Valuation Concerns Pertaining to Assets in Franchise Restaurant Transactions

During our recent webcast, “Considerations for Buyers and Sellers of Franchise Restaurants,” we asked participants if they anticipate being involved in a transaction in the next six months. The majority – 72% – indicated that they plan to be involved in a transaction. Indeed, the number of restaurant transactions increased in 2013 with 132 transactions – up from 115 in 2012, according to S&P Capital IQ. Capital IQ data also shows 31 announced restaurant transactions for the first quarter of 2014. Restaurants continue to be attractive targets for financial sponsors and strategic acquirers. In this issue of the Alert, we look at valuation concerns with respect to assets in franchise restaurant transactions.

An acquiring company is required to place the assets of the underlying business being acquired on the balance sheet at fair value, as defined in ASC 820, Fair Value Measurements and Disclosures. In an allocation of purchase price involving a franchise restaurant, the assets typically involved are real property (owned land and buildings, leases), personal property (kitchen equipment, leasehold improvements), and intangible assets (franchise agreements, brand names, non-compete agreements). Generally, valuation professionals use one of three approaches to value the assets: the cost, market (sales comparison), or income approach.

Real Property

The following are the methodologies used to value certain real property:

  • Land – a sales comparison approach which uses comparable market sales and listings with adjustments for differences between the comparable property and the subject property to arrive at the contributory value of the land.
  • Buildings and site improvements
    • Direct pricing – a cost approach which looks at the replacement cost new and deducts for physical depreciation and functional obsolescence.
    • Indirect pricing – a cost approach which involves performing a trend analysis of the fixed asset record. The validity of this approach is largely dependent on the quality of the fixed asset record.
  • Leasehold interests – an income approach which measures the favorable/unfavorable value of the contract rent with the market rent as of the date of the transaction.

Personal Property

When valuing personal property, the following approaches are used:

  • Direct pricing method – A cost approach which involves a detailed inspection of each location by a valuation professional. Each piece of equipment is listed and priced to determine a current replacement cost. Depreciation is then applied based on the age and condition of the asset to arrive at the fair value.
  • Indirect pricing method – This cost approach is based on the existing fixed asset record. An inflation index is applied to each cost record and the replacement cost is depreciated based on the type and age of the asset to arrive at an estimate of the fair value. If fixed asset records are not maintained properly each year there can often be double and triple counting of assets, resulting in an overstatement of value.

For the seller, an overstatement of value can create a major tax problem in the form of recapture tax. The amount of gain on a fixed asset above the net tax value is taxed, not as capital gains, but as ordinary income resulting in an additional tax burden.

The following chart highlights some of the key concerns for buyers and sellers in a franchise restaurant transaction:

Due to the complexity involved in the valuation of assets in a franchise restaurant transaction, we recommend hiring an independent valuation expert who can handle the necessary adjustments and fixed asset record issues. For more information, contact your VRC professional.