Franchise Agreements: Valuation and Accounting Treatment

Franchise Agreements as Intangible Assets

Franchise agreements represent a significant and often complex category of marketing-related intangible asset under IFRS 3. They create value on both sides of the relationship: the franchisor owns the right to grant franchises and collect ongoing royalties, while the franchisee holds the right to operate under the franchisor's brand, systems, and know-how.

When either a franchisor or franchisee is acquired in a business combination, these agreements must be separately identified and valued. The challenge lies in the interdependence: a franchise agreement's value to the franchisee derives entirely from the franchisor's brand and systems, while the franchisor's agreement value derives from the franchisee's operational execution and royalty payments.

The Franchisor Perspective

When a franchisor is acquired, the franchise agreements represent the right to receive ongoing royalty income from existing franchisees. This is a portfolio of contractual cash flows analogous to a customer contract book.

Valuation: MPEEM or Income Approach

The Multi-Period Excess Earnings Method (MPEEM) is well-suited to franchisor franchise agreements because the agreements generate identifiable, attributable cash flows (franchise royalties and fees) that can be separated from contributions of other assets.

Key inputs include:

Renewal Assumptions

Many franchise agreements include renewal options — the franchisee's right to extend the agreement for additional terms. Whether to include renewal periods in the valuation depends on the specific facts:

• If renewal is at the franchisee's option and historically exercised at high rates (90%+), including renewal periods is typically appropriate
• If renewal requires franchisor approval or renegotiation of terms, the renewal is a new contractual right and may not be included
• The IFRS 3 standard requires considering the entity's historical experience and stated intentions regarding renewals

The Franchisee Perspective

When a franchisee is acquired, the franchise agreement represents the right to operate under the franchisor's brand and systems for the remaining term of the agreement. This is the right that generates the franchisee's revenue and profit.

Valuation Approach

The franchisee's franchise agreement is typically the most valuable intangible asset in the acquisition. Its value can be estimated through:

Cost savings approach: The difference between operating under the franchise system (with brand recognition, proven systems, and national advertising support) versus operating independently. This captures the avoided costs of building an equivalent brand and developing equivalent operational systems.

Excess earnings: The profit earned by the franchisee above a normal return on tangible assets and workforce, attributable to the franchise relationship.

Below-Market vs At-Market Agreements

A critical consideration in franchise agreement valuation is whether the terms are at market rates or favourable to one party:

Below-market franchise agreements generate additional intangible value because they provide the franchisee with economic benefits exceeding those available from a new agreement at current market terms. This premium should be separately quantified.

Accounting Treatment

Recognition

Franchise agreements acquired in a business combination are recognised at fair value on the acquisition date. They meet the identifiability criteria through contractual rights — the franchise agreement itself is a legally enforceable contract.

Amortisation

Franchise agreements have definite useful lives — the remaining contractual term (including probable renewals where supported by evidence). Amortisation is typically straight-line over this period, though an accelerated pattern may be appropriate if franchisee revenue is projected to decline.

Impairment

Franchise agreements should be tested for impairment when indicators suggest the value may have declined — for instance, if the franchisor's brand suffers reputational damage, if the franchise system changes terms unfavourably, or if the market for the franchise's products or services deteriorates.

Franchise Agreements in Multi-Unit Acquisitions

Private equity acquisitions of multi-unit franchise operators present particular valuation challenges because the franchise agreement value is concentrated in the relationship with a single franchisor. Key considerations:

• Concentration risk — dependence on a single franchisor creates significant risk that must be reflected in the discount rate
• Portfolio effect — a portfolio of agreements across multiple franchisor brands diversifies risk
• Management capability — the acquired workforce's ability to operate franchises efficiently is a separate intangible (assembled workforce) that contributes to franchise profitability
• Territory rights — exclusive territory provisions may represent additional value beyond the base franchise agreement

Franchise agreements are one of seven marketing-related intangible assets under IFRS 3. See 35 types of intangible assets for the complete taxonomy, or explore customer contracts and relationships for a related asset class.

Tony Hillier is an Advisor at Opagio with over 30 years of experience in structured finance, M&A advisory, and intangible asset valuation. Meet the team.