Why Don’t More Franchisors Disclose Franchisee Results?

by Ed Teixeira

An Item 19 disclosure is an optional franchisor disclosure made in the Franchise Disclosure Document (“FDD”). It presents the financial performance of the franchisor affiliates, franchisees and company-owned units. It’s been reported that 25-40% of franchisors make a disclosure under Item 19. Based upon various discussions with industry experts I will err on the conservative side and say it’s probably around 30%.

There are numerous reasons why more franchisors don’t provide an Item 19 disclosure:

• Difficulty in obtaining consistent and credible data from the franchisees. The fear that some data is not accurate.
• Complexity of gathering, verifying and presenting the data especially on the part of large franchise systems.
• Disclosing financial data that can be viewed by competitors.
• Mixed financial results, whereby some franchisees perform poorly.
• Reluctance to project future financial performance to prospective franchisees.
• Impacting the due diligence process of prospective franchisees, whereby some could be swayed by the disclosure when making a decision to purchase the franchise.

I expect these reasons will continue to play a role in the decision not to make an Item 19 disclosure.

Franchisor benefits from an Item 19 disclosure:

• Can provide credible financial data to franchise prospects (providing it’s verified).
• Sets the franchisor apart from those franchisors that fail to make this disclosure.
• Can accelerate the franchise prospects due diligence process.
• Forces the franchisor to gather franchisee financial results and thus better monitor the network.
• Can boost the sale of new franchises.
• Can be used by the franchise prospect to conduct a more thorough financial analysis.

Despite these benefits, the fact remains that the majority of franchisors will most likely refrain from making a disclosure under Item 19. Some franchise attorneys believe that more franchisors will make a financial disclosure as they seek to sell more franchises. They may believe that an Item 19 disclosure can be an advantage to their development staff in the sale of new franchises.

Mandatory Disclosure?

There are some who feel that an Item 19 disclosure should be mandatory for franchisors based upon certain qualifying factors such as size and tenure as a franchisor. Although a case could be made for mandatory disclosure the fact remains that the requirements necessary to regulate and audit compliance would be an unlikely position for the FTC or other regulators to take. Then again, is it truly necessary?  There are options that enable a franchisor to provide important financial data to prospects.

The Options:

Under the amended FTC Rule franchisors can provide prospective franchisees operating cost estimates, such as for labor, ingredients and products, so long as this information is not presented as a percentage of gross revenues. If it is then an Item 19 disclosure must be made. Additionally, a franchisor can provide the prospective franchisee with a price list for its product line. If the franchisor does provide prospective franchisees with cost and expense information, the information must be consistent with the information contained in Items 5, 6, and 7 of its FDD. Cost information in combination with additional FDD disclosures can enable a franchise candidate to construct financial projections.

In addition, a franchisor can make an Item 19 disclosure for revenue only. By providing revenue figures a prospective franchisee has a basis to develop a break even and cash flow projection. Some franchisors list franchisee revenue without identifying the franchisee by name or location. This is a rather simple process that a franchisor can follow.

When a franchisor refuses to provide the most basic financial information to prospective franchisees some consider this to be a red flag. It creates the perception of negative financial results from their franchise network.

Vincent DeBiase, a franchise attorney with Corbally, Gartland & Rappleyea, LLP says:  “When I'm representing a potential franchisee, unless the franchise being considered is a relatively new concept or has few franchisees, I have a bias against franchisors that don't make Item 19 disclosures.  On the other hand, when I'm representing a franchisor, I caution them to avoid Item 19 disclosures unless they feel absolutely confident that there is a reasonable basis for the representations they are making and they have the data on hand to back those representations made!”

I would suggest that this response mirror’s what most franchise attorneys would say depending upon the client they represent.

Jeff Connally, President and CEO of CMIT Solutions  states:  “CMIT does provide financial performance data in Item 19 and has for several years. We provide the cost and current retail value of our flagship service offerings thereby giving the franchise candidate the basic “unit economics” upon which to build their business plan. During the discovery process the franchise candidate is able to confirm their assumptions (regarding rate of client acquisition & other business model assumptions) with our existing franchise partners.

We believe that this approach to financial disclosure engages the potential franchise owner in the development of a realistic business plan, and avoids the potential for miss-understandings”

Whether franchisors should make a disclosure under Item 19 will continue to be a controversial topic, based upon which side one represents. Recent changes to the Franchise Rule have made it easier for franchisors to present cost data without being accused of making an “Earnings Claim.”  On the other hand, presenting franchisee revenue under Item 19 can be useful to prospective franchisees.

These two items would provide important information to franchise prospects and add credibility to the franchisor.

© 2010 FranchiseKnowHow, LLC

Ed Teixeira is the President of FranchiseKnowHow, LLC. He can be reached at franchiseknowhow@gmail.com