Can I Trust a Franchisor’s Financial Performance Representations (Item 19 of the FDD, Part 2)

Understanding Item 19, Part 2: The 4 Types of Item 19’s

In our previous review of Item
19, we provided a general guide to items found within a company’s Item 19 Financial
Performance Representation (formerly known as an Earnings Claim; also known as
Article 19).  In part 2, we review how
these Financial Performance Representations can be useful and their limitations.

First, it is important to
understand that the FTC does not require a franchisor to share earnings
information in their Item 19 " it is an option. 
Today, about 50% of companies offer a Financial Performance
Representation (FPR) in their Article 19. 
The rest of the franchise community does not provide any information in
their Item 19.  The primary argument for
inclusion is that it assists perspective franchisees gain more information
regarding the earning potential of the franchise system.  The primary reasons against providing a FPR
fall into one of three areas. 

1. Some franchise attorneys believe that an Item 19
   opens the franchisor to increased risk of litigation. 
2. Some franchise systems do not collect this
   information and therefore they cannot reliably share the information with
   prospective franchisees.
3. Some franchisors do not want to share this
   information because it is not flattering and it would not help them grow their
   system

At this point it makes sense to
take a deeper dive into the different type of FPR’s.  Over the years I have come to recognize that
most FPR’s fall into one of four categories:

Partial FPR of Actual Data

This is the most common type of disclosure. 
Most franchisors collect top level data from their franchisees and they
are comfortable with this type of disclosure. 
You can recognize this type of FPR because it normally includes Gross Sales
Averages, Cost of Goods Sold, Lease Cost and/or possible Labor Cost, but does not
include Earnings, Profit, or other bottom line information.  Normally this information is divided into
groups based on the age of the franchisee. 
A typical breakdown could include franchisees from 12 to 24 month, 24 to
36 months and franchisees in business for longer than 3 years.  This type of information can be a helpful
starting point

Complete FPR of Actual Data

Although rare, some franchisors provide complete FPR’s.  This would include all of the income lines
and all of the expense lines on the P&L. 
This type of FPR stands apart because the FPR will include bottom line
earnings.  It is exceptionally difficult for
a franchisor to consolidate franchisees bottom line earnings; therefore, therefore,
you normally find this type of FPR in franchise systems that have a large
number of company owned locations.  Since
the company owned locations are all run a consistent set of books,
consolidation can be done in a balanced and fair manner. In many ways this is
the best type of FPR.

Partial FPR of Prospective Earnings

There are also companies that provide partial disclosure of prospective
earnings.  You can recognize these
because the information will be top line and it will not be based on
actual performance.  It will be based on
‘anticipated’ performance.  You can
recognize this because the FPR will state, ‘If you sell this much, then your
other cost should be X.’  The fact that
this is based on an assumed sales level does not really give you any
information regarding what is actually occurring and therefore is significantly
less valuable. 

Complete FPR of Prospective Earnings

The final example is a company that provides a completely assumed set of
books.  You can recognize this because
the FPR will state, ‘Here are two or three different sales levels and the
profit you could make if you are able to make these levels of sales’.  Again, there is no connection to actual
performance and therefore the value of this type of FPR needs to be
significantly discounted.

Don’t Rely Completely on Item 19 – Do Your Homework

Strange as it may sound, mistakes often stem from too
much focus on the FPR.  Even though some
companies may provide significant financial information in their FPR, you
cannot fully understand the earnings potential of a franchise system by
reviewing the FPR.  It always requires
in-depth conversations with franchisees following the approach found in Chapter
12 of The Educated Franchisee. By speaking with franchisees you can build a
comprehensive earning statement that is both accurate and educational.  The Financial Performance Representation
found in Item 19 can be an effective starting point but it is up to you to put
time and effort into discovery of the complete and actual performance.

Missed Part 1? Read How Much Will I Make With a Franchise, Understanding Item 19 here.

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