Franchisors’ end of term arrangements – valuation of goodwill versus risk of competition

Section 23 of the Competition and Consumer (Industry Codes – Franchising) Regulation 2014 (Cth) (Code) provides that a restraint of trade clause in a Franchise Agreement (Agreement) is of no effect, if the Franchisee gives notice of its desire to extend the Agreement and the Franchisor elects not to do so.

A restraint of trade clause can be used in a variety of commercial contracts, however it is generally thought of being more readily enforceable where goodwill is involved.  The Explanatory Statement to Select Legislative Instrument No. 168, 2014 issued by the Minister for Small Business in relation to the Code states clearly that the intention of Clause 23 is to ‘provide relief in special circumstances where a franchisee, through no fault of its own, has not had its franchise extended by a franchisor’.

A post termination restraint of trade clause in a Franchise Agreement will not apply if the Franchisee:

• requests that the Franchisor extend the Agreement on the same terms as those contained in the ‘Franchisors’ then current Agreement as they apply to existing Franchisees; and
• is not be in breach of the Agreement or any collateral agreement at the time of the renewal request; and
• it has not infringed the Franchisor’s intellectual property rights or the confidentiality obligations owed to the Franchisor; and
• has contributed towards the development of the goodwill of the Franchise System; and
• it has claimed compensation for the goodwill because the Agreement was not extended by the Franchisor; and
• the compensation was only nominal and not genuine compensation for the goodwill.

Implications to Franchisors of failing to renew

New clause 23 of the Code raises three (3) primary areas of concern for Franchisors:

• Is the Franchise System easily replicated by an unrestrained Franchisee?
• How can the contribution towards goodwill be accurately quantified?
• What mechanisms should Franchisors include in their Franchise Agreements that are equitable in the circumstances?

The answer to these questions will largely depend on the nature of the Franchisor’s business and a suitable mechanism for quantifying the individual Franchisee’s contribution to goodwill at the commencement of the Franchise and at the end.

What accounting measures can be adopted to quantify the contribution towards goodwill?

Drue Schofield, Director of 4Front Accountants, regularly conducts valuations of goodwill said in response to this question:

“There are various methods which can apply to the valuation of goodwill, each one differing in its own way. Determining a fair market value is normally achieved using one or more accepted valuation techniques:

• the net present value of the projected cash flows (discounted cash flow method);
• net asset backing method based on an orderly realisation of the assets;
• the industry market method; and
• the capitalisation of future maintainable earnings method.

It is crucial that Franchisors seek legal and accounting advise before adopting a methodology as each one is different, and may require a combination of two methodologies to get to the most equitable and market-responsive result.  That said, however, the most common, but not always used methodology we’ve found for valuing franchise goodwill is the industry market method.

Although many franchises trade at market prices that are in excess of their valuation fundamentals, they trade at these prices in an active arm’s length market which we’ve found supports the argument of the market being the best reflector of value.

When applying this methodology to a franchise’s business, the valuation achieved under the industry market method should be assessed against that of comparable franchises as the value of other franchises are more relevant if the franchise has a reasonable number of franchisees and there is a strong primary and secondary market.

Franchisors that have a smaller number of franchisees or with no real secondary market do not present a compelling valuation argument, and greater reliance may be placed on industry fundamentals.  In all cases, however, the fundamentals of all valuation methodologies should be considered.“

For Franchisors the issue is whether or not to consider including a valuation mechanism in their Franchise Agreements versus the potential risk posed from competition by the Franchisee.   Each franchise system is different and the decision must be considered on its own merits.

Links and further references

Legislation

Competition and Consumer (Industry Codes – Franchising) Regulation 2014

Further information

If you need advice on incorporating a valuation mechanism into your franchise agreement, contact us for a confidential and obligation-free discussion:

Disclaimer

This article contains general commentary only.  You should not rely on the commentary as legal advice.  Specific legal advice should be obtained to ascertain how the law applies to your particular circumstance.

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