About 25% of U.S. franchisors currently include financial performance representations (FPR's) in their franchise disclosure documents ("FDD"). This percentage has been relatively stable since the FTC first began permitting such representations, formerly called "earnings claims", two decades ago.
Two trends, discussed below, may increase the percentage of franchisors who will be using financial performance representations. First, the general availability of cost-effective financial reporting software that communicates easily between franchisee and franchisor. Second, the new FTC Rule allows more information to be given to prospective franchisees outside Item 19 of the FDD.
Why should franchisors consider adding financial performance representations?
First and foremost, inquiring prospects want to know.
Most franchisor lawyers recommend that their franchisor clients at least consider adding an FPR to Item 19 of the franchise disclosure document . Franchisors are less likely to be the subject of claims by unhappy franchisees about unlawful statements if there is an existing statement in Item 19 that is complete, accurate, and complies with disclosure law. For example, an unhappy franchisee is less likely to succeed with the claim that the franchisor stated that "you will make over $100,000 a year", if there is a disclosure in Item 19 that is inconsistent with this claim, for example that the average franchisee makes $80,000 per year in combined salary, benefits, and profits.
However, the existence of an Item 19 disclosure is no guarantee that a franchisor will not be subject to claims. For example, a recent arbitration held a franchisor liable for inaccurate information inserted in Item 19 relating to company-store profitability.
Why do most franchisors not use earnings claims?
There are three basic reasons.
- Lack of reliable data. Some franchise
systems do not have reliable data on which to base an
FPR's. For example, some franchisors do not even
collect gross revenue data, because they have a flat fee
royalty. Other franchisors collect financial statements, but
reporting is inconsistent. However, as mentioned above, the
availability of inexpensive and standardized accounting and
bookkeeping software has reduced this issue. But even
franchisors who have a consistent and reliable methodology
for reporting franchisee financial statements, rely on the
franchisees for accurate entry of data. For example,
franchisees' own accounting and tax advisors may vary
in how aggressive their approach to deducting certain
expenses in order to minimize taxes.
- Variability of Financial Results. Some
franchise systems with large investments, such as hotels and
large restaurants, have relatively consistent financial
results and reporting standards that can be useful for
prospective franchisees to develop their own business plan
and financial models. In contrast, many other franchise
systems, especially those that involve services or that
require minimal initial investment, have results that vary
markedly among the franchisees. For example, one
franchisee's gross revenue may be 100 times that of
another, and both may describe themselves as successful. Such
widely varying financial results are of more limited use to
prospective franchisees.
- "Sell the Sizzle." Of course, some franchisees' actual performance is lower than potential franchisees' expectations. It is generally not unlawful for franchisors to say nothing about existing performance, and let franchisees draw their own conclusion based on information available, including the information on existing franchisees contained in the disclosure document. For example, the prospective franchisees can determine franchisee transfer and termination rates from Item 20. Prospective franchisees can call existing and former franchisees whose contact information must be listed in the disclosure document. (On the other hand, if a franchisor has reason to know that franchisee profitability is extremely low, for example, that few if any franchisees are profitable, or that most franchisees will probably close in the near future, non-disclosure of these problems as a risk factor arguably violates the duty to disclose all material facts, although this is a grey area of the law.)
Franchisors who can obtain reliable information, explain the variables that affect results, and have franchisees who are profitable should definitely consider FPR's. Franchisors should consider starting with a statement of system-wide average gross sales, or similar easily verifiable data.
What financial information can franchisors give prospects outside of Item 19?
The new FTC rules will allow franchisors to provide certain information to franchisees outside of Item 19. That information still must be accurate and complete, however. The information that can be provided outside of Item 19 is:
a. A franchisor may provide the actual record of an existing operating outlet that a prospect is considering buying.
b. A franchisor may supplement Item 19 information to customize it for a particular location or particular circumstances.
c. Financial performance representations that consist solely of a franchisee's costs, including initial costs disclosed in Item 7 and ongoing costs disclosed in Item 6, and other cost data.
Franchisors should also consider starting with these statements that could be provided outside of Item 19. However, we recommend adding the third of these, cost of goods sold, to a statement of system-wide average gross sales, in Item 19 itself.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
