Welcome to the Restaurant Boiler Room, season 8, episode 5. I'm your host, Rick Ormsby, managing director at Unbridled Capital. Today in the Boiler Room, this podcast is a part 2 continuation of season 8, episode 3's podcast that outlines a broad discussion I might have with a first-time call-in from a potential sell-side client who calls me to inquire about the value and sale process for their business. In part one, we talked about the high-level qualitative factors that affect valuation for various franchise companies and brands. This time in part 2, we will talk about specific valuation methodology and detail the timing and process needed to complete a sale. The restaurant boiler room is a one-stop shop for multi-million dollar merger and acquisition activity and financial complexities affecting the franchise industry. We talk money, deals, valuations, and risk.
Delivered to the front door of franchisees, private equity firms, family offices, large investors, and franchisors on a monthly basis. Feel free to find our content at Unbridled Capital's website at www..unbridledcapital.com. Now, let's enter the boiler room. hey everybody, how you doing? Here we sit in the summertime. Look forward to talking with you and continuing this part 2, which is my idea was I get these calls all the time. People call in. It could be a possible client, either on the buy side or sell side. But in this particular kind of set of episodes, I've fashioned this after just this hypothetical or theoretical sell side client who I may or may not know who calls in and wants to ask some questions about the value of their business. Part of what I did in part one was just to go through a really high level valuation kind of thought process of what I might discuss with the potential client who calls in. It's kind of funny because some of what I talked about, it lasted like 40, 45 minutes and maybe I expected it to be about half that. So like half of what I talked about just goes on in my mind, right? And I don't actually like talk about every detail of that on a first call with somebody. It might overwhelm them, but clearly it starts From A high-level perspective, where last time we chatted about brand, performance, geography, size of the investment, the management team, quality of the financials, what's the reason for selling this business? And then what type of a seller are you and how reasonable are you as a client? All things that come into play in this red flag, yellow flag, green flag way of thinking about a business that you might take as an advisor if you're trying to help someone in a sale process. A lot of these things are just levers and nothing is set in concrete, a lot of gray areas, but collectively over a quick discussion without even going into the details, I can typically size up whether a client is the right type of client that's going to have a successful overall process. And the brand moves up and down. Some brands are better than others in the current environment. Certainly in the time financing may be difficult to get if the brand's not the best. So if the brand is awesome, then someone's reason for selling or how reasonable they might be might not be as important to the discussion of taking the assignment. As opposed to someone who might have a business that's difficult to sell, may have same store sales challenges, quality of the financials may or the management team might not be in place, right? So these are all kinds of things. And then I made some comment about geography as well and size of the transaction. And so all these things go into play when you think about how sellable a business is and it's a living, breathing organism. So that's the first part of it. Today, we'll kind of just chat about the second part of it. I hope I don't put you to sleep today. And I'll go back and say one more time, I hope you're having a great summer as we talk through this. As an anecdotal comment, the market continues to be a little bit quiet. I think I said that on the season eight, episode 3, where we're moving into the summertime, which is naturally in most M&A cycles, a time where you're working on deals, but not maybe taking as many new assignments. I've said this before, but typically the February through April time period are going to be the busiest time of year when a client might be looking at their P&Ls, their balance sheets, income statements. They get their year-end kind of statement when all the documentation for tax is needed with their CPA, and it just becomes a natural time to be considering making strategic moves with your business. Certainly in the late fall, early winter, usually in the October, November time frame, you typically see a pickup in activity as well as someone kind of starts thinking towards the end of a calendar year. I mean, heck, we all do that when it comes to like charitable giving. Like I know I'll just always earmark November, December is okay, how's the year and how much money we're gonna give to our various charities and church organizations and things like that. I think that's pretty typical for most people as they kind of look at how their year is gonna be and what their tax burden is gonna be and wrapping up before the end of the year. and making financial decisions that may stretch into the following year. But the summertime typically is a time where you're working on deals more than you are taking new assignments. There's always 25% of what we do, if I'm just making an estimate, doesn't have any timing, rhyme or reason behind it. You've heard me say that before if you've listened to some of these, like in terms of financing someone's business, raising money for their business, selling a business, finding someone, buy something, these 1/4 of the time, roughly speaking, is unpredictable timing and it may not follow any kind of linear scale. So if someone dies or if someone has a divorce or there's a partnership dispute or if there's one time stress on a business that just pops out of nowhere, these kind of things don't follow predictable timing. But the rest kind of sort of do after a while follow a cadence that is somewhat predictable. I mean, of course, what's predictable anymore, guys and girls? I mean, after going through COVID and all the aftermath I feel like I've explained away one time situations so many times over the last five or six years that I don't even know what's real and what's not or what's up or what's down or sideways anymore. But clearly COVID had a massive impact on timing. And then going back to 2021, wasn't it interesting how that Joe Biden was going to come into office and he was threatening to raise capital gains taxes, who would have thought that would have had a material impact on things and who could have predicted it? But holy moly, people started flying for the doors to sell things and to close them by year end 2021 under any circumstance. And they'd pay double or triple for due diligence timing and like attorneys and people who have to work till the last minute to get deals closed just to avoid having to go into 2022 and sellers having to potentially face much higher capital gains taxes, which of course did not happen because of Joe Manchin saying that he wouldn't vote with the Democrats at that time. Do you remember that? But that was a really big driver of business that I don't know that we could have, in terms of timing, that we could have predicted that really made, for example, the early summer, late spring, early summer, mid-summer time frame in 2021 to be really busy when it otherwise really isn't on a typical year. So I suspect events that kind of cause those things to resurface and timing to change in years as we move forward. But always look at tax kind of differences between years as being a big motivator for people to make decisions. And then of course, you have one-time events like COVID and things that may throw off all the timing. And then maybe some industry-specific event like a big geopolitical risk or something that causes people to change their timing. But typically otherwise, Unless there's death and divorce and distress that you can't expect or you can't forecast, it usually sees the late spring being the busiest time of year for new assignments. the summer being the slowest, other than maybe the December, January timeframe. And then the second busiest time being the late fall. And it's interesting, typically, like right around the time you go back to school is really quiet too. Like usually August and September are usually very quiet months for new assignments. So we just have our heads down working on existing assignments in many cases. But here we sit today, part 2, and I'm going to talk with you a little bit about the specific phone call. So listen back to season 8 3 earlier this year, which probably came out sometime, I'm guessing, around the middle of May. And you're going to be up to speed for what I'm going to talk about today. So after the first piece of the discussion, I usually then move into a specific valuation discussion, which usually... circles itself around EBITDA, real estate, leases, remodeling, sales trends, the upside in a business, and then things like new unit development obligations and franchisors. And these will be more specific. So in a phone call, I can typically within 10 to 20 minutes of asking questions can get a baseline idea of within 10 to 15% what a business is probably worth in our franchise sector. Isn't that crazy? But after 25 years of doing all this stuff. So you tend to develop some expertise after doing it all. But here's what typically happens. The first thing I'll say is, and I'll give you an example. I ask about, okay, give me some idea what the sales are on a per store basis. I will typically say either PRA, AUV, or PSA, depending on how old school you are or where you come from. PRA is per restaurant average. AUV is annual is average unit volume, and PSA is per store average. So you'll hear it in different brands and different lines of franchising or retail use those three terms interchangeably. We typically, in the good old days when I used to work at KFC Corporate, it was always PRAs, but now we typically say AUVs more than anything else. I think it's more of a standard across franchising. So I'll say, what are your AUVs? I don't need it to be exact, but give me some idea what your AUVs will be or are for, let's just say the most recent year, 2026. What do you expect in just high level ballpark of what it is? And someone might say, okay, I've got 10 units and I expect it to be $20 million roughly in sales. I'm gonna say, okay, so your PRA or your AUV is gonna be probably around $2 million, right? Yeah, that's right. And then I'll say, okay, well, how many of your restaurants or if they're not restaurants, how many of your assets do you own the real estate and how many do you not? And they'll say, oh, I've got 10 stores. I got three of them, I own the real estate and seven of them, I don't. Okay. And then give me some idea high level of what your EBITDA margins are. And then I'll say something like, okay, if that's not familiar to you, EBITDA margins could also be like, what is your operating profit before rent? as a percentage. Now this discussion will stop some people in their tracks. Like some of the large people who might call in and own 200 or 300 of something know that number pretty closely. You'll hear them clicking on their spreadsheet on the backdrop and they'll say, oh, well our average EBITDA or operating income before rent is 22.7%, right? They may be really exact with it. And not everybody functions in this way, but typically it's some version of this, right? A mid-level franchisee will at least be familiar with it and say, you know, I'm around 25% more or less. And that may just be a bit of a but directionally close. And then you may talk with a smaller operator and they don't have much perspective of that at all. And I have to guess. And if it's a smaller operator and I have to guess what goes through my mind then is what's the average AUV and what did they just tell me their AUV is? And in my mind's eye, I'll have just some random, non-exact programmed number wired into my head about what the pre-G and AEBITDAR of a certain brand would be at its average AUV. And I may not be right about it, but it'll be a starting place. Usually what I do is I say, okay, my mind's eye. I'm like, I'm gonna just start off, unless I know that they're a really awesome brand that's been doing really well, if it's a legacy brand, I'm just gonna kind of in my mind's eye that's doing, if it's doing close to the average system AUV, which I'll typically have an idea in my mind what the average system AUV is for most of these brands, I'll just assign it in my head at 20% EBITDA margin. Now that's gonna be wildly off on some brands, but in my mind's eye, I just go there immediately and tweak up and down based on what I hear, right? So if I'll go like, okay, Pizza Hut business, 20% EBITDA margins, average AUVs in the Southeast, which is typically has higher margins than like the Northeast or the West Coast where you have bigger minimum wage issues and it's just harder to operate a business. So that might just be where I'd immediately go. If they were to tell me they're in the Northeast, I might make it lower by a couple of points. If they were going to tell me that they have AUVs that are 20% above system average, I might tweak the EBITDA margin up a little bit and I just get a pen and paper and just start fiddling with it on a legal path. right? For all you young people listening, you don't use pens and papers anymore, that's valuable for that. You can't do this on an iPhone, right? While you're talking with somebody. But so then I'll just do that, right? If it's, I don't know. If I hear someone say it's a two and a half million dollar ADV in the Taco Bell space in the Southeastern United States, I'm thinking to myself, like, that's a 25 to 30% EBITDA margin business, typically, depending on who the operator is and how well they're doing, right? So I might pencil in a 27% or something like this. And then I may range it on my little spreadsheet as I'm just going to err on my legal pad as I'm drawing it out. So I asked what the average AUV is. I know what the brand is from our earlier discussion. And I know obviously from our earlier discussion, what the geography is, the performance, generally, the reason they're selling, quality of the financials, the management team. So I get a kind of an idea of how the business typically would land on that EBITDA perspective. One of the things I'll say is some of these businesses, especially some of these investor-led businesses, have really high EBITDA margins. But like it factors like what the EBITDA multiply, we will ultimately place against them sometimes has to change based on that. So if it's in my head that the average EBITDA margin for a business of this person's size is supposed to be around 23 or plus or minus 1 or 2%, and they're telling me, oh, but I'm at 29%, which a lot of these financially driven businesses who they've really been eking out the margins, have really high margins, then I may come back with an EBITDA multiple that's a little bit lower because People want to buy businesses that are average performing businesses, or some people are really excited about buying businesses in distress or that need big turnarounds. But unless they're buying a platform business, most people would rather not pay a top multiple on a business that has the absolute best margins that's humanly possible, right? Because it's going to really high margins multiplied by really high EBITDA multiple creates like a massive price that may look out of whack for some people in their comfort zone. So you got to think about that in the backdrop, and we do deal with that quite a bit. But let's say it's a $2 million AUV, 10 restaurants, three fee properties. And let's say the next thing I'll do is $300,000 remodel expense. That's not always the number, but like in the back of my mind, I'm thinking, okay, without asking too many questions and without getting into all the detail as a placeholder high level, I'll figure 250 to $300,000 is the average remodel. And I'll figure within the brands, if it's a really attractive brand, we'll need to factor in that remodel cost over the next two or three years, but not really thereafter potentially as an early swag. And then if the franchise agreement's expiring in five years or so or less, if it's a brand that's more legacy that doesn't have the growth or quite the attractiveness in the marketplace, I'll stretch that discounting timeframe out from two to three years out to maybe five years, if that makes sense. And so the cost of remodeling and renewing the franchise agreement, whether it's a 20-year agreement or a 10-year agreement with another 10-year extension or whatever the brand's particular kind of requirements are, I kind of factor that, okay? So that depends, you know, and if I know for example that a brand's going through a massive remodeling project, And I know from prior discussions that the average remodel is 5 or $600,000, or I may ask the franchisee, are those remodels? Are they re-images? Are these scraping rebuilds? Or are these like, are you tearing them down to the studs? I may pencil in obviously bigger 5 or 6 or $700,000 remodel costs. And if it's obviously a tear down, which is a scrape and rebuild, then that number is a lot bigger. And so I just start penciling in what I think the remodeling costs will be for the next to five years. And I gather that information. And let's say in this case, that it's a brand where $300,000 is a good swag placeholder for an initial call. And they have, let's say it's a legacy brand, not one of these hot to trot brands. So we're going to look at it out for four to five years. I'm going to say five years. And let's say this particular brand has one remodel due in 2027, two due in 2028, and one due in 2029. Okay. I hope I get all this. So follow all this. And then obviously I've already known the brand, but let's say this is a tier one legacy brand. And so I say to myself, okay, most tier one legacy brands are trading between like in this marketplace, between 4 1/2 and 5 1/2 times EBITDA, right? If you're in a handful of brands that are in the 10 times EBITDA range, there's probably less than a handful in our industry if you're gonna buy a franchisee. but there's probably a couple, maybe three or four, right? And then you've got a couple that are, I won't name them by brand, but they're the usual suspects that have done really well. And then you have another couple of brands that are in the seven to nine times range, and then the rest of them are in the four and a half to five and a half times range. And then if it's like a tier 2 brand, a smaller brand that's okay performing but not great, or a larger brand that's struggling, you may drift down into the three and a half 4 1/2 times EBITDA range, okay? But for the purposes of this discussion, let's say I listen, it's a legacy QSR brand. It's doing kind of average, no spectacular growth story, but it's not dying on the vine either. We're gonna put a five times EBITDA multiple on it is just what I would think. And then, okay, and then I've got basically enough to do an initial valuation here. So here's how I would do it. I would say, $2 million AEV business, and I've got my calculator out here as we go through this, times 10 stores is $20 million, right? Now follow me here. So $20 million, I'm gonna say the pre-G&A EBITDA, let's just use, let's use 20% in this case, okay? Just simple math. So 20% pre-G&A EBITDA numbers times $20 million is $4 million in pre-G&A EBITDA, right? Follow me? And then let's say that the average rent on for example is going to be 7%. So 7% times $20 million would be 1,000,004. So we take 1,000,004 off of that number. And that becomes like our rent. Now it's a total guess, okay? But the reason why I have to break those out separately for the purposes of this discussion is because, what did we say? Three pieces of real estate here that I got to value separately. All right? So let's swag 7% rent here. May not be right. I'll usually ask the client, okay, what's your average rent on your stores that you don't own the real estate? And they're like, oh, it's about 7%. Okay, so I'll take 7% of the entire $20 million AUV and you'll see why in a minute. And then that leaves you with $4 million of pre-G&A EBITDAR less than 1,000,004, and that leaves you $2.6 million in, that's what we call EBITDA, pre-G&A EBITDA. After which then we take an allocation for G&A. Now when I ask for pre-G&A EBITDAR, that means that number does not have any impact of owner salary or above store area coaches, regional vice presidents, any of the above store kind of expenses are excluded when I ask, when I'm trying to calculate the pre-G&A EBITDAR number, right? And I put it in as a common G&A factor afterwards. I'm proud to say it started this trend. One of the people who started this trend 25 years ago Because you see all kinds of variability, I mean, crazy variability between people's businesses and how they operate them. You may have somebody who owns 100 restaurants or non-restaurant franchise assets and has it and is running on 2.5% GNA for all above store operations and leadership and owner salaries and everything. Wow. Maybe they have high AUVs, maybe they're great operators and they run it really tight. You may have lower AUV businesses where it's an owner operator who he's the owner and he's the area coach and he may run 6 or 7% GNA as a percentage of sales because that's what it takes to run that smaller business. And so obviously there's benefits of scale. The GNA kind of starts, the GNA starts to get squeezed in a positive way, lowered as a percentage of sales typically as the business increases. unless the size of the business is accompanied by really low AUVs, if that makes sense. So I'd listen for that. In this particular case, let's say 3 1/2% of sales. Usually it's between 3 and 4% of sales is what we typically task the business with in terms of G&A expense. Sometimes we'll take something as low as 55, 50 to 55, $60,000 of G&A per store instead of a percentage. But in this case, let's take 3 1/2%. So 3 1/2% of $20 million. would be, if you have your calculators out with me, that is $700,000, okay? So we would take that $4 million in pre-G&A EBITDA, less 1,000,004 for the allocation for our swag rent, and less $700,000 for G&A. And that leaves us with $1.9 million in what we call post-G&A EBITDA. Now I'm gonna round this up to $2 million so we can just use simpler math. Is that okay with you? I hope. So then we take $2 million, we multiply it by our five times, and we get 2 million times 5 is 10 million bucks, right? So that becomes our business value before considering the cost of remodels. Now in this particular case, $10 million, well, in this particular case, we had, what do we say, one remodel due in 2027, two due in 2028, and one due in 2029. And we're gonna use this kind of swag assumption that there's 300,000 each. Before we come up with a value, we put a deduct value for this remodel cost against that $10 million, and then we come up with the final value for the business operations only, not the real estate. Okay, if you're following me. So in 2027, we have one remodel due, $300,000. Well, let's just say we're going to ding that for the entire $300,000 of the purchase price, because as soon as someone buys this business, they're going to remodel that store right away. The one that's due in 2029, let's only ding it for half of the value of the remodel, 150,000. And the two that are due in 2028, let's ding it for $250,000 each. So that's a half $1,000,000. I mean, it's not exact. And this isn't necessarily exactly how we do it. And it depends on all the circumstances before, right? Like what brand it is, what the remodel cost is, How likely is it to be the remodel to result in higher sales in the store? How many remodels are bunched together? How realistic is it for somebody to be able to remodel on this schedule if they buy this business quickly? Because that alone, some of my buyers are going to say, man, it's a lot of remodels. If you got 10 remodels to do in the next three years, I've got to ding the price a lot because that's a lot of money out of my pocket that I'm going to have to solve for that I currently don't have to, right? So it's not really a really easy thing to do, I'm actually going to take the 2029 remodel and ding it by $200,000, okay, just to make the numbers easy. So 1 remodel at $300,000 full deduct in 2027. $250,000 each in 2028 equaling 500,000 and then one for $200,000 in 2029, which is discounting it down $100,000 for the fact that it's 2 1/2 years away. Add all those three together and you get $1,000,000 of swag. So I take that $1,000,000 against the $10 million in business valuation and we come up with a business final business valuation of $9 million in this theoretical crazy example. Okay, so I'll pause for a minute and have you think about that. As we go through it, you'll see one thing I'll point out and then we'll do the real estate separately. On the business side, if we were to assume instead of 20% EBITDA margin, it was 25% EBITDA margin, okay? 25% EBITDA margin at $20 million in sales is what? You guys are good with math. It is $5 million in EBITDA, not $4 million. I'm trying to show you the impact of the EBITDA margin assumption, right? If I assume this business has a 25% EBITDA and not a 20% EBITDAR. I mean, the remodels are going to basically stay the same, right? And as you can see, it takes $1,000,000 off the price, which is not inconsequential. But if I was to say, oh, maybe a buyer wouldn't discount it that heavily, it might go down from $1,000,000 deduct to like a $700,000 deduct. It doesn't have a material impact. I mean, it does have a material impact on the valuation, but not like this EBITDAR assumption on the initial verbal phone call will have, right? And then the other thing as through the example that you see is that the G&A factor matters. Whether it's $50,000 a store, if it's 2 1/2 percent or $50,000 a store versus 4% or $800,000 a store, well, that matters by a tune of $300,000 in EBITDA and that times A5 multiple affects the valuation by a million and a half. That change alone would bump our $9 million valuation up to 10 and a half million dollars. Now, realistically, I gave you bands for that. So in most cases, we're talking about whether it's a 3 or 3.5% GNA factor, and that's only a half a percent on 20 million, which is $100,000 times 5 is $500,000 in value. So that takes our, in most cases, our $9 million value to either maybe 8 1/2 to 9 1/2 million, right? But to go back to the EBITDAR discussion, this is where the big change is made. If we assume a 25% EBITDAR number, we're at $5 million in EBITDAR, not 4 million in our previous example. And if everything else stays the same, Now we're sitting on $3 million rounded up of EBIT of post-G&A EBITDA instead of two. And $3 million times 5 is 15 million minus our $1 million in theoretical remodeling, present value remodeling discount gets you $14 million instead of $9 million. And $14 million divided by $9 million is a 55.6% increase in valuation. So you can see how really quickly jumps based on the EBITDAR discussion. And most people in a first conversation, most people can't delineate within the EBITDAR range very closely, especially with a client who doesn't know exactly what their EBITDAR is. I can typically get it within 1% typically on a phone call just by asking all those questions I asked in season eight, episode three and today. So that is obviously a big item. I'll typically on a page write down a little range. In this particular example, we got though a $9 million business because we've got 20% EBITDA margins. And this business at 9 million bucks after the $1 million discount on 20 million in sales, $2 million AUV times 10 stores. is 9 million over 20 million is 45% of sales. In my head, no general ranges of what should be reasonable as a percentage of sales too, just as a backdrop. If you were to tell me something had a $2 million AUV and the business only price was 45%, I would say that was a really bad valuation because most $2 million businesses are gonna have, that's a pretty good AUV for most of the businesses that we work with, right? And so most of those types of businesses, unless they're in bad geographies with high minimum wages or they're operated poorly, et cetera, et cetera, are going to have better than 20% EBITDA margin. So immediately when I hear 45% of sales for a business that's business only price for a $2 million AUV business, I say, whoa, something is low there. You know what I mean? Sometimes in the Taco Bell world, you may have a $2 million AUV business where it's worth 150%, 125 to 150% of sales with no real estate. That's the upward bound of it because obviously the EBITDA multiple is much higher, the EBITDA margins are gonna be higher, the remodels don't get stretched out for as many years in a buyer's eye because the brand's more exciting and they wanna buy it and they're willing to pay more and do more for it. So, and then on the other side, If you're dealing with 20% EBITDAR margins, but only 1,000,003 AUV, or you're dealing with like at 1,000,003 AUV, 18% EBITDAR numbers, but let's just use 1,000,003. If you're using 1,000,003 AUV, 13 million in sales, 20% EBITDAR margins is only $2.6 million in pre-G&A EBITDAR. Less 1,000,004 G&A is 1,000,002 left, less $700,000. Now you're following me, right? So now we're at $500,000 of post-G&A EBITDA. multiplied by 5 is only two and a half $1,000,000 less $1,000,000 in remodeling discount. Holy cow, now we're down to a million and a half dollars for the entire business. And that's a million and a half dollars divided by $16 million in sales. And now our business as a percentage of business values, a percentage of sales is 9.375%. But really, and I'm telling you guys, it can get that ugly. because some of these stores, the other item we need to talk about is like rent. Some of these businesses may have not 8% rent, they may have 10% rent. As the AUV drops down, if the franchisee has done a bunch of sale leasebacks and the business has dropped in sales by 10 or 15%, they did those sale leasebacks five years ago when the AUV was 1,000,005 and they were at 8%, that's $120,000 in rent, right? What's 5, what's 8% of 8% of 1,000,005 is, yeah, right. Oops, $120,000, right? So the rent's 120,000, but their AUV has dropped to 1,000,002. Well, their rent percentage has now increased from 8% to 10%. And unfortunately, we've had a lot of brands that have gone through that type of sales decline over the last couple of years. So when that happens and you're modeling through kind of a pre-G&A EBITDAR that's dropped and a percent rent that has increased. Now we're potentially dealing with a business that might have no business value. So it goes all over the board and it goes crazy in a hurry. And sometimes that shocks and surprises people. But I hope this gives you some guardrails. And then now we're in this particular example, which is obviously not a well-performing example. Like I said, $2 million AUVs and only 20% EBITDAR margins. We have three pieces of real estate. Now, I would have asked enough questions when I got to my 7% rent assumption, which is 1,000,000 for in rent. I was, like I'd intimated before, what is the rent on the non-fee properties? Usually most operators have some idea. They'll be like, you know, like, and I would say, okay, well, what's kind of your average rent? What do you, know, and I may get to an opinion there. What we will typically do is then say, if I hear them say, oh, 6 1/2% rent, I'll say, okay, well, for these fee properties, we're going to burden them, hopefully with 8% no more than that, but usually between 7 and 8% internally. And so then I'll use that to create the real estate valuation. Okay, so in this particular case, I'm just gonna go ahead and say 8% rent. I'm gonna assume that 1,000,004, which was 7% of the total $20 million in sales, $2 million a store times 10 stores, includes this implied or imputed 8% rent that I'm just gonna assume for the three fee properties for purposes of valuing the real estate separately. I know that is a lot of technical mumbo jumbo, but typically, as with all things, this is just a crazy example. If something that I say here piques your curiosity, you don't understand, you think it's not right or whatever, call me, we'll talk about it, right? But in this particular situation, then I'll take, okay, you've got three fee properties. We're gonna assume, what's the sales volumes on your three properties? They say, oh, they're averaging two and a half million dollars. I'm like, wow, okay, two and a half million dollars for those fee properties. And we're gonna assume 8% rent on those fee properties. So 8% of two and a half $1 million for those three properties, right? is going to be $200,000 imputed rent per property times 3 is $600,000 in rent. So in order to develop a real estate value, we need to get some sort of a net operating income or rent. And then we need to assume a cap rate. And then we take the two, take one divided by the other, and we come up with a general value of the real estate. So in this particular case, we have three stores where he owns the real estate or she owns the real estate. Those stores are averaging 2 1/2 million, collectively 7 1/2 million. We're gonna assume that we can place an 8% imputed rent against those three. And it's that 8% rent is already encompassed in our million for rent that we have calculated already to determine the business value. That's a very key point I just said. So if you don't understand that, reach out to me and let me know because you don't want to double count or under count the rent. The implied rent has to be included in the business value calculation, okay? Otherwise we're not counting the rent enough. Like we're not taking one side of it because when we develop the real estate value, we have to lower the business value by that same corresponding imputative rent. Otherwise, we have an overinflated business value, okay? But 7.5 million in sales, 8%, that's gonna be the number. Usually we're gonna migrate between 7 and 8% rent. We're gonna do what's called a rent coverage calculation and look for a rent coverage to be to the two, ideally 2.5 times or more, but certainly more than two times. And as we get more towards two times or less, we will start to move the rent factor down, the imputed rent factor on the fee properties down from 8% to 7 1/2 to 7, maybe even go as low as 6 1/2 or 6. But in this particular case, we'll stay at 8. We never go above 8%. Buyers push back significantly when you do. Some franchisors will not allow their businesses to be transferred at rents that are more than 8%. So we fix them at 8% as a max or a cap. In this case, So we're at 8%, which is $600,000 in rent, which is just 2 1/2%, or pardon me, 8% times 2 1/2 million times 3 properties. And now what we're just debating is the cap rate. And so we take that $600,000 in rent divided by the cap rate, and that equals what the real estate value is. Now let's just take for simple math, a six cap rate. Well, if you take $600,000 in imputed rent and divide it by 6%, a cap rate of 6, you get $10 million in real estate value. And if you were to take it by 7%, just as a cap rate, just random number, then you get $8.6 million in real estate. And if you were to take it by 5.5%, you get, you get $10.9 million in real estate. So the cap rate has a huge determination. It could swing the real estate value by 20% based on the cap rate differences, right? And so to get the cap rate right is a really big deal. In this particular case, if we're gonna assume the business value is $9 million, and I'm telling you the real estate's worth $10 million, but the variability in the real estate could be like 8 million to 11 million and your expectations are built on 11 million and the business value is 9 million, then you think the full thing's worth $20 million. And if I think the real estate's worth a different cap rate that puts the real estate value at 8 1/2 million, then I think the business is worth 17 1/2 million. You think it's 20 million. We got too big of a delta. I don't even want to really work for you. Does that make sense? right? Because that's a big difference. That's what is that? I think it's just 20 million divided by 17 and a half million, right? That's got to be 12% difference, right? 20 divided by 17.5 is yeah, like 14% gap. And that's typically too big of a gap. I don't want to take a client that has expectations that are more than 10% above where I am. I mean, it would warrant further evaluation because in the detail, it would send it to my team and they spend hours and hours going through years of P&Ls and looking at add backs and thinking about and thinking about remodel costs more granularly and GNA and all these different things. And we could come up with, like I said earlier, a 10 to 15% different valuation just by going through all the details. This is just a swag conversation I'm having with a franchisee. but through the end of this hour-long conversation, I can typically get within 10 to 15%. If they want $20 million and I think it's worth 17 and a half million, then I'm 15% off. I want to investigate it further, but I've got a yellow flag there immediately, if that makes sense. So that's how it works. The comment I'll make about the cap rates is you have to have some discernment when dealing with the cap rates. Cap rates vary on a lot of things. Certainly the biggest thing is as interest rates change, as the 10-year treasury changes, cap rates move kind of sort of non-linearly alongside 10-year treasuries and specifically in interest rates generally, but they're a little bit stickier because people who buy real estate aren't doing it just for reasons of borrowing money at the prime rate or at so forth plus a certain spread. Instead, they may have other reasons to buy real estate. This is getting kind of geeky into the details, but somebody who buys real estate may have a tax play. They may have just sold a warehouse in California 90 days to find an asset and another 90 days to close or 120 days to close on that asset or they have to pay that wacky California tax, 13.3% plus 37% business on the federal level. They pay over 50% tax on the sale of that property and they fully depreciate it. And they're like, holy cow, I've got a $4 million property that I owe $2 million in taxes on. And those types of people don't necessarily think about 1/4 or 1/2 point turn in interest rates applied to a change in cap rate. I mean, they're typically going to want the market pricing, but they don't make exactly in many cases a totally linear decision. That's if interest rate goes up 25 basis points, then cap rate changes 25 basis points, right? So for that reason, you don't see one-to-one correlation. There's usually a delay, deals still happen at a better, if interest rates rise, sometimes the degradation of cap rates will happen over a period of time thereafter. That might be 6 to 9 months for like a set of deals to roll all the way through to closing to get more comps. So these things just are reasons why cap rate discussions become very important. Cap rates vary based on geography, based on brand, based on the guarantee, based on the number of years left in a lease. This is important. If you own a restaurant that owns or a non-restaurant that, you know, in our example, but it has a franchise agreement that expires straight up in four years, well, a buyer is not going to pay you a current market price and cap rate for the real estate in many cases, unless They have, unless it's negotiated, that they have the ability to walk away if a franchisor does not allow the franchise to be renewed for 20 years at the end of the four years remaining. Does that make sense? For that reason, sometimes, I mean, there's all kinds of scenarios where we would talk with a seller or buyer about keeping the real estate, selling the real estate alongside the package, sell some of the real estate and not some of the others. That's a whole discussion for another day, but we asked them about what their expectations are. What do they want to do in retirement? What's their general philosophy? Do you want to just walk away from it all and pay taxes on it and be able to sleep at night? Do you want to continue on some sort of real estate capacity for a while? What do you want to do? But essentially, Sometimes clients want to sell the real estate with the business. Sometimes they want to keep all the real estate with the business. Sometimes they want to do a hybrid strategy. It's all over the board. But when you do see people keeping real estate, part of some of the real estate, but not all of the real estate, if you see that particular scenario, sometimes a combination of that would include either selling some of the real estate that's not as strong performing alongside some of the weaker restaurants or non-restaurant franchises, that would be one reason, or a unit is either performing great, middle or low, but it has a franchise that's expiring pretty quickly. And they don't want to take the risk that a buyer has an out to walk away from their property based on the not knowing whether the franchise will get renewed or not. So they might then sell the real estate with the business if they weren't otherwise planning to. And then the buyer takes that risk in the future of that lease getting of that franchise agreement being renewed and maybe there's a slight, smaller, slight discount to the valuation of the real estate, if that makes sense. And then of course, that all depends on the brand too, because some brands, it's almost a rubber stamp that you're going to get your, you know, as long as you're in good standing, going to get their 20 year franchise renewed. Some don't operate that way. And so there's another level of knowledge that you need there as you go through it all. And that's important. But in this particular case, We look at all those factors like the geography, there's probably a 50 point basis point change in cap rates based on geography, based on the guarantor. So like if you're going to sell your real estate to a third party and not to the franchisee who buys your business, you're going to want to know that the lease that you have in place with the franchisee, all things equal, you're going to want to sell your business to a franchisee who's bigger and larger and has a better guarantee so that the real estate will sell at a slightly better cap rate as opposed to selling it to a franchisee who's and that smaller franchisee can command as attractive a cap rate in the 1031 market when you sell your real estate separately. And you see this happening quite a bit with people who. might sell their business to back to a franchisor, for example. So if you own a franchise business and you sold it to a franchisor and your franchisor is publicly traded and they would guarantee the real estate, and then you would either keep the real estate or sell it separately at a different time, you're at a place where you have a great guarantee with a corporate backed client and publicly traded. And that guarantee is gonna command a better cap rate, maybe as much as 50 basis points or 100 basis points better cap rate than what it otherwise would. And we just did the calculation in this simple example, just three pieces of real estate, 100 basis points difference in cap rate can matter like by $1,000,000 on a value of $10 million. So it makes a big difference and it could even be more than that. So those are some things to think about. Now the methods of selling real estate and this goes into pricing the cap rate are what's the likelihood that the real estate would be sold to the buyer of the business? What's the likelihood that the real estate would be sold to a third party, a real estate investment trust or a 1031 buyer? And then those three, we kind of assess those three things in that initial call. I'm usually doing that in my head in 30 seconds, but we've talked about it for a long time on this podcast, so my apologies. But I think about this and I say, okay, this business, because it's a legacy brand, it's not gonna have as much cachet on the 1031 market it's going to be difficult to sell. This is probably a perfect example of a business that's going to real estate will sell to the buyer of the business and the franchisee wants to sell the real estate, not keep it. Then I'll take a current cap rate and I'll start at 6 1/2 cap rate. And I'll just say in this particular case, yeah, I'll bump it up to 6.75 or 7 cap rate just for swag purposes. for this initial call. And keeping in mind that these headline cap rates that you see on the 1031 market are not the same as was a franchisee is going to pay for the real estate whose business they're going to buy. Just they're not going to pay typically quite as attractive cap rates, but keep in mind that there's not as much brokerage cost and all that stuff that go with it when you sell the real estate to another franchisee. So that's just out there, but I'll start with the 6 1/2 cap rate. I'll listen to the method of potential sale of the real estate if they want to sell it. evaluate all of it and who it'll likely sell to. And then we'll go as low, typically as a six cap rate and as high as a seven cap rate, just for purposes of a swag call. If it's really distressed real estate, we might bump it up above a seven cap rate to 7 1/4 or 7 1/2. And then you come up with a business or real estate value in this case where that's somewhere between 8 1/2 and $11 million. In this case where we have a 6 1/2, let's say we're gonna use a 6 1/2 cap rate on $600,000 in rent. I think we came up with somewhere around 9.2 million or whatever the number was. So in this valuation example, we're at $9 million business price, $9.2 million real estate price, $18.2 million overall. Like I said, typically within 10, no more than 15% off on initial call like that. And that gives someone something to chew on to decide whether they want to take the next step of taking the 30 or 40 hours of time it takes to collect all the data and all the information over multiple years, all the lease information, and then to put it all into the model, ask all the questions, and to go to the next phase, which is to get a more detailed valuation that's more actionable, if that makes sense. So as we conclude today, that is our part 2. Now that I'm looking at it and we've gone over 50 minutes, I may do a part 3 here that talks about timing and process in a sale. So be listening for that for the next, I guess maybe season 8, episode 6 or episode 7, but that'll put a bow tie or whatever, a tie up the discussion, the podcast discussion on this topic of what happens when a client calls in and we have the initial call I hope what you'll find if you're a would-be seller of a business or a franchisee or someone who's buying franchises is that this gives you a little bit of a feel for what valuation is, but within a range, right? We're not trying to get exact here. And then the other thing is it tells you the complexity of doing this, which there's a reason why the investment banking business is a big business because it's a big amount of work to get to the right valuation for these companies. As always, thank you so much for listening. I hope you're having a great summer and we look forward to talking to you soon. Thanks again.
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