What Is an Item 19 Financial Performance Representation?
A financial performance representation is any written or oral statement or communication made by a franchisor to a franchisee or the public about the actual or potential financial performance of a franchised business. If a franchisor elects to make a financial performance representation it must be disclosed in Item 19 of the Franchise Disclosure Document and must comply with the disclosure requirements of the Federal Franchise Rule and, at the state level, NASAA and NASAA's Commentary for Financial Performance Representations.
The definition of what qualifies as and constitutes a financial performance representation is broad and includes historical data, projections, and pro-formas. Under the Federal Franchise Rule, financial performance representations are 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 Item 19 Financial Performance Representations Come Up During the Franchise Sales Process?
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?"
How you address and answer these questions and, whether or not your FDD includes Item 19 financial performance representations will play a major role in your franchise sales process. 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 Is the Rule About Item 19 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 FDD Item 19. 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.
FDD Item 19
FDD Item 19 is the section of the Franchise Disclosure Document where franchisors must disclose their financial performance representations. If a franchisor elects to make a financial performance representation, it must be fully disclosed in Item 19 and must comply with federal and state franchise laws.
During the course of the franchise sales process franchisors cannot provide financial information that goes beyond the exact disclosures contained in Item 19. The restrictions related to financial performance representations relate to direct communications with franchisee candidates and, also, advertisements and public information disclosed by a franchisor. Within the franchise registration states, state regulators review and evaluate financial performance representations to determine whether or not the nature and the type of Item 19 disclosure made by a franchisor conforms to federal and state specific requirements.
What Type of Information Is Typically Disclosed in an Item 19 Financial Performance Representation?
Financial performance representations are typically based on historical financial data focused on the gross sales and income achieved by corporate and franchised outlets during the most recently completed calendar year. At a baseline level, the most common financial information reported by franchisors relates to "Gross Sales" followed by "Cost of Goods Sold," "Gross Profit," and, in certain instances, EBITDA, and KPI driven sales and customer data. Although permitted under the franchise rules, franchisors rarely report pro-forma financial data as the requirements for reporting pro-forma data is stringent and requires a detailed foundation of assumptions and underlying data. Although there are many legal and compliance issues that must be reviewed, as a franchisor, you have a good amount of flexibility in developing your Item 19.
What is the Legal Standard Developing Item 19 Financial Performance Representations?
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.
What If You Don't Make an Item 19 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.
If you do not make an Item 19 financial performance representation, you must disclose the following disclaimer in FDD Item 19:
We do not make any representations about a franchisee’s future financial performance or the past financial performance of company-owned or franchised outlets. We also do not authorize our employees or representatives to make any such representations either orally or in writing. If you are purchasing an existing outlet, however, we may provide you with the actual records of that outlet. If you receive any other financial performance information or projections of your future income, you should report it to the franchisor’s management by contacting […], the Federal Trade Commission, and the appropriate state regulatory agencies.
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.
Can You Include Disclaimers in Your Item 19 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."
- For projections:
"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."