FDD Item 19 Financial Performance Representations
What Is a Financial Performance Representation?
A financial performance representation is a written or oral statement made by a franchisor to a prospective franchisee, in an advertisement, or to the public, where the franchisor provides information about sales or other financial data about the franchised business. The definition of a financial performance representation is broad and, in addition to actual data, includes projections and pro-formas.
Under the Federal Franchise Rule, a financial performance representation is defined as:
Any representation, including any oral, written, or visual representation, to a prospective franchisee, including a representation in the general media, that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits, or net profits. The term includes a chart, table or mathematical calculation that shows possible results based on a combination of variables.
How Does the Issue of Financial Performance Representations Arise for Franchisors?
In the ordinary course of the franchise sales process, prospective franchisees will ask questions about the actual or potential financial performance of the franchised business. Questions like:
“What do your numbers look like?”
“What is the gross revenue for your corporate location?”
“What do you take home?”
“Can you help me project my revenues and earnings as a franchisee?”
“What should I estimate my revenues to be in years one, two, three, etc…?”
“What profit margin should I expect?”
“Can you give me a pro forma worksheet to estimate my revenues and profit?”
So, the issue of financial performance representation arises in the franchise sales process. How you, as a franchisor, address these issues and whether or not you include a financial performance representation in your FDD will play a major role in the sales process.
What Is the Rule About Financial Performance Representations When Selling Franchises?
The rule is that as a franchisor you cannot make a financial performance representation unless the financial data is stated and contained in Item 19 of your FDD. If your FDD does not include Item 19 financial performance representations, you cannot, under any circumstance, publicly disclose or provide franchisee candidates with financial performance data or information. This restriction will apply to you directly and to all agents that are involved in the franchise sales process, including sales agents, brokers, and other franchise sellers.
All Item 19 financial performance representations must comply with the federal franchise rule, state rules, and NASAA Franchise Registration and Disclosure Guidelines, including the financial performance representation commentary adopted on May 8, 2017.
How Important Are Financial Performance Representations to the Sales Process?
Very important, both, from a franchise sales perspective and a legal perspective. From a franchise sales perspective, they provide prospective franchisees with important validating factors and metrics for comparison with competing franchise brands. Franchise brokers are also extremely interested in financial performance representations and typically favor brands that disclose their data. From a legal perspective, including a financial performance representation helps to insulate a brand from false franchisee claims, i.e., where a franchisee claims that although the FDD did not include a financial performance representation the franchisor’s sales agent orally disclosed information.
What If You Can’t Make a Financial Performance Representation?
There are many reasons why you may not be able to make a financial performance representation. Some reasons may include the inability to document or verify your information, or inconsistencies that may exist between your internal data and other reported data. Although it is always better to have a quality financial performance representation, many start-up and established brands do not make Item 19 financial performance representations and still achieve significant franchise sales. The impact of not including an Item 19 financial performance representation will depend on your internal sales team, your business, the industry that you operate in, and whether or not your competitors include Item 19 financial performance representations in their FDDs. If you cannot include Item 19 financial performance representations in your initial FDD, we recommend that, over time (whether one, two, or three years later), you engage in a record-keeping process that will enable you to include quality financial performance representations. Keep in mind that as franchisees establish and open their own franchise outlets, you will also need to include franchisee data.
What About Franchisee Data?
Franchisee data must also be included in your financial performance representation. For start-up franchisors this, initially, will not be an issue but, over time, as franchisees establish and open their franchised outlets, franchisee data must be included in your Item 19 financial performance representations. For this reason, it is important that, as a franchisor, you put systems in place to properly record franchisee data and that your records include the categories of data that will be included in your Item 19.
What Type of Information Is Typically Disclosed in a Financial Performance Representation?
Although there are many legal and compliance issues that must be reviewed, as a franchisor you have a significant amount of flexibility as to the data included and reported in your Item 19. At the most basic level, an Item 19 financial performance representation may be limited to “Gross Sales” data for company-owned and franchised outlets. At more advanced levels, depending on the quality and nature of the data, an Item 19 financial performance representation may include calculations of:
Gross Profit, i.e., Gross Sales less Cost of Goods and Services sold;
EBITDA, i.e., Gross Sales less Cost of Goods and Services sold and less Operating Expenses less interest, taxes, depreciation, and amortization;
Other data points unique to your business or indicative of performance like average sales per customer or transaction, number of customers served, number of services provided, products sold, plus more.
There are many legal compliance components to a financial performance representation, and your Item 19 should be carefully planned out and developed with your franchise lawyer.
What Is the Legal Standard for Developing and Disclosing a Financial Performance Representation?
As a franchisor, you must ensure that you have a “reasonable basis” for the information and representations made in your FDD Item 19 financial performance representations. You must also maintain written documentation and records that substantiate your Item 19 claims and demonstrate your reasonable basis. Prospective franchisees may request this documentation. The information reported in your financial performance representation does not need to be audited.
Once disclosed, as a franchisor, you must ensure that the data and information underlying your Item 19 is and remains accurate and without any material omissions. If there is any change in the operations of the franchised business, the accuracy or facts underlying the bases of your financial performance representations, or economic changes that render your data misleading, you must immediately amend and update your FDD and Item 19.
An example of a material event rendering and impacting Item 19 Financial Performance Representations includes the 2020 COVID-19 Coronavirus pandemic. As a result of the 2020 pandemic many franchise systems experienced shut-downs, impacted sales, and, in certain instances, the need to modify their services and how they were delivered, i.e., online learning, curb-side delivery, etc… In response, the franchise state regulators forming the NASAA Franchise Project Group issued guidance advising franchisors about the impact of COVID-19 and the potential for the 2020 pandemic to render Item 19 data misleading. The analysis applied by the NASAA Franchise Project Group, applied the following logic:
- That Franchisors possess an obligation to maintain and ensure that they possess a reasonable for ensuring that the Item 19 data reported in their FDD is representative of the Franchised Business;
- That in 2020 many franchise systems were financially impacted y COVID-19 and faced closured and modifications to their operations;
- That if a franchise system was financially impacted by COVID-19 in 2020 or was required to change its operations, then an Item 19 financial performance representation that includes historical financial data for 2019 may be misleading and requires FDD amendment to include 2020 data or to remove the Item 19.
Can You Include Disclaimers in Your Financial Performance Representations?
You can, but the disclaimer that you may use is extremely limited. Under NASAA guidelines, you may use only one of the following two disclaimers and nothing more:
For historical representations:
“Some [outlets] have [sold] [earned] this amount. Your individual results may differ. There is no assurance that you’ll [sell] [earn] as much.”
“These figures are only estimates of what we think you may [sell] [earn]. Your individual results may differ. There is no assurance that you’ll [sell] [earn] as much.”
To learn more about financial performance representations, and how we can help develop, review and improve the Financial Performance Representations in your FDD contact our team at (718) 979-8688 or by email.