How to decode the financial data listed in a Franchise Disclosure Document
Many entrepreneurs have one burning financial question when they consider buying into a franchise: “How much money can I make?”
While several factors affect the success of any business, prospective franchisees can find useful information to answer this question in Item 19 of a franchisor’s Franchise Disclosure Document (FDD). Franchisors may include information about Financial Performance Representation (FPR) or financial projections for franchise units in Item 19, but not all Item 19s are the same.
Depending on the brand, Item 19 may contain industry-specific terms or financial terms that are unfamiliar to prospective franchisees. The type of information provided can range from specific and clear to vague and confusing.
What is Item 19?
In Item 19, franchisors can provide information about past or projected sales, income, expenses or profits for franchised units. In franchising, these terms are commonly referred to as FPRs or earnings claims.
The FPRs a franchisor creates act as a snapshot of the potential path to profitability and may include average gross sales, adjusted gross sales, breakdowns of unit sales. It may also breakdown costs such as goods, labor, leases and more. Regardless of the type of information included, the FPR must have a reasonable basis that allows potential franchisees to gauge how much money they could earn if they decide to join a franchise system.
FPRs are industry specific, and brands will include information relevant to their specific industries in Item 19. For example, a preschool franchise such as The Goddard School may list occupancy rates, or the number of students enrolled, while fast food brands may include the costs of labor and ingredients.
What if Item 19 has no FPR?
While FPRs are crucial to a prospective franchisee’s understanding of a business’ financial performance, having FPRs in Item 19 is not required under franchise law. Franchisors may choose not to provide this information because they don’t have enough data to provide a reasonable basis for financial performance representations or because the information they have reflects poor or uneven performance.
Before selecting a brand, prospective franchisees should contact current franchisees and the company’s vice president of franchise development to learn more about the brand, its growth, its success rate and the franchisor’s FPRs or its decision not to provide any FPRs.
Not providing FPRs in an Item 19 makes it nearly impossible for a prospective franchisee to assess potential profitability. The very best Items 19s include EBITDA, or earnings before interest, taxes, depreciation and amortization, for every unit. This information equips potential franchisees with the most useful information for analyzing the system’s performance.
Why is Transparency Key?
Franchise Grade, a franchise research company, found a direct correlation between the success of a franchise system and its financial transparency, according to a six-year study released in 2016.
About 45 percent of the 1,905 franchise systems surveyed for the study didn’t provide an FPR in an Item 19 and saw a slight decline in the total number of franchises, from 135,154 in 2010 to 134,348 in 2016 – a loss of 806 locations.
More tellingly, the 54 percent of those Franchise Grade surveyed that included FPRs in Item 19 reported growth. Of the franchise systems that included FPRs, 652 collectively added 17,927 locations since 2010 – a 13.1 percent increase.
The specificity of information disclosed by franchise systems varies, but the study found systems that included more information experienced an increase in the total number of locations. Franchise Grade also found that companies with FPRs included a range of information, such as system-wide gross sales, quarterly breakdowns and data from locations that were open for more than one year.
Systems that included expense data, such as gross margin, earnings before interest and tax (EBIT), earnings before interest, taxes, depreciation and amortization (EBITDA) or earnings before interest, taxes, depreciation, amortization and rent (EBITDAR), had the highest growth rates of all surveyed systems – up to 18.4 percent growth.
Regardless of Franchise Grade’s findings, each franchisor should give prospective franchisees a clear picture of potential costs and earnings. The overall sentiment of the market, real estate values and franchisee support within a franchise system, among other factors, also affect a franchise’s success rate. The information in an Item 19 allows potential investors to understand and evaluate their potential cash flow.
As a prospective franchisee, it’s important to seek expert advice to evaluate what a franchise company’s financial performance representations are and what those representations could mean for the future of your business.
Jim DiRugeris is Vice President of Franchise Development at Goddard Systems, Inc. and is responsible for overseeing the continued growth of the brand while strategizing innovative ways to reach new markets and potential franchisees. With nearly a decade of franchise industry experience and having worked in both the franchise development and real estate side of the business, Jim is in a prime position to scale Goddard System Inc.’s growth to new heights.