One of the first questions a potential franchisee is likely to ask about a franchise is “How much money can I make?” While the Franchise Disclosure Document (FDD) is intended to help franchisees make well-informed decisions about whether to buy the franchise, it does not require financial information about existing franchises or franchisor-owned locations. Nonetheless, a franchisor may want to (and may feel pressured to) provide some financial information to encourage franchisees considering buying the franchise. This can be helpful but is wrought with potential pitfalls. If franchisors do choose to include such information, known as financial performance representations or FPRs, those representations must be included in Item 19 of the FDD and must meet strict requirements. Before deciding whether to make financial performance representations, franchisors should consider the following:
Information to disclose
Generally, FPRs contain information about the historical or projected financial performance of the franchisor, its affiliates, its franchisees, its company-owned units, or some combination of the above. Franchisors must have a reasonable basis for the FPR, must disclose the basis and assumptions underlying the representation and must make available to the prospective franchisee, upon reasonable request, information which substantiates the representation.
FPRs include any written or verbal information concerning the actual or potential sales, income, profits, revenue, earnings, margins or profitability that may be derived from the operation of the franchise business. When including FPRs in the FDD, franchisors must provide detailed data including high, low and average financial figures. In addition, franchisors must keep in mind that although they may be able to include some disclaimers about their FPRs, there are limits to those admonitions.
Profitability of the business
Franchisors often want to include an FPR in the FDD because they believe they cannot sell franchises unless they prove to franchisees that the franchise will be profitable. They think that franchisees will assume the worst if they cannot see actual revenue amounts for existing units. But there are pros and cons to revealing historical or projected financial performance even if the units are generally profitable.
If your financials are not strong or you have widely varying results among locations, you should strongly consider not including FPRs. While this may make the franchise harder to sell, less than optimal financial performance will also turn off buyers.
Assuming your financial picture is excellent, you may want to include an Item 19 disclosure. It makes the franchise more credible and marketable. However, keep in mind, that you cannot cherry-pick the information to be included. If there are any underperforming locations, you cannot simply omit those locations, or you may risk a lawsuit.
If the financials are strong and would support a positive Item 19, before taking that leap, franchisors should be aware of the possible liability arising from improper FPRs and how easy it is to inadvertently make a financial performance representation outside the FDD. First, it is unlawful for franchisors to make an FPR that is not true or cannot be substantiated when it is made. As discussed above, franchisors must provide complete information and they must have a reasonable basis for their numbers. Second, as indicated above, all FPRs must be included in Item 19 of the FDD. Thus, sales personnel should not discuss the financial results of any location unless that specific information is included in Item 19 of the FDD.
In addition, FPRs are not limited to expressing revenue information. Franchisors may face liability if they or someone on their behalf, such as a sales representative, provides financial information from which an FPR can be inferred. For example, average ticket information and the number of sales made in any given period may constitute an FPR, because those two numbers might allow a prospect to calculate revenues. Thus, franchisors should take great care they do not verbally or in writing provide any financial information not included in Item 19. Best practice is to consult an experienced franchise attorney who can educate and train sales personnel on the applicable rules. Such training can help ensure compliance with all laws and avoid significant liability.
There are many benefits and pitfalls involved with Item 19. A franchise attorney can help you weigh the risks and rewards of making FPRs to put your franchise in the best position for sale. Contact Lusthaus Law for a consultation.