid surprises or unexpected tax consequences.
Written by Dick Gorski
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