McDonald’s Franchises Valued on Cash Flow in Tennessee Divorce

Tennessee business valuation law case summary. Tennessee divorce and family law from the Tennessee Court of Appeals.

Bertuca v. Bertuca, No. M2006-00852-COA-R3-CV (Tenn. App. 2007).

In Tennessee Divorce, Valuing McDonald’s Franchises Based on Cash Flow

The value of McDonald’s franchises was the issue on appeal in a divorce action filed by Mrs. Jo Bertuca against her husband, Mr. Theodore Bertuca.  The divorce was granted on June 23, 2005, but the trial court reserved the issue of a division of marital assets—namely the restaurants—which was tried in February 2006.

Although there were other assets to be divided by the court of appeals, it was Mr. Bertuca’s 90% ownership in Capital Food Services (“CFS”) that received the most evidence and attention at the hearing.  CFS was a Tennessee general partnership that owned and operated seven McDonald’s franchises located in Wilson County.  The trial court determined the value of CFS increased by $1,000,000 above the amount that was paid for the restaurants; hence, the value of Mr. Bertuca’s interest increased by $900,000.  One half of that amount was awarded to Ms. Bertuca.  Mr. Bertuca appealed questioning the trial court’s valuation of the business.

The CFS partnership agreement contained a buy-sell provision that provided that if either partner wanted to retire, that individual was required to written notice.  The remaining partner was permitted to purchase the retiring partner’s interest at the book value as of the end of the previous fiscal year of the partnership.  If he chose not to purchase the shares, the alternative was to liquidate the partnership.

Capital initially bought and sold three McDonald’s franchises. In February 2004, CFS was offered the opportunity to purchase two McDonald’s franchises.  Two Mount Juliet franchises and another restaurant in a convenience store were acquired in February 2004 for $1,038.000; and two franchises in Lebanon were acquired in July 2004 for $867,000.  Two additional McDonald’s franchises in Lebanon were purchased in November 2004 for $440,000, making the total amount paid for the seven franchises $2,345,000.

According to the evidence presented at trial, a McDonald’s Corporation (“McDonald’s”) franchisee does not own the real estate of the restaurant—that is generally owned by McDonald’s.  The franchisee must pay rent and is responsible for maintenance and upkeep of the building.  At the time the franchises were acquired, McDonald’s notified CFS Food Services that one of the Lebanon restaurants would have to be rebuilt.  At the time of the hearing, CFS had contracted to have the restaurant rebuilt at a cost of $950,000.

The McDonald’s franchise agreement stated that the franchisee could be required to rebuild a restaurant, and there also was a clause that prohibited a franchisee from transferring or assigning its interest in the franchise without prior written consent of McDonald’s.  Testimony at the trial court hearing disclosed that McDonald’s imposes strict guidelines on the sale of its franchises, and frequently required a significant down payment for purchase with financing to be repaid in no more than seven years.  Additionally, the corporation required the franchisee to be able to service the financing with monies generated from franchise operations, which could place a ceiling on the resale value of a franchise.

At the trial court hearing, Mr. Bertuca presented his valuation expert, Burt Landers, a CPA who represented 14 McDonald’s franchisees, including CFS.  Landers had been involved in the purchase or sale of 125 McDonald’s franchises, and here Landers testified that as of June 25, 2005, CFS’s franchises were worth no more than their purchase price one year earlier. First, Landers determined the gross value of each franchise by using a multiple of free cash flow, which he testified was standard valuation practice for McDonald’s franchises.  The cash flow was determined by taking the net income of each franchise during the previous 12 months and reducing that amount by interest expense, depreciation, amortization and general and administrative expenses. Landers then multiplied that result by five to determine the gross value of each franchise, which according to Landers, was standard in valuing McDonald’s franchises.

After arriving a gross value, he then added current assets and deducted current liabilities and notes payable to find a net value of each franchise.  Landers determined the net value of the seven stores to be $484,734.41, and testified that Mr. Bertuca’s interest in the franchises actually had a negative value due to the requirement of rebuilding one of the restaurants.  In addition, he also owed his father $124,200 in a business loan.

Mrs. Bertuca’s valuation expert was David E. Mensel, also a CPA.  Menzel’s practice was forensic accounting and business valuation.  Menzel was a certified valuation analyst and wrote and taught a valuation course.  Menzel used a capitalization of income method for valuing CFS.  With the data given him, he initially valued the business at $3,078,042 net of the indebtedness using a 12% capitalization rate.  Mr. Bertuca’s counsel questioned this at trial and also on appeal, alleging that Menzel’s opinion was based on: (i) doubling the trailing six month period of income rather than using a 12-month period; (ii) using only six months of debt service; (iii) failing to account for general and administrative costs; and (iv) failing to consider CFS’s obligation to rebuild one of the restaurants.  Mensel admitted that his opinion was based on his understanding of the supplied information.  He testified as to the value of CFS using the cash flow figures supplied by Landers, and also used the 4.76% of sales for general and administrative expenses but adjusted downward for unnecessary expenditures and what he considered excess profits contained in the financial statements of McDonald’s Management Company.  Based upon these numbers, Mensel testified the value of Mr. Bertuca’s 90% interest in CFS was $1,671,000.

In rebuttal to Mensel’s testimony, Mr. Bertuca called upon Ms. Claudia Straw, who was a CPA and a managing partner in an accounting the firm that provided valuation and litigation support services.  Straw specialized in McDonald’s franchises and was Chairman of the National Franchise Consultants Alliance—a group of nine CPA accounting firms throughout the U.S. that predominantly represent McDonald’s franchisees.  According to Straw, when valuing a McDonald’s franchise, the income approach is preferred, specifically the discounted cash flow method.  Using that method, the future income a restaurant is expected to generate is projected and discounted to the present day.  Applying this method to Mr. Bertuca’s restaurants, Straw concluded they had not increased in value from what CFS paid for them in the preceding year; however, because CFS accumulated some cash in excess of its current liabilities, she determined there was $493,000 in capital equity in the business as of the date of divorce.  As a result, she reduced Mr. Bertuca’s 90% interest in that amount by a 20% marketability discount, and also deducted the $124,200 indebtedness of Mr. Bertuca to his father.  Accordingly, with those computations, Straw determined Mr. Bertuca’s interest in CFS to have a value of $231,000.  She also refuted the testimony of CPA Menzel, charging that the 12% capitalization rate he used resulted in a cash flow multiple of 8.33.  In Straw’s opinion, that multiple was too high, and she testified that she had never seen a sale of a McDonald’s franchise at such a high number.

The court of appeals stated that there were a number of acceptable methods available to determine the value of a corporation or business entity, which include: (1) the market value method, (2) the asset value method, and (3) the earnings value or capitalization of earnings method. The choice of the proper method or combination of methods depends upon the unique circumstances of each business entity.  A public corporation’s value is most reliably determined using the market value method, as there is an established market for the corporation’s stock which will enable a court to arrive at the price a willing buyer would pay for the stock.  However, the stock in closely held corporations is rarely traded, and the same is true of partnership interests. The appellate court thought it improper to attempt to place a value of a closely held corporation or partnership interest using the method generally used to place a value on a public corporation.

Valuation in this case was complicated by several factors: (i) the restaurants had been recently acquired, and there was a short earnings history; (ii) the earnings history that did exist was skewed because, in order to give the partnership a sound financial basis, the elder Mr. Bertuca did not charge management fees; and (iii) the partnership had an obligation to rebuild one of the Lebanon restaurants which had an effect on the value of the partnership (the rebuild had not occurred at the time of the divorce).  As a result, the court said, each valuation expert made some attempt to normalize income and expenses in order to more accurately reflect the partnership’s future financial situation.

The court of appeals noted that Landers testified based upon information given him by CFS, that the partnership had recognized a net cash flow of $412,663 during the trailing 12-month period. Two of the restaurants had only been owned by the partnership for eight months.  Landers normalized the income for these two restaurants by dividing their income during the time they were owned by the partnership by eight to arrive at an average monthly income, and then multiplying that amount by 12 to determine the income for the prior year.  In addition, Landers included as an expense an amount for general and administrative expenses even though the partnership was not being charged for these services.  The amount he included equaled 4.76% of sales which was the average amount charged by McDonald’s Management Company to the other franchises that it provided management services.  Landers was of the opinion the restaurants owned by CFS   had a gross value of five times the annual cash flow.

At the end of June 2005, CFS reported owning equipment having a cost basis of $1,911,228. The partnership claimed depreciation on this equipment in the amount of $550,725.  Menzel testified depreciating the equipment over five years would not be appropriate since, according to generally accepted accounting principles, the period of depreciation should reflect the useful life of the equipment.  The court noted that a five-year straight line depreciation of this equipment would amount to $362,246—the amount of depreciation claimed exceeded the five-year straight line depreciation by $168,479.  Menzel suggested the sum of $152,782 would be appropriate. That figure approximately represented a 12½-year straight line depreciation and exceeded the amount claimed by $397,943.  Landers explained that some of the stores had aged, and that one was  30 years old; for these reasons, CFS accelerated the depreciation, but there was no testimony on the age of the actual equipment in each store or its remaining useful life.

The second item the court of appeals noted was the amount of amortization claimed by CFS.  CFS claimed amortization of the franchise fees that it paid of $32,133.  CFS paid $45,000 each for 20-year franchises on the five stand alone restaurants.  Straight line amortization on each of these five stores would amount to $2,250 or a total of $11,250. CFS also claimed $1,000 amortization on the restaurant located within the Lebanon Wal-Mart, which combined for a total of $12,250 or $19,883 less than the amount claimed.  The bulk of the difference was that CFS   claimed amortization in the amount of $21,133 on the Lebanon restaurant that was to be rebuilt. The rebuild, however, did not appear from the evidence to affect the franchise period in any way or require CFS to pay an additional franchise fee upon completion.

The court of appeals thought that Mensel’s most important testimony was that, based upon the income figures presented by Landers with some adjustment of the general and administrative expense, the value of CFS was $1,671,000.  This value was based upon the capitalization of income method using a 12% capitalization rate.  However, Mensel’s opinion failed to include a consideration of the impact of the obligation to rebuild the Lebanon restaurant.  Straw also valued CFS’s using a capitalization of income method known as the discounted cash flow method.  After making her adjustments and projections, Straw determined that the restaurants were worth no more than CFS paid for them, and the value of the partnership was the excess of cash on hand less current liabilities or $493,000.  The court of appeals said that the validity of Straw’s opinion is based upon the appropriateness of the methods and assumptions she used.  Finally, the trial court based its opinion upon the “fair market value” of CFS.

The court of appeals’ view was that the primary value of CFS was the income it produced, and as such, the preferred method of valuation would be to determine its earnings value using a capitalization of income approach.  In arriving at a determination of value, the court of appeals began with Lander’s net cash flow total of $412,663, and increased that amount by the excess depreciation ($168,479) and amortization ($19,883) claimed by CFS.  In addition, CFS was about to borrow $950,000 to rebuild the Lebanon restaurant. According to the amortization schedule, CFS would incur additional interest expense in the amount of $63,047 during the first year of the note.  As a result the court of appeals assumed CFS was entitled to additional depreciation for the rebuild and that the restaurant equipment would have a useful life of at least 10 years. Accordingly, the court deducted the additional interest and depreciation from cash flow, leaving a normalized cash flow of $442,978.

That amount of income capitalized at the 12% Mensel found appropriate, indicated a value of $3,691,483.  That amount was increased by the cash on hand ($1,016,829) and reduced by current liabilities ($525,891), the amount of the notes payable on June 30, 2005 ($2,199,028), and by the amount of the note to rebuild ($950,000).  Based on all of the relevant evidence, the court of appeals concluded that CFS had a value of $1,033,393 at the time of the divorce; since the value determined by the court was close to the value found by the trial court, the court of appeals affirmed the trial court’s finding on the value of the partnership.

Bertuca v. Bertuca, No. M2006-00852-COA-R3-CV (Tenn. App. 2007).

See original opinion for exact language. Legal citations omitted.

To learn more about Tennessee business valuation law, see Business Valuation in Tennessee Divorce Law. To learn more about the division and valuation of professional practices in divorce, see When Professionals Divorce in Tennessee: Valuing Professional Practices.

Miles Mason, Sr. JD, CPA handles complex divorce matters including business valuations and forensic accounting issues. View his professional biography listing books and articles published on business valuation and forensic accounting, seminars presented to lawyers, judges, business valuation experts, and forensic accountants. Miles Mason, Sr. authored The Forensic Accounting Deskbook: A Practical Guide to Financial Investigation and Analysis for Family Lawyers, published by the American Bar Association. The Miles Mason Family Law Group, PLC’s offices are located in Memphis, Tennessee and serves West Tennessee and Nashville.