Go ahead: Pick a franchisee. Any franchisee. Any industry. Any brand.
Ask them why they bought into the system.
You’ll likely get a wide variety of answers. Maybe they grew up eating at that restaurant and have a nostalgic connection? Perhaps they see the auto repair industry’s growth potential as a driving force? It could be that they just always really, really wanted to own a coffee shop franchise.
Ignore those answers and ask again.
I bet the real answer is the same every time: money.
That’s why franchisees buy in, right? Sure, they believe in the brand, the business model and the founder’s vision—all great attributes. But, at the end of the day, they’re looking for a solid return on their investment.
That means one Item in their Franchise Disclosure Document (FDD) is likely the one they turn to first: Item 19—the Financial Performance Representation (FPR). It’s important for good reason. Item 19, while not mandatory, discloses earnings claims from existing franchise owners and corporate locations. This fine print section can contain critically important information to consider when analyzing which franchise, if any, to buy into.
Item 19 can be one of the most influential factors in an entrepreneur’s decision to buy a franchise, so it’s important to know how to read, interpret and understand the document. Therefore, 1851 Franchise asked some of the industry’s most respected experts to help shed some light on what to look out for.
Not All Item 19’s Are Created Equal
The first thing to look for is to see if an Item 19 actually even exists in an FDD.
“That’s not always the case,” said Lee Plave, a franchise attorney with Reston, VA based Plave Koch PLC. “An Item 19 isn’t required by law. But, it tells a franchisee what they can earn. So, you might think a franchisor would definitely want to include that information. But, that’s not always the case. Sometimes that information may not put them in the best light, so it’s omitted. But, the absence of an Item 19 doesn’t necessarily mean something negative.”
“If you can’t stand behind your numbers, then you shouldn’t put them in, but it’s not necessarily a red flag just because they’re not there,” agrees Kay Ainsley, Managing Director of MSA Worldwide, a franchise advisory group. “The franchisor may be just starting to franchise. Or, they may only have locations in one market, and don’t want to mislead people. It may not be that the numbers are bad. It could be just the opposite. It may be that they’re really strong in that one market and the franchisor doesn’t want to set unrealistic expectations. There can be a wide variety of reasons behind including or omitting them, so it’s best to do the research to find out why.”
Assess the Data
Because all Item 19’s are not created equal (or, sometimes, created at all), comparing them to one another is not an “apples to apples” situation, even if they’re for similar businesses or in similar industries.
“It’s critical to determine if the Item 19 is a historical presentation of data or a prospective presentation of data,” Plave said. “A historical presentation can be useful to see where the franchise system has been. A prospective, on the other hand, can be useful too, but it’s more theoretical. It’s more of a ‘we believe’ this is what’s possible as a franchisee. There is a big difference there, so it’s important to interpret the data correctly.”
“Is the data an average of all locations? If so, are they all in New York City or in South Dakota? Are they in markets that are similar to the one you’d like to open a franchise in? These are important questions to ask when reading through an Item 19. Franchisors aren’t trying to mislead people, but the data can be confusing. Because of that, prospective franchisees need to know what to look for. The average sales information is important, but it’s important to be aware that it is an average,” Ainsley said.
Read the Footnotes
Footnotes in an Item 19 can offer lots of additional information that can help explain exactly how the performance representation was calculated and what made up the data set or sample size. More importantly, it can shed light on what wasn’t included.
“Look at the notes carefully,” Ainsley advises. “What kind of information is being provided? How does that information relate to where your location would be? Franchisors should try to provide the most realistic information they can, and footnotes can help explain things like where units referenced are located. That can mean a lot in some industries, like restaurants, for example. Are the referenced locations in a mall space? Are they freestanding? Are the inline? What is the square footage of those locations? Are the Average Unit Volumes (AUV) of those locations corporate or franchise owned? The sales expectations can vary wildly from location to location in those scenarios.”
“Look to answer the question: how much of the system is represented in the FPR? If the subset of what you’re looking to build isn’t the same, then you need to do more research. If you’re looking to build a mall based location and the FPR only represents standalone locations, that doesn’t give you the full picture,” Plave said.
Footnotes should also explain what’s left out of an FPR, Plave says.
“If you have a system of 100 units, but you only reported on 92 of them, why is that? Are they different style units maybe? Perhaps those 92 units are new style units, and the other eight are old style units that the franchisor doesn’t intend to sell again. Share that. Franchisors should trend toward over-sharing in footnotes. There is generally room for additional disclosure,” he added.
There is generally great value in making an earnings claim in the Item 19, Ainsley says. But, it may not be for the reason you might think.
“Making an earnings claim gives protection to a franchisor,” she said. “It lays out the numbers. It shows what it possible, and sets expectations on both sides and gives protection on both sides. The franchisor says: we back this, because this is what we put in writing. The most recent study I’ve seen says that 60 percent of franchisors do include some earnings claim in an Item 19. That could be a full P&L, just topline sales, cost of goods sold, or some other combination, but it’s becoming a more common thing to see those earnings claims included.”
An earnings claim may also have another added benefit for a prospective franchisee.
“The claim generally makes it easier to get funding from a bank or to get a loan approved,” Ainsley added. “Bankers are looking closely at a potential franchisee’s prospective business plan. When bankers can see that those numbers are in line with what the franchisor sees as possible, or what other franchisees are experiencing, they are much more likely to approve the loan.”
It’s important to remember that the contents of an Item 19 is completely up to a franchisor, and most are likely to only put in the results that look good. Because of that, capturing the entire financial picture requires another step.
“Make phone calls to franchisees, and ask them what their actual experience is in relation to what’s in the FDD,” Plave said. “You’re making a major investment decision, and the best way to see if it’s a fit for you is to ask those who have already made it.”
“Item 19 can shed a lot of light on what’s possible, and as importantly, what’s likely not possible from a franchise purchase,” Ainsley said. “So, it’s critical to do your homework and understand it as fully as you can.”