When reviewing an FDD, a franchise candidate needs to understand what they can find in the Financial Performance Representation.
To learn more about why Item 19 is one that shouldn’t be overlooked when reviewing a Franchise Disclosure document, 1851 Franchise caught up with Lane Fisher, a franchise attorney/lawyer at Fisher Zucker who currently represents more than 500 franchise brands in business transactions and complex franchise litigation. We also spoke with Tom Spadea, a Franchise Attorney at Spadea Lignana and the founding member of the Philadelphia Franchise Association, who has been lead counsel for dozens of new franchise launches and has assisted franchisors and franchisees alike with a variety of legal issues, including private equity transactions, litigation, trademarks, partnerships, and real estate deals.
Below, Fisher and Spadea weigh in on the five reasons why Item 19 is important in an FDD.
1. It’s a barometer against which to measure the things you hear verbally over the course of the sales process.
Fisher says that Item 19 is a barometer for franchise prospects to be able to measure what they’ve heard through the entire sales and exploration process down on paper.
“People have the ability to distinguish their unique propositions and points of differentiation in Item 19,” Fisher said. “For example, if you’re a commercial cleaning concept and you clean the most stadiums, this allows you to distinguish yourself in often crowded landscapes and to make the Item 19 more productive.”
2. It allows for shorter due diligence calls because you’re not starting from scratch.
“Instead of having to construct the economics of a franchise opportunity, you can identify and verify through shorter due diligence calls because you’re not starting from scratch,” Fisher said. “It allows franchisors to provide information about highly efficient units, such as those located in malls, kiosks, strip malls and different size restaurants, which allows you to know what footprints are the most the productive.”
Spadea discusses that validation is definitely an important part of the process. He points out that during these calls, it’s not about finding out how much someone is making, but it’s about finding out how transparent the franchisor is and how accurate they’re being in their reporting.
“I tell everyone looking at buying a franchise to talk to as many franchisees in the system that they can. I tell them to talk to those that are happy, upset and mediocre performers. Are they satisfied with the business they’re now in and is it representative of the business they were looking at getting into,” Spadea said. “A good way to judge is by how realistic the Item 19 is. Franchisors can write it in a way to put their best foot forward. They might segregate groups or only talk about the best performers. They can give prospective on the reliability factor instead of direct historical data so you can look at the Item 19 as the potential of a business model you have to build yourself.”
3. It allows you to look for strong unit economics and predictability.
Fisher says you want to look for a speedy ramp-up because you don’t want to run out of cash at the one or 10 yard line. He advises you want to look for “what the most efficient configurations are, and how much you can make — a concept’s profitability.”
He comments that a franchisee can use it for predictions. For example, if someone is looking at opening a tutoring franchise, and the average customer comes every week for three years, “it’s a little like insurance, more residual income.”
Spadea notes that the Item 19 should be viewed much differently if you’re buying an existing franchise.
“Buying an existing franchise is totally different, but if you’re buying a business model and not buying an existing business, people need to understand the Item 19 is more of a generalization. It’s meant to provide a ballpark range and let them understand the general mechanics of the business model – profitability structure, potential revenue, range in revenue – all to give perspective of analysis of whether or not the business plan is close to what they want to acquire,” Spadea said. “The real due diligence comes in talking to franchisees, the franchisor, understanding the brand and understanding the support. Item 19 should be an important part of the process, but not the only part.”
4. It helps build transparency and it’s a very important data point for prospective franchisees to understand the business model.
Spadea says that “historical results aren’t exactly predictive of future performance, but it is a very good benchmark for what the franchise prospect might expect once they become a franchisee.”
Fisher warns that when a franchise is in its infancy, the first three locations in the same area are always going to be profitable. However, opening that same brand in a new location is going to be harder to build out. He recommends that if someone is in this position, it’s beneficial to look into a competitor’s Item 19 or industry stats to try and set expectations, or to access through validation with the earliest franchisees.
5. It helps you put together a business plan.
“I think that the Item 19 is simply a data point and I think sometimes candidates rely too heavily on the numbers,” Spadea said. “You’re not buying an existing business, but it can help you put together a business plan and help them build their own business model around what they expect as a franchisee.