Feb 7th, 2008
Complex Valuation of Food Franchises - Court Adjusts Income Approach
Bertuca v. Bertuca, 2007 Tenn. App. LEXIS 690 (November 14, 2007)
Five years before this Tennessee couple divorced, the husband formed a partnership with his father to acquire and operate McDonald’s franchises in their mid-Tennessee region. The husband owned a 90% interest, but both partners had equal management rights, including any decision to sell. Their buy-sell agreement set a purchase price at book value; or, alternatively, the partners could liquidate.
A year prior to the divorce, the partnership acquired seven franchises for a total of $2.345 million. The partners financed $2.23 million and contributed $150,000. To raise his 90% share, the husband borrowed $124,200 from his father—a debt that remained outstanding at the divorce. The father, who owned/operated fourteen McDonalds through a separate entity, provided management services at no charge so that his son’s partnership could gain a foothold in the franchise business.
Pursuant to the particular franchise agreements, the McDonald’s Corporation owned the underlying real estate and rented it to the franchisee. Strict guidelines prohibited the sale of any franchise without McDonald’s’ consent. The partnership was also obligated to rebuild one of the franchises in its entirety, at an estimated cost of $950,000.
Battle of experts, with rebuttal on the side
The husband’s valuation expert was a CPA who represented fourteen McDonald’s franchises and had been involved in the sale of over 125. In his opinion, as of the valuation date, the partnership’s seven franchise were worth no more than the purchase price paid the year before.
To reach this conclusion, he first calculated the gross value of each franchise by using a multiple of free cash flow—which he testified was standard practice for valuing a McDonald’s franchise. Cash flow was determined from each operation’s net income during the prior twelve months and reducing it by interest expense, depreciation, amortization, and general/administrative expense. Multiplying this by a factor of five (4.5 to 5 was the standard for McDonald’s, he said), he reached the gross value. He added current assets and deducted current liabilities to arrive at a total net value for the seven stores of approximately $485,000. Given the partnership’s obligation to rebuild one restaurant and the husband’s obligation to repay his father’s loan, the expert said the marital interest in the partnership actually had a negative value.
The wife presented a CPA who was also a credentialed business appraiser and forensic accountant. Using a capitalization of earnings method and a 12% cap rate, he initially valued the partnership at just over $3.078 million, excluding debt. Applying cash flow figures supplied by the husband’s expert and the same general/administrative expense—adjusted downward for what he believed to be unnecessary expenses and excess profits—to reach a final value for the husband’s 90% interest of $1.671 million.
To rebut this value, the husband presented a CPA and managing partner of a valuation/litigation support firm who specialized in valuing McDonald’s franchises. This expert criticized the wife’s for using a 12% cap rate to reach a cash flow multiple of 8.33—higher than she’d seen for any sale of a McDonalds, she said. The preferred method was a discounted cash flow method (DCF); hers projected the income of each restaurant over seven years discounted by a 20% discount rate. Although her DCF indicated that the seven franchises had not appreciated beyond the purchase price, the partnership had $493,000 in equity. After applying a 20% discount for lack of marketability and deducting the loan to his father, she valued the husband’s 90% interest at $231,000.
Complicated valuation
Based on the three expert reports, the trial court valued the fast food partnership at $1 million, and the husband’s interest at $900,000. After awarding him the business, it ordered him to pay the wife $450,000 in equal monthly installments over seven years. The husband appealed, claiming the valuation was contrary to the evidence and failed to account for the buy-sell value and a marketability discount.
The appellate court found that a number of factors complicated this valuation, in particular the recent acquisition of the restaurants, their limited earnings history, and the need to rebuild one. The partnership earnings were also skewed by the father’s contributing his management services for free. In addition, there were problems with each of the primary experts. The husband’s expert applied excess depreciation and amortization. The wife’s expert failed to consider the cost of the rebuild. The rebuttal expert’s valuation conclusion was wholly dependent on the “appropriateness of the methods and assumptions” she used.
“In our view,” the Court said, “the preferred method of valuation would be to determine [the partnership’s] earnings using a capitalization of income approach.” How its interests appreciated to $1 million, as the trial court found, was “uncertain.” The parties were entitled to de novo (new) review, based on all the evidence—beginning with the net cash flow figures from the husband’s expert of $412,633. Adjusting for interest expense on the rebuild and excess depreciation, the Court reached normalized cash flow of $442,978. It used the 12% cap rate from the wife’s expert to reach a value of nearly $3.7 million. After adjustments for cash on hand and liabilities—including the obligation to rebuild—the Court found a value of $1.033 million.
Because this value approximated the trial court’s conclusion, its findings were left undisturbed. The Court declined to adjust for a marketability discount, because a sale of the husband’s interest was not “necessary or desirable.” Similarly, the buy-sell agreement did not affect the ultimate value conclusion because a sale was not planned or imminent.
