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The ABCs of FDDs - First Installment: Item 19

One way, and perhaps the best way, to think about a franchise disclosure document (FDD) is that it represents the minimum level of information that a franchisor must provide a prospective franchisee before selling a franchise. Most FDDs by their sheer bulk give the impression that they are documents that contain everything a prospective franchisee could possibly want to know about the franchise he or she is considering. This is emphatically not the case. In fact, arguably the most useful information a prospective franchisee can gather about a franchise comes only indirectly from the FDD: “validation,” i.e., interviews/conversations with current and former franchisees and franchisee associations whose contact information is required to be disclosed in the FDD.

Nevertheless, a comprehensive and thorough understanding of the FDD should be the foundation of any prospective franchisee’s due diligence. An FDD contains essential, truly vital information that must be thoroughly read and fully understood. This includes a breakdown of start-up and other franchise fees associated with operating a franchised unit, a table detailing a prospective franchisee’s total investment, a description of termination and renewal rights and, in some cases, projections about how much an individual prospective franchisee may earn in the future. Specifically, an FDD must provide 21 separate disclosure items, attach a copy (Item 22) of all proposed franchise-related agreements (e.g., the franchise agreement, real estate and equipment leases, personal guarantees, etc.) and include two copies (Item 23) of a prescribed receipt acknowledgment. You will be better prepared to work your way through an FDD, though, if you have a clear understanding of what you can expect to learn and, maybe more importantly, what you may not learn from an FDD. This series of articles summarizes the takeaways and limitations of an FDD’s 21 disclosure items. The series begins with perhaps one of the most significant required disclosures, Item 19 (Financial Performance Representations).

Before launching into a discussion of the FDD disclosure items, it’s worth a minute to talk about how to read an FDD. Unless you’re in the purgatory inhabited by franchise lawyers who draft and read FDDs as a daily staple, it’s almost certain that you will approach the task of combing through the FDD with the same enthusiasm with which you would greet an invitation to read a dictionary. Still, although it’s a pretty decent understatement to call the task of reading through an FDD arduous, it’s an absolutely necessary undertaking. So, here are some tips to make it less challenging:

1. Do not attempt to read the entire FDD in one sitting. You have at least 14 calendar days to get through the document before you make any binding or financial commitment so why not take all the time you need? Read one or two items at a time and put the FDD down for the night.

2. Read actively and summarize what you’ve read. Mark your copy of the FDD with questions and notes, highlight passages that are particularly important to you and flag pages that you want to reread or refer to later. Finally, I suggest writing a short summary of each FDD item immediately after you’ve read it as a check on how much you’ve understood and retained. Reading an FDD isn’t like reading just about anything else in your daily lives; anything less than 100% comprehension can be very expensive.

3. Enlist the help of experts, including a certified public accountant, an experienced franchise attorney and a knowledgeable franchise consultant. Unless you’re a CPA the Item 19 Financial Performance Representations and the Item 21 Financial Statements may be unclear at best and inscrutable at worst. Similarly, certain items (e.g., Item 8 (Restrictions on Sources of Products and Services), Item 9 (Franchisee’s Obligations), Item 12 (Territory) and Items 13 and 14 (intellectual property and proprietary information)) should be reviewed with the guidance of qualified legal counsel. Finally, a franchise consultant can offer context for your review and help you formulate the questions you should ask the CPAs, attorneys, franchisors and current and former franchisees.

ITEM 19 – FINANCIAL PERFORMANCE REPRESENTATIONS

What you will learn. Item 19 disclosure is permissive, not mandatory. If a franchisor elects to disclose financial performance representations you may get some great information about historical or projected results, including specific levels or ranges of actual or potential sales, income, gross profit or net profit. Moreover, this information must have a reasonable basis and must be backed up in writing.

What you may not learn. Well, maybe everything. Item 19 may be one of the most important disclosure items in an FDD but it’s not required disclosure. In fact, by most estimates, about 70-80% of all franchisors elect not to provide financial performance representations (FPRs). There are a lot of reasons – some good, some not so good – that a franchisor may decide against including FPRs in their FDDs. For example, the franchisor simply may not be able to get reliable data from their franchisees. They also may have a very limited operating history, making historical representations or projections only marginally, or not at all, helpful. On the other hand, franchisors simply may have determined that any FPRs may paint a not so pretty picture. You won’t learn from the FDD why a franchisor chooses not to make financial performance representations. If that’s their choice, all you get is mandated boilerplate. Accordingly, if a franchisor opts not to provide FPRs, an indispensable part of your due diligence is to understand why.

Even if you do get FPRs, you need to be mindful of certain limitations. For example, if the FPR relates to past performance, the franchisor may choose to disclose the actual results from only a subset of outlets that share certain characteristics like location. While this may be better than nothing, it could be worse than nothing. If a frozen yogurt franchisor’s subset includes only Florida outlets, for example, and you intend open a store in, say, North Dakota, the data may be irrelevant or even misleading for your situation. Further, there’s no requirement that historical FPRs be based on generally accepted accounting principles (GAAP). This doesn’t mean that historical financial performance data need not be truthful and reasonable, but it does mean that such data is not subject to any uniform or consistent accounting standards. This makes apple-to-apples comparisons of financial performance representations among franchises difficult.

If a forecast of future financial performance is provided in a new franchisor’s Item 19 disclosure, the required “clear and conspicuous” admonition that actual results may differ from the FPR results might be, well, an understatement. It more aptly be replaced by a paraphrase of the observation attributed to Benjamin Disraeli: “There are three kinds of lies: lies, damned lies and projections.” This is perhaps a bit harsh, but, as one author described them, projections can be likened to a pilot’s flight plan. The plan may be well thought out and reasonable but your two-hour flight might turn into a 10-hour ordeal. Due to weather, traffic and other unforeseen circumstances, you may end up idling on the tarmac or circling your destination airport for a lot longer than you planned. Similarly, despite the best and most reasonable financial performance representations, the arrival at your financial destination for your franchise unit may be delayed or you may find yourself in a long layover. While Item 19 projections must be reasonable and supported by written substantiation, they are, ultimately, guesses. Educated guesses, but they are guesses nevertheless. This is particularly so with franchises with limited operating histories. Even so, a reasonable and validated indication of how well you may do as a franchisee can provide a very meaningful and sensible degree of comfort that you won’t get in its absence.

Finally, even if an FDD provides no financial performance representations, you may be able to get essentially the same information from current and former franchisees as well as franchisee associations.

Mike Sheehan is a franchise consultant and attorney. He is the president of Focus Ventures (www.focusonfranchise.com) and formerly served as a securities attorney and as general counsel for a Fortune 100 financial services company.
© 2012 Mike Sheehan

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