As any new franchisee can tell you, the decision to invest in a franchise involves a great deal of research. This research includes finding the right industry, identifying the right franchise system, considering the proposed market, and determining the financial viability of the business. It’s a big decision. For many prospective franchisees, the ultimate choice to invest understandably turns on the expected financial return.
It is therefore no surprise that prospective franchisees want franchisors to tell them how much money they can expect to make from the operation of their franchise. But franchisors cannot tell them how much revenue their franchises can generate. There is simply no way for franchisors to predict how a particular franchisee will fair in the market. Moreover, if not done correctly, disclosing information about the actual or potential financial performance of franchised and/or franchisor-owned outlets can cause a host of problems for franchisors.
Franchisors are generally required by the Federal Trade Commission’s Franchise Rule (“FTC Rule”) and various state regulations to provide prospective franchisees with a franchise disclosure document (“FDD”). The FDD is intended to provide the franchisee with certain specific information about the offering, the franchisor and the franchise system. The FDD must also contain certain exhibits including the agreements that the franchisee may be required to sign. The information contained in the FDD is organized into 23 Items of information. Item 19 is entitled “Financial Performance Representations.” Essentially, if the franchisor wants to provide information about the financial performance of the system (“FPRs”), it must have a reasonable basis for the information and the FPRs must be contained in the FDD.
Notwithstanding the opportunity for franchisors to provide certain FPRs, many choose not to. Franchisors make this decision for a variety of reasons. For example, some franchisors may fear that data collected from independent franchisees is inaccurate or inconsistent. Franchisors may also want to avoid disclosing financial information to their competitors. Some franchisors may avoid disclosing information that shows a poor or mixed financial outlook, particularly when the financial health of the franchise system appears drastically affected by a few poorly-performing franchisees.
Unfortunately, the omission of this information can impact the ability of prospective franchisees to gain an understanding of the revenues that can be generated from ownership of the franchise and to assess the financial health of the system.
So, where can franchisees turn to learn about the potential viability of the franchise and the health of the system?
1. Look to Other Franchisees
A very important Item in the FDD is Item 20 in which franchisors must provide contact information for current and former franchisees. This information is required so that prospective franchisees can learn about the franchisor, the system and franchised units. Existing franchisees are permitted (although not required) to discuss with prospective franchisees, their business, their experience as a franchisee, and their perspective on the franchise system as a whole. This type of information may include information relating to actual costs to develop and operate the unit as well as information about revenue earned such as information about which products and services generate greater profit and why. All of this information can be used by the prospect to anticipate costs and project possible revenue. Prospective franchisees will want to take full advantage of this opportunity and communicate with as many current (and former) franchisees as possible. However, it is important to remember that many factors may come into play in a franchisee’s success or failure. For instance, a newly opened unit may not initially achieve the same success as one that has successfully operated for several years. Also, franchisees that operate in big cities may not provide a realistic outlook for franchisees looking to invest in smaller markets. While information provided by existing and former franchisees can be hugely helpful in ascertaining projected costs and revenue, prospective franchisees should remember to keep a realistic perspective when interpreting the information existing franchisees may give them.
2. The Franchisor’s Financial Statements
Attached to the FDD as an exhibit will be the franchisor’s financial statements. The FTC Rule requires franchisors to provide independently audited financial statements for the preceding three years. This information can give prospective franchisees an idea of how financially healthy the franchise system is as a whole. Financial statements which show lack of capital, lack of liquid assets, a negative current ratio (meaning current liabilities which surpass the franchisor’s current assets), and poor growth should raise a red flag. It is also crucially important to evaluate where the franchisor’s revenue is actually coming from – franchisors who rake in revenue from the sale of required products or services to their franchisees may be simply profiting at their franchisees’ expense. However, evidence that the franchisor’s revenue is largely derived from receipt of franchisee royalties, may indicate a healthier franchise system.
3. Develop a Business Plan
Franchisees should conduct sufficient due diligence and obtain adequate professional guidance from accountants, financial planners, attorneys, etc. so that they can develop their own business plan. An experienced accountant, business consultant or attorney familiar with franchise law should be able to help.
Attorney Julie Lusthaus is a partner in the firm of Einbinder & Dunn, LLP. She focuses her practice in the area of franchise law, serving as counsel to both franchisors as well as franchisees. She can be reached by phone at 212-391-9500 or 914-705-5417 and via email at firstname.lastname@example.org.
Mackenzie Dimitri is an associate attorney practicing franchise law and related litigation on behalf of franchisors and franchisees at Einbinder & Dunn, LLP in New York City.
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