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Parsing Item 19 Disclosures: A Case Study

You may be somewhat reassured if the franchise in which you intend to invest provides Item 19 financial performance representations in its franchise disclosure document.That's because the disclosure is optional and most franchisors choose not to provide it. Even if Item 19 disclosure is provided, however, you cannot let your sense of reassurance distract you from focusing on the task that lies ahead. Specifically, you need to determine:

  • What is disclosed and, perhaps more importantly, what is not disclosed,
  • Whether the Item 19 disclosure is a reasonable basis upon which to think about average annual income, and
  • How to use the disclosure to make a reasonable comparison to your situation.

Unless you carefully understand the Item 19 disclosure you will be unable to make these critical determinations. And if you cannot do this, you may be better off not reading the Item 19 disclosure in the first place rather than reading but misunderstanding it.

To illustrate these points, let's take a closer look at Jimmy John's Item 19 disclosure in its 2012 Franchise Disclosure Document (FDD).

What's Disclosed. You don't even need Jimmy John's FDD to get started. Just go to their website. Here, Jimmy John's provides some fairly compelling "facts and figures for people who like that sort of thing":

  • Average Annual Gross Sales                 $1,360,396
  • Average Food & Paper Costs                        26.63%
  • Average Net Profits from Operations         $285,158

If you can't plunk down your money fast enough and count yourself among the friends of "facts and figures," take a closer look at the website disclosure and then take a very close look at the FDD. Each of the above figures has an asterisk and, as it turns out, the facts and figures only reflect averages for 19 affiliate-owned restaurants that opened before January 1, 2007. Moreover, almost all affiliate-owned stores are located on college campuses, sites likely to generate significantly more traffic than a traditional strip mall in a town whose population remains unchanged when the fall semester begins. So what's the big deal? Aren't these figures a reasonable proxy for what you can hope to earn?

Maybe, but maybe not.

A Reasonable Basis for Comparison?

The footnote linked to the asterisk informs you that you may get a somewhat better approximation of earnings potential in the actual Item 19 disclosure where you will get more relevant system-wide "facts and figures" for franchise-owned restaurants. The average numbers for franchised restaurants are significantly less compelling. The actual 2011 average annual gross sales (after deducting coupons and promotions) for the 1,092 franchised Jimmy John's restaurants open for operations during the entire 2011 fiscal year were $812,092, a precipitous 40% drop from the gross sales figure that enticed you to look further. That's still a pretty attractive number, though.


JIMMY JOHN'S AVERAGE STORE PRO FORMA INCOME STATEMENT FOR FY 2012
Income:  
Gross Sales $812,092
Less: Cost of Sales 216,260
Less: Labor and Payroll Taxes 207,814
Gross Profit $388,018
   
Operating Expenses:  
Operating Costs $124,047
Advertising 36,544
Royalties 48,726
Total Operating Expenses $209,317
Operating Profit $178,701
Annual Portion of Intial and Ongoing Costs not Included in JJ Examples
Franchise Fee $3,500
Leasehold Improvements 17,500
Furniture, Fixtures & Equipment 14,500
Interest 12,000
Other Start-up Costs 2,000
Total Costs not Included in Examples $49,500
   
Adjusted Pre-Tax Profit $129,201

But let's look a little further. Jimmy John's Item 19 somewhat helpfully supplies a couple of income and cash flows statements for two of its affiliate-owned and operated restaurants. I say "somewhat" because you're still looking at a Golden Delicious-to-Granny Smith comparison of affiliate-owned-to-franchised restaurants. In addition, Jimmy John's cherry-picked two of its highest grossing, campus-based affiliate-owned restaurants for this presentation. Unsurprisingly, the top line for each of these selected restaurants topped the average affiliate-owned Jimmy John's restaurant FY 2011 annual gross sales of $1,360,396 by a healthy and yawning margin of 3.3% and 24%, respectively. The bottom line is only somewhat less impressive: operating profits of $350,377 and $261,262, respectively, compared to an affiliate-owned average of $285,158 for restaurants opened for five years.

Comparing Apples-to-Apples

With no apparent sense of irony, Jimmy John's tells you that "we believe the data in these statements are reliable." But they don't tell you whether the results portrayed are a reliable indication of the results you may achieve except to say that "your individual results may differ." Charitably, that's a pretty hefty understatement. And you only need a calculator or spreadsheet to learn how big an understatement.

So, let's take the income and cash flow statements and populate them with more likely data. We start with Jimmy John's 2011 fiscal year average annual gross sales of $812,092 and apply "common size" principles to borrow cost of sales, labor and payroll taxes and operating expense percentages from the sample statements of income and cash flows in Jimmy John's Item 19 disclosure to derive our own, perhaps more realistic statement.

The operating profit drops from $350,337 and $261,262 all the way down to $178,701. But we can't stop here if you want to get to your real pre-tax profit. The statements of income and cash flow in Jimmy John's Item 19 disclosure don't get you to this important metric. To get there, you need to account for upfront costs that come from your own resources or are financed. Whether they are self-funded or financed, these start-up costs still affect your bottom line. And, if they are financed, they will affect your cash flow as well. So, taking into account items like the franchise fee ($35,000), leasehold improvements and FF&E (the latter two derived from the high end of Jimmy John's Item 7 Estimated Initial Investment range), and amortizing those costs over the 10 year franchise life, you come up with a net income (not including owner's salary, management bonuses, administrative salaries, unit option plans and income taxes) of $129,201. (To see all of my assumptions, please visit my Franchise Focus Blog).

As you can see, Item 19 requires some careful parsing to help you understand what you really want to know: how much money can I make. If the $285,158 average operating profit caught your eye, you need to understand what's behind that figure, whether it's a reasonable basis to determine your own operating profit and how to make it a more apples-to-apples comparison. It's really not a question whether "your individual results may differ." They will. The real question is by how much...for people who like that sort of thing.


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. His Franchise Focus Blog (www.franchisefocus.blogspot.com) focuses on helpful information, tips and current news for prospective franchisees.

This article should not be construed as legal advice or a legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only and you are urged to consult your own franchise attorney concerning your own situation and any specific legal questions you may have.

© 2012 Mike Sheehan. All rights reserved.

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