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When researching franchise opportunities, it’s important to examine Item 19 in a franchisor’s Franchise Disclosure Document (FDD). Indeed, the first question most prospective franchisees ask a franchisor is, “How much money can I make in this business?” Since the U.S. Federal Trade Commission (FTC) passed the franchise compliance rules in 1979, some franchise companies may respond, “We can’t tell you because the FTC won’t allow us to.” Take heed because this statement is false and always has been.
FTC Regulations Govern the Disclosure of Financial Performance Information
Guidelines for the 1979 FTC regulations governing the sale of franchises specify that franchise companies may make “earnings claims” under certain conditions. The 2007 revised FTC rules contain a similar provision with different terminology. The FTC now refers to “earnings claims” as “financial performance representations.” Its regulations again specify that franchisors may make them under certain conditions. Notably, under the current rules, franchisors electing not to provide prospective franchisees with financial performance representations must make a specific disclosure. They must inform the candidate that the FTC does allow them to release this type of information as long as (a) there is a “reasonable basis” for it and (b) it is published in Item 19 of their Franchise Disclosure Document (FDD).
Why Wouldn’t a Franchisor Publish Item 19 Data?
A franchise company may make any financial representation as long as it complies with FTC rules, which aren’t very tough to meet. Most franchisors that publish an Item 19 disclosure provide basic sales revenue information, because they collect this data from their franchisees on royalty payment reports. Some franchisors go further and report on the basic cost of goods sold, because it is fairly easy to determine and usually consistent among franchisees. A smaller number of franchisors also specify typical expenses incurred by a unit, usually grouped into fairly broad categories (rent, labor, etc.). In this way, they produce a gross margin or cash flow type of report. A very small number of franchisors go so far as to provide a full profit and loss income statement (usually drawn from data on company-owned units).
Even though the FTC gives franchise companies a great deal of flexibility as to the financial performance data they provide to prospective franchisees, not all companies disclose this information. Why not? Below are five reasons why a franchise company might elect not to provide financial performance information
Reason 1: They are a new company and lack a sufficient track record.
In other words, they don’t yet have enough data for it be useful in showing a pattern or indicating how a typical unit will perform. Once they have a larger number of units operating for a longer period of time, their data will be more meaningful and they will be more likely to provide it. If a new company puts forward any financial figures, it may raise questions about whether or not there is a “reasonable basis” for the information. In order to comply with the FTC regulations, it is safer for them to hold back from publishing any earnings information.
Reason 2: They don’t want to invest time and effort in gathering the information.
Many franchise companies do not regularly collect specific financial information (especially as it pertains to operating expenses) from their franchisees. The company may believe that the performance of its existing units is not indicative of what a new franchisee will experience. It can be quite time consuming and/or expensive for a franchise company to collect this information if they are not already doing so for other purposes.
Reason 3: They have concerns about the accuracy of available data.
Even when a franchisor decides to make the effort to collect revenue and expense data from all franchisees, it’s possible their data may not be entirely accurate. Perhaps not all of the franchisees prepared their data accurately and/or in a uniform way. Or there could have been errors in the assembly of the data into a composite report. Any of these problems could result in data that might be challenged later as “misleading” and therefore become the basis for litigation. That is a risk all franchisors want to avoid.
Two reasons that will give you pause.
They have an excuse: their franchise attorney “told them not to.” This excuse doesn’t work as well as it used to! Most of today’s franchise attorneys openly advocate for franchisors to include Item 19 in their FDD. They argue that the positives almost always outweigh any risks associated with the disclosure.
Their performance figures would not be attractive to potential franchisees. Ouch – this one obviously presents a problem. There is no way to know how often this is the reason franchisors decide not to publish an Item 19. You will have to uncover this circumstance yourself during your research.
What Conclusions Should You Draw?
If faced with an FDD that has no Item 19 information, you will need to figure out the reason the company didn’t publish this data. They may specify any of the above reasons, but it’s important to dig deeper and determine for yourself what you think is going on.
If you conclude that the company is not publishing an Item 19 because (a) they are too new or (b) the information would show that them in a bad light, you should immediately cross that company off your list. That’s the best way to minimize your risk.
If you think that they are not providing financial performance data because it is too hard for them to accurately gather it, you have the option of trying to get some information yourself. You could contact current franchisees and ask them about their unit’s performance. But take everything you hear with a “grain of salt” because if the franchisor wasn’t able to collect accurate data you will likely have some difficulty as well.
In any case, you will get a strong sense from the existing franchisees you visit with. When you don’t have Item 19 data to rely on, it’s safest to walk away from companies where you hear mixed or negative feedback. If the franchisees you visit with are happy and profitable and excited about their future, that is a strong indication that you have found a wonderful opportunity, even without Item 19 data to consult.Read More
Evaluating the information in a Franchise Disclosure Document (FDD) is a critical part of investigating a franchise opportunity. It’s helpful to have a few quick ways to assess whether the franchise is one to avoid. Here are 4 ways to spot clues in a Franchise Disclosure Document that may indicate problems ahead. These tests will help you whittle down your list and find the high-quality opportunities out there without wasting your time.
1. Item 20 of the Franchise Disclosure Document: Unit Counts
Here’s the simplest test of all. Review Item 20 of the FDD to assess whether the number of operating units is growing, staying constant, or declining. You can also find this data in online publications such as the Entrepreneur 500 list, which is published each January. Consider a declining number of units a red flag, regardless of the explanation supplied. It suggests significant risk for anyone buying into that business.
2. Item 3 of the Franchise Disclosure Document: Litigation Experience
Check the FDD to see whether there has been an increase in litigation between the franchisor and franchisees in recent years. The unfortunate reality is that when franchisees are struggling and/or failing, there is frequently an increase in litigation. This happens as people look to assign responsibility or blame others when their business is not working out. If you see a pattern of significant or increasing litigation (again – regardless of any explanation offered) you may want to avoid investing in that franchise.
3. Franchise Disclosure Document Exhibits: Audited Financial Statements
Every franchise company is required to attach their last three years of audited financial statements as an exhibit to their FDD. There are two things we want to learn from these financial statements.
First, we want to assess whether the franchisor is financially stable and has the resources to survive for the long run. We would hope to see a financial statement indicating that the operation is profitable, the cash flow is positive, and capital reserves are strong.
Second, we want to look at the accounts receivable figure on their balance sheet. If that figure has been rapidly increasing, consider it a red flag. For most franchise companies, payments from their franchisees represent a large portion of accounts receivable. A rapidly increasing balance indicates that franchisees are struggling to pay their bills, which is never a good sign.
4. Trends in Same Store Sales
Because franchisors are not required to disclose same store sales in the FDD, you’ll likely have to request this information from the franchisor. The question to ask is: during the past few years, have same store sales increased, decreased, or remained level? As you can imagine, most systems make every effort to increase the average performance of their units year over year. If the sales trend for their units is flat or decreasing despite these efforts, their business volume is clearly vulnerable to economic downturns. While a flat or decreasing trend might not be reason alone to disqualify the franchise, consider it an issue to carefully investigate prior to moving forward.
To receive a franchise company’s FDD, you’ll usually need to complete a short online questionnaire. Reviewing the 4 items above can be done in about an hour. This process will greatly improve your chances of avoiding mistakes and reaching a successful outcome in your search for a franchise opportunity that suits your interests and goals.Read More