FDD Item 19 Financial Performance Representations
As a franchisor, it is important to understand what financial performance representations are, how the issue of financial performance representations comes up, and when to disclose financial performance representations in Item 19 of your FDD. Below is a summary of vital information about Item 19 and financial performance representations.
What Is a Financial Performance Representation?
A financial performance representation is a statement or representation made by a franchisor – whether in writing, in an advertisement, through information made available to the general public, orally in statements made to a prospective franchisee, or otherwise – where a franchisor discloses or makes available information about the financial performance of the franchisor’s existing corporate locations, franchise locations, or prospective franchise locations. 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 Financial Performance Representation Issue 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. Prospective franchisees will ask 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 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’s 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 performance representation is stated and contained in Item 19 of your FDD; and when Item 19 does contain a financial performance representation, the information that you can discuss with a franchisee is limited to what’s disclosed in Item 19, i.e., you cannot discuss or provide a franchisee with more information than is expressly disclosed in your FDD. 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.
If your FDD does not include Item 19 financial performance representations, you cannot, under any circumstance, publically disclose or provide prospective franchisees with information that would qualify as a financial performance representation. 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.
How Important Are Financial Performance Representations to the Sales Process?
From a franchise sales perspective and from a legal perspective, financial performance representations are important. From a franchise sales perspective, they will 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 maintain favorable data. From a legal perspective, including a financial performance representation serves to insulate a brand from false franchise claims, i.e., where a franchisee claims that although the FDD did not include a financial performance representation, the franchisor or the franchisor’s agent orally disclosed information to them.
What If I 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 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 a quality financial performance representation. Keep in mind that as franchisees establish 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 open and establish 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 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 that may be 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, 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 Standard of Review for Information Disclosed as 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.
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."
If you would like to learn more about our franchise development process or how we can assist in developing your Item 19, check out our Franchise Launch Program. If you are an existing franchisor and would like to upgrade your Item 19 financial performance representations, learn more about our Franchise Counsel Program.