What are the differences between the business valuation of a franchise and the business valuation of an independently owned business? To answer this question, we need to understand how operating a franchise is different from operating a non-franchise.

Owning a franchise comes with a number of benefits. There is a proven business model, recognizable brand name, extensive training, ongoing support, and group purchasing power when it comes to supplies and materials. These benefits come at a cost. The business owner needs to pay a franchise royalty fee (often structured as a percentage of sales), ongoing advertising fee (also often structured as a percentage of sales), and often has to incur a franchise transfer fee if the business is sold to someone else. In addition, the business owner is limited to what he or she can and cannot do with the business. There are strict rules as to how the business can and cannot be operated, which might be a benefit if the business owner likes structure or lacks the experience, or a detriment if the business owner has a great marketing idea to grow the business but the franchisor refuses to approve it.

Perhaps the greatest hidden cost of owning a franchise, however, is the question of freedom. All businesses, franchise or not, have an industry standard for how much the owner is supposed to take home. For instance, suppose the business is in an industry where the owner typically takes home 15% of revenues. If the business is non-franchise, the owner will take home 15% of revenues if the business is run well. If the business is a franchise, however, the business now has to pay a franchise royalty fee and other fees to the franchisor, which can take a significant chuck of revenues. In other words, the franchise owner may not have enough profit left to hire a manager and become an absentee business owner. The franchise owner is forced to be an owner operator and work day in and day out at the business, unless he or she starts owning multiple franchises.

When it comes to the business valuation of franchises, business buyers often get excited about the benefits of owning a franchise while downplaying the costs. After all, the franchisor spends a good amount of money on marketing so it can sell more franchise opportunities and collect more franchise royalty fees. Given the positive imagery, mystique, and romanticism of franchises, business buyers will often pay more for a franchise than they will for a non-franchise. In other words, for the same amount of seller’s discretionary cash flow, a franchise can often achieve a higher multiple in the business valuation compared to a non-franchise.

Having that said, it is important to note the difference between a new franchise opportunity and a franchise resale. When the franchisor advertises the dream of owning a new franchise, the franchise disclosure statement will often list the costs involved in opening up a new franchise location. For instance, it might cost $350,000 to open up a new location, and many people are willing to risk $350,000 on a new location with no proven sales. Suppose the franchisee spent $350,000 to open the new location, and it is now two years later. The business does $400,000 a year in sales, and the owner takes home $20,000 a year. Despite the fact that this location has $400,000 a year in proven sales and the equipment is only two years old, this franchise resale is not worth $350,000 on the market. In fact, business buyers will compare this franchise resale to every other business for sale on the market. For a business that only generates $20,000 a year for the owner, the value is likely to be $50,000 or less with all equipment included. After all, who wants to buy a business and only make $20,000 a year?

When it comes to the business valuation on franchises, the dream is more powerful than the reality is. People are willing to pay $350,000 or more to open a new location with no proven sales, and baulk at the idea of paying $50,000 for an existing franchise location with $400,000 in proven sales. In people’s mind, for better or for worse, the fact that one can make $400,000 in sales at this location is proven, but the fact that the owner can only take home $20,000 a year is also proven. Having that said, some astute business buyers will take advantage of the lower business valuation of franchise resales, buy an almost brand new franchise, and grow it to the next level. Once the business becomes highly profitable for the owner, the business valuation of the franchise will increase dramatically even more than non-franchises will due to the allure of franchises that are always on the mind of potential franchise owners.

Advantage Business Valuations provides business valuation services for small to mid-sized business owners in the United States. Founded by Aaron Muller who has valued thousands of companies as a business broker, Advantage Business Valuations helps small to mid-sized business owners determine the value of their business with ease and confidence. To discover the value of your business, visit www.AdvantageBusinessValuations.com.