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Franchise Earnings Claims: What You Can and Can't Say

Business.com / Technology / Last Modified: June 4, 2018
Image credit: Gustavo Frazao/Shutterstock

The franchise sales dynamic is unique from most marketing or sales models in that the presentation is both a sale and a marriage proposal wrapped into one.

The franchise sales dynamic is unique from most marketing or sales models in that the presentation is both a sale and a marriage proposal wrapped into one.

When a franchise transaction is completed, the franchisee often is committed to a 20-year relationship. This means that during a franchise sale, the franchisor needs to be careful in who they sell to and do their best to qualify the buyer before executing a franchise agreement.

Essentially, the franchisor has a responsibility to both the franchisee and the franchise to ensure that franchisees are awarded franchises as opposed to being sold on the idea. Franchisors are permitted to say, ask and evaluate franchisee candidates on qualifications they deem relevant. Unlike a hiring interaction with a potential employee where there are questions that can't be asked and regulations around how an interview can be conducted, franchise sales do not have the same rules. In the end, it is a sale – not a new hire. This allows franchisors to scrutinize buyers before making the decision to award a new unit and ensure that only the best candidates are franchisees. 

Also, as part of a franchise sale, the financial viability of the franchise itself is always a significant consideration for the franchise buyer. Franchise regulations are careful to protect buyers from what could be considered a fraudulent earnings claim, essentially where a buyer is induced to make an investment with promises of potential earnings or income. Franchise regulations are reviewed and enforced by the Federal Trade Commission on the federal level and at the state level in registration states. The rules are similar to Blue Sky laws, which protect investors from being misled or promised results from a securities offering. This creates a unique dynamic for a franchise seller in that only historic financial information can be presented during the sale, and the franchisor is required to include certain disclaimers in the Franchise Disclosure Document (FDD) in order to present the financials at all.

Item 19, also known as the financial performance review, is a section required in the FDD in which a franchisor presents financials. This section effectively lists historic financial information, and there are specific rules about how the information in this section is to be compiled and presented to franchisees. The presentation by the franchisor must match exactly what is in Item 19 of the FDD. This is where some franchisors get into trouble or have difficulty understanding what is allowed and what isn't.

My advice to franchisors is to always have a franchise attorney help you assemble the data for Item 19 to verify you have the correct disclaimers and documentation in place when you present the information to a prospective franchisee. The reality is that the franchisor has liability in a franchise relationship for many years if the earnings claim was presented incorrectly. I have had transactions I took part in that were managed incorrectly and franchisees who made money from the franchise yet still were able to extricate themselves from the franchise relationship due to incorrect earnings claims. Many times this can happen by accident where a franchisor presents what they earn in profits and accidentally makes such comments as, "You should do much better than us in your market," or "Your profits should be higher than what ours were." 

So how do you put together a viable financial performance representation/earnings claim? Start with organizing your numbers and putting together the financials for your corporate business. These do not have to be audited or "tax return" numbers, but you must be able to document how you came up with the numbers and have reasonable assumptions which could be defended if necessary.

The earnings claim must be presented in a format that is based on fact and is accurate for the time period defined in Item 19. Generally, this should be the last calendar year or 12 months of operating history. Beyond this, the numbers should be clear and concise. Further, the source for those numbers should be clear, such as from a point-of-sales system or from bank statements that could be verified. In addition, the corporate business should relate to the structure which is being franchised.

I have worked with businesses that perform a range of services at the corporate level and have streamlined what the franchisee will do, which alters the revenue model significantly. For example, a moving services business was doing large-scale storage and performing other services that the franchisee would not be handling. The corporate business was generating in excess of $20 million per year, but what a franchisee would be doing involved a small subsection of this work. The earnings claim had been generated based on three trucks providing moving services (historical data was used to create this data), and the earnings claim was incorporated into the FDD.

In my opinion, financial performance representations/earnings claims are a necessary part of effective franchise sales. From the franchisor's perspective, they must be organized, structured and planned effectively before going to market, because they drastically improve the franchise presentation and, ultimately, the success of the franchise.

Have a franchise attorney review the Item 19 prior to going to market, but without the ability to discuss financials, a new franchisor has a very difficult hill to climb in convincing a franchisee why they should invest in their brand.

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