A large number of businesses operate as “franchises,” in which a separate entity creates a brand identity for a product or service that is sold through a system of franchised retailers or wholesalers. Examples include automobile dealers, hotels, beer distributors, restaurants, video, auto and other rental outlets. These businesses normally grant to the franchisor the rights to specify certain marketing and operational practices and define geographic sales territories. In return, the franchisee is normally granted the exclusive right to represent the brand within a certain area, and pays some royalty. Franchises in some industries are further governed by state and federal laws. We describe the sources of value in a franchisee business. We note that these sources include growth options for the brand itself, and the risk of termination of the brand, in addition to the expected discounted cash flow from the current business. These additional sources of value and risks mean that standard capitalized income approaches using recent earnings as a base will often produce erroneous value estimates.
To address the magnitude of “brand risk” in a franchisee valuation, we outline a model to value future business earnings subject to termination risk for the franchise. We present a simple formula to incorporate that risk, which can be incorporated in a modified capitalized income approach for valuing franchised firms. To illustrate the magnitude of the errors that result from ignoring termination risk, and to validate the recommended formula, we present results of Monte Carlo trials of a simple model. We recommend a parameterization of the model, based on experience over the past 100 years in the automobile industry.
Our results underline how “rules of thumb” can provide grossly misleading value or damages estimates. We also describe common sources to disputes between franchisees and franchisors, and recommend steps to take when estimating damages for a franchised firm. An appendix includes a mathematical derivation and summary Monte Carlo methodology.