The Elusive Earnings Claim

Finding franchisee earnings is difficult for a franchise buyer

WASHINGTON — Although experts say that it is critical for franchise investors to understand average earnings for outlets in a franchise system, finding a store's earnings for would-be franchise buyers can often be like finding a needle in a haystack. First, a minority of franchisors are willing to provide it. And even when provided, these claims can be manifested in many forms. That makes it nearly impossible to compare one franchise brand’s earnings potential to another.

“Just about every franchisor knows what its franchisees are making and they can make that information available,” says Robert Bond. “For one reason or another, very few decide to make that information available. It would seem to me to be incumbent on the International Franchise Association, the Federal Trade Commission, or whoever dictates these kinds of things, that they should make it compulsory for a franchisor who has been in business for five years or who has over 20 operating units. They should be compelled to give whatever information they have on their franchisees. Certainly the most important bit of information that a franchisee can get before he or she makes a $200k or $500k investment is to have a sense of what he or she can make. My sense is that very few [franchise buyers] have a clue on what they can make.”

Government Requires Franchisors Provide Some Info, but Not Franchisee Earnings

It’s not that franchisors do not have earnings information about their franchisees. They do.

The president of the American Franchisee Association, Susan Kezios, explains, “Franchisors collect or have a contractual right to collect earnings information from franchisees.” She says that franchisors know a franchisee’s revenues and more “because this information is the basis for paying royalties.” Ms. Kezios recalls that  when she herself was a franchisee for VR Business Brokers, she was required to send her franchisor an income tax return for her business every year.

Craig Tregillus, franchise director at the Federal Trade Commission, says that the commission is concerned that if franchisors were to disclose earnings that it would be misleading to prospective franchisees. Worse yet, mandating earnings reports might impose extra burdens and costs on existing franchisees.

David French, vice president of government relations for the International Franchise Association, explains, “The FTC adopted a voluntary approach to financial performance representations (FPR) for a number of reasons. One factor that the commission considered was the difficulty of establishing a single disclosure format that would be relevant for all sectors of franchising. The commission also recognized that mandated FPRs would impose extensive, new data collection requirements on franchisors and franchisees, and also might expose franchisees for liability for indemnification should a franchisor, relying on the franchisees’ data, be found to have violated the Rule. The commission also concluded that mandated information would not equal a higher level of assurance from the threat of false earnings claims.”

The FTC in 1997 observed that it was important that the federal government not get involved with free market forces. The Commission wrote that it “does not support the view that a franchisor's failure to provide earnings information is necessarily deceptive or unfair. Approximately 20 percent of franchisors currently choose to make earnings disclosures. Thus, in theory, prospective franchisees can find franchise systems that voluntarily disclose earnings information. If prospective franchisees were to seek out such franchise systems, or demand the disclosure of such information from franchisors, ordinary market forces may compel an increasing number of franchisors to disclose earnings information voluntarily, without federal government intervention.”

The International Franchise Association agrees that this is something best handled by the marketplace. “Instead of imposing a mandate, the FTC adopted an approach that would encourage the marketplace to demand more accurate and relevant data that the franchisors would want to provide voluntarily,” says French.

But the American Franchisee Association disagrees. “The FTC’s failure to require this disclosure is as unconscionable as it is incomprehensible,” AFA president Kezios states. “Those of us in franchising know far too many franchisors who use the FTC’s failure to require full disclosure as a means to conceal their franchise operation’s weak financial performance.”

Kezios continues, “Franchisors have had over 25 years to voluntarily provide historical financial performance information and the vast majority of them have still not done so,” she emphatically declares. “If one supposedly buys a franchise because they are buying a proven business, then where’s the proof of being proven? Where’s the track record for a franchise?”

In a 2007 article on the IFA website, Bret Lowell of franchisor law firm DLA Piper LLP reasoned that earnings claims are problematic. “First and foremost, how reliable can the past performance of any business be as an indicator of future performance?” he asks. Lowell explains more about the problems with disclosing earnings claims, stating, “Within the same line of business, and even within the same franchise system, there are so many variables due to location, market size, population and economic changes that many franchisors are reluctant to provide a ‘crystal ball’ view of future unit performance.”

The AFA president again rebuts such assertions. “In cases where a franchise system has a track record of financial results, whether they are good, bad or mixed, that is the single most vital item of information a potential investor needs to have,” she states.

Franchisor attorney Lowell also asserts, “In addition, the Federal Trade Commission requires that franchisors who do make ‘earnings claims’ (or ‘financial performance representations’) follow very strict guidelines. As a result, many franchisors have adopted not to make any claims at all.”

But Robert Bond, author of How Much Can I Make? on finding and constructing realistic franchise cash flow statements, interjects that this is not accurate. “A company can provide earnings claims in any form they want as long as they can justify the methodology,” says Bond. “Some will provide estimated gross sales. Some will provide the top 10% of the franchises and get their actual numbers and some will do it legitimately and disclose the whole panorama across all their franchises. So it’s a real mish mash.” Bond continues, “The franchisor simply had to properly document anything it represented as an earnings claim statement. There would be an infinite number of ways the franchisors can skin a cat.”

“Most give cursory information,” he adds.

Marketplace Solutions?

In emphasizing the importance of the marketplace providing earnings claims instead of the FTC mandating it, David French was asked what market solutions the IFA provided to its franchisor members to encourage financial performance representations among franchisors.

“We do not require our members to provide an earnings disclosure for many of the same reasons that the FTC concluded that mandated disclosures were impractical,” he said. “As an industry trade group for franchising, our focus is to provide a forum for ideas and best practices where our members can exchange information with some of the brightest minds in franchising. The subject of appropriate disclosure of earnings claims, for example, is a frequent topic at IFA meetings such as the annual convention and the Legal Symposium.”

When asked if the IFA provided financial spreadsheets, templates or software to help its franchisor members gather financial performance representations of its franchisees, French replied, “Franchising happens in so many different sectors of the economy, I don’t know how we would design a template that would be useful or appropriate.”

Federal Trade Commission Squelches States’ Efforts to Mandate Franchisee Earnings Disclosure

In the late 1990s, the North American Securities Administrators Association worked on drafting a proposal to mandate financial performance information in the form of a recommendation to revise Item 19 of the UFOC guidelines [now called the Franchise Disclosure Document]. NASAA makes recommendations for states to enact uniform laws, guidelines, and regulations in the investor protection areas of its member states — in this case, the states with franchise registration laws. States, attorneys and advisors had been split for years over whether to mandate franchise earnings disclosure. The issue was not only divisive but also extremely complex in the way it would impact franchisors, franchise owners and would-be owners. Finally, after considerable toiling over the particulars of what to require, the Association’s Franchise and Business Opportunity Project Group was preparing to recommend member states require mandating earnings disclosure.

Bob Webster, current director of communications for NASAA, observes that the Project Group ended up not making a formal proposal. Webster explains what happened. “The FTC would require NASAA to prove to it that such a requirement provides equal or greater consumer protection than the current franchise disclosure requirements, which allow franchisors the option to include financial performance information or not,” he declares. He further explains, “In 1997, at the same time the Franchise Project Group was studying this issue, the FTC released its Advanced Notice of Proposed Rulemaking under the FTC Franchise Rule, in which the FTC concluded that the rule review record 'does not support the view that a franchisor's failure to provide earnings information in a disclosure document is necessarily deceptive or unfair.' In order to mandate financial performance information for franchisors nationwide, the FTC would have to adopt that requirement.”

“The FTC ultimately opted not to adopt this requirement,” says the NASAA spokesperson.

That’s probably diplomatic talk for saying that as NASAA was about to recommend mandating earnings claims, something that individual states would adopt, the federal government preempted the move by changing the benchmark, and that made it extremely difficult for state administrators to proceed. That goes against the usual federalist practice of letting states experiment with laws and when it catches on the federal government considers adopting it.

Franchise attorney Rupert Barkoff was involved with NASAA at the time. He gives this insight into the road block. “The FTC’s rationale was that earnings claims might be misleading unless we have economic proof [by NASAA] that it won’t be misleading. The FTC was concerned that it may actually be more harmful to have a franchisor make a bogus or bad statement of franchisee earnings rather than have them simply state nothing.”

Barkoff recalls, “NASAA sort of scratched their head and finally said that they wouldn’t be able to get funding to do what was needed in that regard.” A study categorically proving that providing franchisee earnings to business buyers wouldn't harm them could be quite expensive.

The well-regarded franchise attorney disagreed with the FTC’s decision. “The FTC took the position that they would rather have people acting like cowboys, rather than bring some discipline to the industry by having a written earnings claim requirement.”

Barkoff observes that the failure to mandate an earnings claim has not been good for the industry. He argues that by not disclosing financial performance representations, franchisors are less protected from lawsuits.

“I remember [franchisee attorney] Eric Karp saying, ‘show me a Franchise Disclosure Document that doesn’t have an earnings claim, and I’ll show you a lawsuit,'” declares Barkoff. “The temptation to create numbers when those financial representations aren’t available is very strong.”

Barkoff asks, “Does the franchisor leave it to the salesperson to pull the trigger whenever he wants to, or do you say, ‘Here’s your ammunition [i.e. the financial performance representation].’?”

“Written earnings claims can be an insurance policy,” says Barkoff. “If a franchisor controls its sales force by offering written historical numbers in its disclosure document, then it becomes a lot more difficult to bring a successful lawsuit [by a franchisee to its franchisor] for fraudulent earnings claims.”

The revisions had taken some twelve years of endeavor before they became effective in July of 2008. Because of the difficult effort involved in making even small changes, state regulatory insiders think it is highly unlikely that the FTC will institute anytime soon the major change of making franchisee earnings statements mandatory.

Spending considerable time and effort nowadays in both Australia and the United States, Barkoff offers this observation between the two countries: “In Australia, the government can strike quickly. These types of adopted changes can take place in seven or eight months. Compare that to the FTC in their attempt to modify their rule, which took twelve years.” Worse yet, he says, “The changes were not much more than a tempest in a teapot.  . . . There were hardly any significant modifications other than allowing documents to be disclosed electronically.”

More Franchisors Now Providing Franchisee Financial Performance Representations

According to the IFA’s Mr. French, “A report done in January of 2007 shows that the trend toward franchisors making financial performance representations is increasing — over 18 percent of all active franchise systems make earnings claims.” French continues, “Of those that have been in business for more than five years, it’s over 25 percent. For those franchise systems in business eight years or more it’s over 50 percent.”

“What the report shows is that franchise systems that have been operating for a longer period of time, with more units, tend to make earnings claims more than companies with less of an operating history,” says David French. “As systems mature they have more operating history and better data and they can make better forecasts.”

The IFA's numbers are different from what Frandata reports. According to Frandata, a franchise research and consulting firm, there are now some 35 percent of franchisors who provide some sort of financial performance representation in their Franchise Disclosure Document. They know those percentages because “from a sample of over 2,000 franchise brands for which we have current data, we identified over 700 with FPRs,” says Darrell Johnson, CEO of Frandata, the company that collects and calculates the data.

Mr. Johnson explains why he is confident of the accuracy of his numbers. “Information and analysis around those topics is what franchisors and suppliers pay us for. We want to be as accurate as we can be. We owe it to our clients and to the industry.” Frandata sells their tracking information to prospective franchisees.

World Franchising Network’s Rob Bond, who also spends considerable effort collecting franchise data, has a somewhat different take. “There are probably 3,500 active franchisors in North America,” declares Bond. “On balance maybe 400 companies will provide an earnings claim statement. We actually track some 250 of those companies and sell the information to prospective franchisees.”

That would be about 11 percent of franchisors that make some sort of franchise performance representation, or 24 percentage points lower than Frandata’s info.

Darrell Johnson explains the minutiae of the data and the importance of knowing whether there are 2,400 franchisors out there or 3,500. “The challenge in such statistics is not identifying those brands that disclose Item 19 data. The challenge is defining the franchise universe, which is constantly changing.”

So who’s right? Are earnings representations a rare phenomena or are they becoming a standard?

According to the state of Maryland, there are some 1,354 franchisors registered there. Peggy Shanks, senior franchise examiner with the Maryland Securities Division, reported at the IFA Legal Symposium in May 2009 that approximately 40 percent of franchisors registered in Maryland made some type of financial performance representation in Item 19 of their franchise disclosure document. And in October 2008, at the ABA Forum on Franchising Annual Conference in Austin, Texas, Illinois franchise attorney Cassandra Karimi reported that approximately 40 percent of franchisors registered in Illinois made some kind of financial performance representation.

ProForma provides sales estimates for all and start up franchise figures, 2009 FDD

Those percentages come closest to Frandata’s 35 percent estimate.

But it is possible that franchisors who register in Maryland or Delaware tend to be national, established chains. Only 14 states require franchisors to register in order to sell their franchises in the state. Smaller chains might want to avoid the costs of preparing registration disclosure documents in these two registration states. That could mean that Maryland and Delaware numbers could skew to the large franchisor chains, with more of these disclosing franchise unit earnings.

Greg Muzzillo, founder and co-CEO of Proforma, a chain of some 700 print franchises, sees the importance of putting a lot of effort into declaring franchisee earnings on the Franchise Disclosure Document. He states, “We detail our earnings claims because we believe that our potential franchise owners have the right to know! They are investing the time, money and energy into the company, and they don’t often get a second chance at launching a successful business. We want our owners to make the best decision and are committed to providing them with the information they need to do so.”

He adds, “Asking about earnings is a fair question. I think that franchise organizations should work harder to answer that question for their franchise candidates. We truly owe it to them! In addition, at Proforma we are proud of our earnings claims. We want people to know that for little investment, they can make just as much or more than franchise organizations with substantially more investment and risk.”

Franchise researchers think these types of fuller disclosure from companies like Proforma is an encouraging sign. “The trend is in the right direction," says Bond. "More franchisors are doing it. And the information is more meaningful than it was ten years ago.” But with a twinkle in his eye, Bond adds the caveat, “It’s been a slow increase.”

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Related Reading:

• FPRs: Not for Everybody, FranchiseUpdate
• Robert Bond: Where To Find Earnings Claims
• Earnings Claims by Paul Steinberg, Forum
• Franchisees Kept Out of Earnings Forecasts for Their Own Loans
• Exposed by Not Having Earnings Claims? Then Have Salespersons Write Records