How to Know if an Earnings Claim is Typical

Hand a prospective franchisee a copy of your Franchise Disclosure Document (FDD), and they’re likely to flip quickly to see if one section is included: the Item 19. After all, what franchisee wouldn’t want to know how much money they could make with your franchise?

If you’re a prospective franchisee, the answer to that question can be complicated. While a franchisor may (likely will) tell you that their franchise has high earning potential, you should always do your own research before investing money. If you find an Item 19 in the FDD you’re looking at, and then also find an earnings claim, how can you really be sure that it’s reflective of the real amount you might earn as a franchisee? After all, there are a lot of variables to contend with.

Below are some critical things to consider to ensure that you’re making an accurate assessment of the earning power you might have as a franchisee.

Is History an Indicator?

Though it may be tempting, comparing one earnings claim to another is not “apples to apples,” even if the FDD is for a similar business or in a similar industry.

“It’s critical to determine if this is a historical presentation of data or a prospective presentation of data,” said Lee Plave, a franchise attorney with Reston, VA based Plave Koch PLC. “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.”

A Reasonable Basis

It’s important to remember that franchisors are not required to make an earnings claim. But, if they do, the Federal Trade Commission requires that they have a reasonable basis for their claims.

Despite that protection, it’s still critical for franchisees to understand the context in which the claim is made. For example, does the earnings claim list gross sales, devoid of operating costs? If it does, then things like operational costs, start-up fees, and royalty payments will come out of that figure. The franchisor may also list just the franchises with the best revenues, and not present an overall average revenue figure. Location also plays a major role.

“Footnotes 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,” said Kay Ainsley, Managing Director of MSA Worldwide, a franchise advisory group. “Footnotes can help explain things like where the 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.”

Just because someone in one town makes a certain amount of money from the franchise, doesn’t mean that you will make the same. The FDD should give you the sample size and the location of the sample size.

Setting Expectations

Franchisors may ask you to sign a statement saying you received an earnings claim. If that request happens, even verbally, you should ensure you record it. Failing to do so could result in waiving your rights to claims in a potential future lawsuit.

For that reason, the earnings claims can actually serve as a protection to a franchisor.

“The earnings claim lays out the numbers,” said Ainsley. “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.”