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Franchisors Shouldn’t Hold Back on Financial Disclosure

by Ed Teixeira

It’s important that franchisors disclose as much meaningful financial information about their franchise opportunity as possible. Providing franchise candidates this kind of information can prevent future franchisee problems from arising.

Recently, I received a telephone call from an individual looking to purchase a franchise. The person received my newsletter and asked if I could answer an important question. He explained that he was considering several locations to lease space for a franchise. He had contacted the franchisor about operating costs. In particular, he was seeking some information regarding the costs for leasing retail space. According to the prospect the franchisor told him that he couldn’t provide any cost or expense data other than the information contained in the FDD. My first response was to ask if he was represented by a franchise attorney. His response: “Not yet.”

I explained to him, that under the Revised Franchise Rule, cost and expense data was not considered to be a financial performance representation. I provided a quick overview of the FDD and in particular Item 19, explaining how the previous regulations were strict and somewhat ambiguous when it came to financial disclosure. Now, franchisors can disclose expense and cost data, which should help franchise prospects make a more informed decision. My admonition to the individual was to seriously consider whether he should proceed in purchasing the franchise.

This isn’t the first time this situation has come up. Franchisors that hide under the previous Item 19 requirements are either ignorant of what they can and cannot disclose or are patently withholding important information from the franchise candidate. If the franchisor is a start-up then they should have some information from their pilot operation.

Following is the guidance contained in the FTC Compliance Guide

FRANCHISE RULE
16 C.F.R. Part 436
COMPLIANCE GUIDE

Does Cost Information Constitute a Financial Performance Representation?

The presentation of cost or expense data alone is not a financial performance representation. Accordingly, the disclosure of fees, required purchases, and expenses reported in Items 5 through 7 ordinarily will not constitute a financial performance claim that would have to be disclosed in Item 19. Nevertheless, a presentation of cost data, coupled with additional sales or earnings figures, from which prospective franchisees could readily calculate average net profits, is a financial performance representation, and does trigger the Item 19 disclosure obligation.

This experience caused me to consider why franchisors should disclose more cost and expense data, providing they comply with the FDD disclosure requirements.

Enables the prospect to construct a more accurate break even and cash flow analysis.
If the franchisor provides this information to candidates it will enable the franchisor to more effectively qualify prospects. For example, how did the candidate incorporate this information into their financial models?
A good amount of franchisee start-up problems and potential failures are caused by under estimating expenses as much as poor sales.
When expense and cost information is not fully disclosed it’s only a matter of time before the franchisee has the correct information.
The franchisor should provide prospective franchisees as much cost information as allowed since it can assist the candidate in their decision making.

For some reason, certain franchisors fail to disclose particular franchise cost information despite being allowed to do so. Disclosing this information can increase the probability that both parties make the right decision.