A guide for planning and properly disclosing Financial Performance Representations in your FDD
- The basics of Item 19's
- How important Item 19's are to the sales process
- What information is typically disclosed
- Sample Item 19 Financial Performance Representations
What are Item 19 Financial Performance Representations?
A financial performance representation is a statement or representation made by a franchisor – whether in writing, in an advertisement, through information made available to the general public, orally in statements made to a prospective franchisee and otherwise – where a franchisor discloses or makes available information about the financial performance of the franchisor’s existing corporate locations, franchise locations or prospective franchise locations. The definition of a financial performance representation is broad and, in addition to actual data, also includes projections and pro-formas.
Financial Performance Representations
Under the FTC Federal Franchise Rule a Financial Performance Representation is defined as:
Any representation, including any oral, written, or visual representation, to a prospective franchisee, including a representation in the general media, that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits, or net profits. The term includes a chart, table or mathematical calculation that shows possible results based on a combination of variables.
What is the Rule about Financial Performance Representations When Selling Franchises?
The rule is that as a franchisor you cannot make or disclose, to the public or franchisee candidates, financial performance representations unless they are first stated and disclosed in Item 19 of your issued and current FDD. You cannot discuss or provide a franchisee with financial performance data that is not expressly disclosed in your FDD Item 19. All Item 19 financial performance representations must comply with the federal franchise rule, state rules and NASAA’s Franchise Registration and Disclosure Guidelines, including the financial performance representation commentary adopted on May 8, 2017.
If your FDD does not include Item 19 financial performance representations you cannot, under any circumstance, publicly disclose or provide prospective franchisees with information that would qualify as a financial performance representation. This restriction will apply to you directly and to all agents that are involved in the franchise sales process, including sales agents, brokers, and other franchise sellers.
How Important are Financial Performance Representations to the Sales Process?
From a franchise sales perspective and, from a legal perspective, financial performance representations are important. Financial Performance Representations provide franchisee candidates with important metrics and data helpful for validating your brand and closing deals. Franchise brokers overwhelmingly favor brands with good financial performance representations.
Legally, financial performance representations also serve an important role by helping insulate against false franchise claims where a franchisee claims that although the FDD did not contain Item 19 financial performance representations that the franchisor made oral or written representations outside the FDD., i.e., where a franchisee claims that although the FDD did not include a financial performance representation that the franchisor or, the franchisor’s agent, orally disclosed information amounting to a financial performance representation.
What if You Can’t Make a Financial Performance Representation?
There are many reasons why you may not be able to make a financial performance representation. Reasons may include your inability to document or verify information or, inconsistencies that may exist between your internal data and other reported data. Although it is always better to have a quality financial performance representation, many times startup up and emerging brands forego this option in the initial years.
The impact of not having an Item 19 financial performance representation will depend on your internal sales team, your business, the industry that you operate in, and whether or not your competitors include Item 19 financial performance representations in their FDDs.
If you cannot include Item 19 financial performance representations in your initial FDD, we recommend that over time (whether one or two years later), you engage in a record keeping process that will enable you to develop and include a quality financial performance representation in your FDD. Keep in mind that as franchisees establish and open their own franchise outlets, you will also need to include franchisee data.
What About Franchisee Data?
Generally, franchisee data must be included in your financial performance representations. For start-up franchisors, initially, this will not be an issue but, over time, as franchisees establish and open franchised outlets, franchisee data must be included in your Item 19. For this reason, it’s important that, as a franchisor, you put systems in place to properly record franchisee data and that your records include the categories of data that will be included in your Item 19.
What Information is Typically Disclosed in a Financial Performance Representation?
Although there are many legal requirements that must be complied with, franchisors are afforded a significant amount of flexibility as to the data that may be included and reported in Item 19. At the most basic level, an Item 19 financial performance representation may be limited to “Gross Sales” data for company owned and franchised outlets.
At more advanced levels, depending on the quality and nature of the data, financial performance representations may include calculations of Gross Profit, (Gross Sales less Cost of Goods sold) and, even, EBITDA (Gross Sales less, Cost of Goods and, less, Operating Expenses). Due to variations in financial data, typically, we do not recommend financial performance representations that go beyond EBITDA calculations.
A financial performance representation may also include other metrics and data that can help give prospective franchisees better insight into your business and business model. For example, an Item 19 may include average sales per customer or per transaction, number of customers served, number of services provided or products sold. Basically, if the metric can be verified and is accurate, it may be included in your Item 19 financial performance representation.
What is the Standard of Review Required for Financial Performance Representations?
The standard is that, as a franchisor, you must have a “reasonable basis” for the information disclosed and, representations made, in your Item 19. You must also maintain written documentation and records that substantiate your Item 19 claims and demonstrate your reasonable basis. Although uncommon, franchisee candidates have the legal right to request access to review the backup documentation used to prepare your Item 19. The information reported in your Item 19 and your backup data do not need to be audited.
What is Disclosed in Item 19 if No Financial Performance Representations are Made?
SAMPLE:
ITEM 19
FINANCIAL PERFORMANCE REPRESENTATIONS
The FTC’s Franchise Rule permits a franchisor to provide information about the actual or potential financial performance of its franchised and/or franchisor-owned outlets, if there is a reasonable basis for the information, and if the information is included in the disclosure document. Financial performance information that differs from that included in Item 19 may be given only if: (1) a franchisor provides the actual records of an existing outlet you are considering buying; or (2) franchisor supplements the information provided in this Item 19, for example, by providing information about possible performance at a particular location or under particular circumstances.
We do not make any representations about a franchisee’s future financial performance or the past financial performance of company-owned or franchised outlets. We also do not authorize our employees or representatives to make any such representations either orally or in writing. If you are purchasing an existing outlet, however, we may provide you with the actual records of that outlet. If you receive any other financial performance information or projections of your future income, you should report it to the franchisor’s management by contacting … [FRANCHISOR CONTACT AND INFORMATION], the Federal Trade Commission, and the appropriate state regulatory agencies.
What is Disclosed in Item 19 if Financial Representations Are Being Made?
It depends on your business, your industry, and the KPI’s that are important to you and your franchisee candidates. At the most basic level, every good FPR starts off with Gross Sales data. From there, depending on your business and the available data, your FPR may include additional data that includes costs, gross profits, EBITDA calculations, and KPI’s.
Good financial performance representations:
- Answer questions that franchisee candidates will be asking about the economics of your business
- Provide detailed and clear definitions about the terms and categories of data reported in your representations
- Include, when available, gross profit data
- Include, when available, KPI’s specific to the operations of your business
- Account for variations within your franchisee population such as, number of years open, territories serviced, full-time vs. part-time, and other qualifying factors that may be applicable
- Are representative of the franchised business and are based on reliable financial data documented by your team.
Levels of Financial Performance Representations
Below is an overview of common forms of financial performance representations. These are only examples and it’s important to keep in mind that there’s no set formula. Many times, good financial performance representation are built around your brand, data available to you, and KPI’s that will be important to your franchisee candidates.
(1) Gross Sales Only FPR – Financial performance representations that disclose Gross Sales data only are typically used when more detailed information is not available or may be misleading to franchisee candidates. Gross Sales only FPR’s demonstrate potential sales volume that may be achieved by franchisee candidates but lack more detailed data related to profitability and KPI’s.
Gross Sales FPR’s are typically calculated by providing combined and average data sets for company owned outlets and franchised outlets. These data sets are required to include “Average”, “Median”, “High, and “Low”, and, may be broken down into performance quartiles. Also, if there is a demonstrated variation in franchisee operations, e.g., length of time that the franchised outlet has been open, reported part-time franchisee operations vs. reported full-time franchisee operations, etc., then the data may be broken down even further.
Example of what a Gross Sales Only Financial Performance Representation may look like:
ANALYSIS OF RESULTS OF COMPANY-OWNED OUTLETS
FOR THE REPORTING PERIOD
This analysis contains a historic representation of Gross Sales achieved by our Company Owned Outlet during the Reporting Period. During the Reporting Period we had one (1) Company Owned Outlet. This Company Owned Outlet operates within a densely populated market where the [ ] brand maintains significant awareness among consumers and a significant market
presence for over nine years.
ANALYSIS OF RESULTS OF OPERATIONAL FRANCHISE OUTLETS
FOR THE REPORTING PERIOD
This analysis contains a historic representation of Gross Sales data achieved by our Operational Franchise Outlets during the Reporting Period. During the Reporting Period we had 100 Operational Franchise Outlets in the United States and of these 100 Operational Franchise Outlets, 50 were open and in operation for the full twelve (12) months comprising the January 1, 2019 to December 31, 2019 Reporting Period. We include the results of only those 50 Operational Franchise Outlets (the “Reporting Operational Franchise Outlets”) that were open and in operation during the full twelve-month period of the Reporting Period. During the Reporting Period, 25 of our Reporting Operational Franchise Outlets qualified as a Full-Time Franchisee Outlets and 25 qualified as a Part-Time Franchise Outlets.
(Partial Sample with Placeholder Data)
(2) Gross Profit FPR – Gross profit financial performance representations provide franchisee candidates with critical information about potential profitability. Gross profit is calculated by disclosing Gross Sales less Costs of Goods Sold and Services Provides. Gross profit is not net profit and does not include operating expenses that, typically, will vary from franchisee to franchisee.
Costs of Goods Sold and Services Provided are, typically, limited to the direct costs associated with the product or service sold. Below is an example of the definitions and calculations used in disclosing a “Gross Profit” Item 19 Financial Performance Representations. The example is to demonstrate the process of defining terms and calculating Gross Profit and, although, the example is based on a “restaurant” this type of FPR can be develop for any business, whether retail or service based. The only things that change is how we define “Costs of Goods Sold” or “Costs of Services Provided”.
Example of what a Gross Profit Financial Performance Representation may look like using a “Restaurant”
(Partial Sample with Placeholder Data)
DEFINITIONS
(a) Cost of Goods Sold – means Food Cost and Paper Goods Cost incurred by the Restaurant. Cost of Goods Sold does not include labor costs and other Operating Expenses.
(b) Food Cost - means the direct costs incurred by the Restaurant for all food and beverage ingredient items that are used in preparing a Restaurant menu item. Food Cost does not include Paper Goods Cost, the cost of labor used in preparing or serving menu items, and all other expenses associated with operating a Restaurant.
(c) Gross Profit – means Gross Sales less Cost of Goods Sold.
(d) Gross Sales – means the total revenue derived by each outlet less only sales tax, customer discounts, customer allowances and returns. Other than the deduction of sales tax, customer discounts, customer allowances and returns, there are no other deductions from revenue in determining Gross Sales.
(e) Paper Goods Cost – means the direct costs incurred by the Restaurant for all paper goods including, cups, utensils, packaging and materials used to serve Restaurant menu items. Paper Goods Cost does not include Food Cost, the cost of labor used in preparing or serving menu items and all other expenses associated with operating a Restaurant.
Gross Profit FPR calculations can be developed for any business. The key is to properly define the terms and ensure that you properly disclose what is and what is not included within the Cost of Goods Sold / Services Provided Calculation. For example:
- Service Based Business, cost of goods sold and services provided may be defined to include (a) non-management labor costs associated with the service provided, plus (b) direct cost to franchisee of any product or good that is sold.
- Retail Based Business, cost of goods sold and services provided may be defined to include (a) non-management labor costs associated with the products sold, plus (b) direct cost to franchisee of any product or good that is sold.
Developing the right Gross Profit FPR requires an evaluation of your business and clearly defined definitions. The benefits of providing a Gross Profit based FPR is that they allow franchisee candidates to evaluate “top line” profitability.
Adjustments for Fees Specific to Franchisees
As you will note in the example above, if a FPR discloses more than just Gross Sales, legally, we are also required to make adjustments to disclose franchise related expenses that are incurred by franchisees but not company owned outlets. Examples include adjustments for royalty fees, brand development fund fees, and other mandatory franchise agreement fees.
(3) EBITDA FPRs – EBITDA - earnings before interest, taxes, depreciation, and amortization - FPR’s disclose cash flows generated by the franchised business. Due to the complexity of obtaining and disclosing EBITDA calculations, EBITDA FPR’s are not the standard, but when available and, when developed properly, can be may be extremely effective for start-up and emerging franchise brands. EBITDA FPR’s generate broker interest and help close deals.
Examples of “Operating Expenses” include: Rent, Credit Card Processing, Marketing, Insurance, and all other expenses except those used in calculating costs of goods sold and, except interest, taxes, depreciation, and amortization.
Costs of Goods Sold and Services Provided are, typically, limited to the direct costs associated with the product or service sold. Below is an example of the definitions and calculations used in disclosing a “Gross Profit” Item 19 Financial Performance Representations. The example is to demonstrate the process of defining terms and calculating Gross Profit and, although, the example is based on a “restaurant” this type of FPR can be develop for any business, whether retail or service based. The only things that change is how we define “Costs of Goods Sold” or “Costs of Services Provided”.
Partial Example of what an EBITDA Financial Performance Representation may look like using a “Restaurant” example
DEFINITIONS
(a) Cost of Goods Sold – means Food Cost and Paper Goods Cost incurred by the Restaurant. Cost of Goods Sold does not include labor costs and other Operating Expenses.
(b) EBITDA – means earnings before interest, taxes, depreciation and amortization and is calculated by subtracting Operating Expenses from Gross Profit.
(c) Food Cost - means the direct costs incurred by the Restaurant for all food and beverage ingredient items that are used in preparing a Restaurant menu item. Food Cost does not include Paper Goods Cost, the cost of labor used in preparing or serving menu items, and all other expenses associated with operating a Restaurant.
(d) Gross Profit – means Gross Sales less Cost of Goods Sold.
(e) Gross Sales – means the total revenue derived by each outlet less only sales tax, customer discounts, customer allowances and returns. Other than the deduction of sales tax, customer discounts, customer allowances and returns, there are no other deductions from revenue in determining Gross Sales.
(f) Operating Expenses – means ordinary and recurring expenses, including labor and rent, incurred in connection with the operations of the Restaurant. Operating expenses do not include expenses and charges related to interest, taxes, depreciation, or amortization, and do not include franchisee related expenses such as royalty and other fees identified in Item 6 that you would be expected to pay to us.
(g) Paper Goods Cost – means the direct costs incurred by the Restaurant for all paper goods including, cups, utensils, packaging and materials used to serve Restaurant menu items. Paper Goods Cost does not include Food Cost, the cost of labor used in preparing or serving menu items and all other expenses associated with operating a Restaurant.
(4) Custom KPI FPR’s – FPR’s can be customized to your business. If a gross sales, gross profit, or EBITDA based FPR’s cannot be disclosed, consider KPI based financial performance representations with KPI’s – specific to your business and, that may help answer questions, like:
- What is the average number of customers serviced by each franchise location?
- What is the average price charged per product or service? What percentage of customers are recurring customers?
- What is the average cost of products sold?
- What is the average cost of key supplies required for services provided?
KPI’s are limited in scope, not as informative as Gross Profit or EBITDA calculations but, may serve an important role in answering franchisee candidate questions and providing them with a framework to validate your brand.
WHAT COMES NEXT?
Together we’ll work to understanding your business and developing competitive financial performance representations that are a good fit for your brand. If your business is a restaurant or retail based business that operates from a fixed brick and mortar location, then including FPR’s that, at the most basic level, include Gross Sales will be critical with, Gross Profit and, potentially, EBITDA preferable. If your business is service based, Gross Sales and Gross Profits will be the preferable calculations. However, for service based businesses there is more flexibility to develop KPI based FPR’s.
Over time, it will be critical to timely plan out your Item 19 FPR’s and ensure that you implement franchisee reporting procedures necessary to ensure the timely development of your Item 19 FPR’s to coincide with your annual FDD renewals and registrations.