Owners of franchise businesses often overlook the value of intangible assets unique to such businesses. Understanding franchise intangible assets can help franchisees maximize the benefits of bringing new capital into their franchise business and can help avoid costly financial mistakes. With the right understanding and strategy, franchisees can maximize the economic benefit of capital investments in their business as well as the benefits from sales of the business later on.
Intangible assets in a franchise business
Some types of intangible assets found in franchise businesses are well-known, such as the goodwill or trademarks of a brand and its processes. Many business owners are aware that national brands may have significant intangible value because consumers readily recognize the brand. When a new franchisee enters a franchise platform, they typically make recurring annual payments for the intangible assets of the franchise brand and the right to use the brand name, proprietary formulas and processes, and other property of the brand.
However, when considering capital investments and other transactions, business owners often fail to consider the value of the intangible assets they bring to the table as owners and operators of the franchise business. Properly considering the intangible value in a franchise business can have meaningful economic consequences on the benefits parties realize in capital investment transactions and sales of the business.
Some examples of franchise intangible assets
Franchisees are typically individuals who own and operate a franchise location, and franchise brands often require franchisees to satisfy a number of requirements in order to receive and maintain the franchise brand’s approval. The franchisee must go through an initial application process, maintain certain levels of net worth or capital funding, complete week(s) of training on how to be an ambassador for the brand, attend ongoing education, meetings with other members, peer-to-peer mentoring, and meet performance benchmarks. The franchisor can be very selective about who they allow to represent their brand, and franchisees are often thrilled to find they have received the approval of the franchisor and can open their business.
However, the savvy franchisee can read between the lines; since the franchisor’s approval is far from guaranteed, receipt of the approval provides the franchisee with a right to operate one or more franchise locations, which carries a potentially significant intangible asset and value.
Maximizing the benefits of the franchisee’s intangible assets
The intangible value associated with the approval to operate a franchise business is frequently overlooked by franchisees when they’re considering partnering with capital investors. When implementing an expansion of the business, an approved franchisee should keep in mind that they bring their own intangible assets to the table. By having the approval of the franchisor, the franchisee saves potential investors the effort to go through the time-consuming and expensive process to receive franchisor approval, which is not guaranteed. As such, with the expansion of each new location, the franchisee could ask for economic consideration to recognize the intangible value the franchisee brings to the deal by having franchisor approval secured.
As an example, let’s examine XYZ Pizza. XYZ Pizza has a lengthy franchise process and, after completing the process, John was approved to be a franchisee. John opens two locations immediately and business is very good. In order to expand, John needs to raise additional capital, and Amy is willing to contribute capital for each new store John opens. John, who understands the value of the intangible assets he brings to the deal, negotiates with Amy to structure the deal so that John and Amy will be 50/50 owners of each new store they open in a partnership together. For each new store, Amy contributes $1 million in cash, and John contributes an intangible asset consisting of his agreement to use his franchisor approval to open or acquire new franchise locations, which is valued at $1 million per location.
The fair market value of the property that Amy and John each contribute is calculated as part of their economic capital, or economic interest, in the joint venture.
In our example, each new XYZ Pizza store that John and Amy want to open requires two things: (1) an approved franchisee with rights to open and operate new franchise locations, and (2) $1 million in cash. Effectively, John is valuing his franchise approval at $1 million per location. Therefore, for each new store they open, John would increase his economic capital by $1 million.
If John didn’t negotiate the transaction to account for the intangible value of his franchise approval, the impact to him could be significant upon the sale of a franchise location. Using the example discussed above, if John and Amy decide to sell the assets of a franchise location, each of them will each receive $1 million of proceeds as a return of their capital investment before any items of gain and loss are allocated to them. This table illustrates the basic economic outcome to Amy and John of a sale of a franchise location at $5 million, assuming they owned the franchise location in a 50/50 partnership that didn’t have any debt or hold any other assets.
Alternatively, if John didn’t negotiate an assignment of value to his franchise approval, Amy would receive $1 million as a return of her capital investment, and the remaining sales proceeds would be split between Amy and John based on the items of profit and loss that need to be allocated to them. As a result, if John didn’t assign value to his intangible asset, the proceeds John would receive from the sale would likely be much lower and Amy’s would be higher.
Franchise intangible assets & transactions: Better position yourself by planning now
The economic impact to a franchise business owner can vary depending on the facts and circumstances of their position and the business planning steps they took. The economic and tax outcome of a transaction can vary based on the entity type that the owners choose, the terms they include in their operating agreements, and whether they sell the equity or the assets of the business. Often, the planning decisions the owners make before forming the business will have a significant impact on their economic outcome, so it’s important to consider these issues early on.
