Top 5 Things to Know About Item 19
If you are considering buying a franchise, the legal details may seem daunting at first. That’s why it’s always suggested to consult with an experienced franchise attorney to ensure you fully understand the FDD, and in particular, Item 19, which deals with financial performance.
1. The FTC Rule neither mandates nor prohibits providing financial performance representations.In general, a "financial performance representation," or an "FPR," is data regarding the revenue or profitability of a franchisor's locations or company-owned outlets. Whether or not brands want to provide an FPR is at a franchisor's discretion. But if an FPR is provided, it must have a reasonable basis and be presented in Item 19 of the disclosure document. A franchisor that does not provide an Item 19 disclosure is prohibited from discussing financial performance numbers with prospective franchisees, including the answer to the popular question, "How much will I make?" Instead, prospective franchisees must look to industry information and other franchisees that are already in the system for this information, and not the franchisor.
2. The overwhelming trend is to include an Item 19 disclosure.Twenty years ago, many franchise attorneys routinely advised franchisors to be weary of providing an Item 19, reasoning that it would be all-too-easy for clever franchisee attorneys to poke holes in the FPR and somehow assert that the Item 19 disclosure was misleading. For that reason, even franchisors with strong results frequently chose not to include an FPR. At that time, because a vast majority of franchisors did not provide an FPR, leaving it out of a brand's FDD did not raise a presumption that the financial performance of a franchise system was weak. But that trend has changed.
In 2017, electing to include an FPR has now become the general rule, instead of the exception. In fact, not including an FPR might even raise a red flag to many prospective franchisees. Even so, there are a number of other reasonable explanations why a franchisor may decide to not include an FPR in its disclosure document. The first being that their financial data is too limited to provide a reasonable basis for inclusion in the disclosure document. Financial data is often too limited in a smaller franchise system with a shorter operating history. Many reasonable franchise attorneys would argue that a system should have at least three to five units in operation for over a year to have a "reasonable basis". However, it is increasingly common to see an FPR even when a system only has a single unit in operation. The second reason may be that the financial data is unreliable or not accessible. That might be the case with cost data for franchised outlets, but almost all franchisors have access to their franchisee's revenues due to the required payment of royalty fees. Finally, Item 19 would be misleading to a prospective franchisee. That might be true for a franchisor that only has franchised or company-owned units in a foreign country or units that have substantially different characteristics (e.g. size, location, products offered) from the franchise being offered.
3. FPRs vary widely both in terms of format and content.There are few specific technical requirements imposed on franchisors by the FTC Rule with respect to FPRs, and that is evident in the wide variation of Item 19 disclosures. Due to that variation, it is critical that a prospective franchisee understand exactly what is covered in the FPR.
Some franchisors choose to include only revenue information in their FPR on both franchised and corporate units, without cost information. It is also common for a franchisor to only include revenue and cost data on their company-owned units, revenue data on franchised units and to exclude cost data on franchised units. Only including cost data on the company-owned units and not the franchised units might be a necessity because franchisee cost data is unavailable or unreliable. If that is the case, a prospective franchisee must consider whether the brand unit costs take into account increased costs that a franchisee might incur, including any fees due under the franchise agreement. In addition, a prospective franchisee should consider that the company-owned unit costs might be lower due to operating efficiencies and greater management experience.
Another common format for an FPR consists of presenting revenue and cost information on certain categories of cost, including labor, rent and COGS. Other typical variations include breaking out subsets of units by size or geographic location, only including units that have been in open for a certain number of years or months and only including results for periods after a reasonable "ramp up period". Although less common, many franchisors only provide FPR data on a certain percentage of their top-performing units (e.g. the top 10 or 20 percent).
To mitigate risk and comply with legal requirements, franchisors should provide a well-drafted FPR that explains in plain terms what is included in the FPR, exclusions from the FPR and any differences in the characteristics of the outlets included in the FPR and the outlet to be operated by the franchisee.
4. A franchisor that does not include an FPR in Item 19 may provide cost data outside of the disclosIf a franchisor does not include an Item 19 disclosure, it may still provide cost data to prospective franchisees. Being able to provide cost data with respect to certain costs (e.g. labor, rent) may be helpful to a prospective franchisee. However, a franchisor cannot express costs as a percentage of revenue. If a franchisor does provide cost data, it needs to be careful to not provide additional information from which total profits or revenue could be determined.
5. After the sale, a franchisor is free to provide financial information to its franchisees.The sharing of financial information is often crucial for benchmarking and analysis purposes within a franchise system, and is a key benefit that a franchisor can provide its franchisees. Fortunately, the prohibition on FPRs outside of a disclosure document only applies before the investment decision has been made. This means that a franchisor may provide any type of financial information to its system franchisees including revenue, profits, costs, etc. once the sale is consummated. However, a franchisor sharing financial information within the franchise system must keep in mind that it cannot provide an FPR outside of the disclosure document to an existing franchisee that is considering purchasing an additional franchise. In other words, it cannot provide an FPR outside of the disclosure document in connection with an existing franchisee's investment decision to purchase another franchise.