FRANCHISE: Disclosures in statutory regulated markets

The Franchise Disclosure Document (FDD) underlies the Franchise Agreement. The USA represents the world’s most statutory regulated franchise market where the FDD contains “items” of disclosure.

Item 18 presents any public figures-current or past politicians, celebrities etc-who may be involved in the franchisor business. Item 19 deals with franchisor’s financial performance representations. While franchisors are not legally-bound to present information on potential income or sales, when they do, they should have a basis for their claims and be able to substantiate. Franchisors must address the following areas when earning claims are made. First the sample size. When a franchisor claims certain earnings, they should disclose the sample size, the number and percentage of franchisees who reported earnings at the level claimed.

Second, average incomes. Average figures tell very little about how individual franchisees perform. An average figure may make the overall franchise system look more successful than it is because just a few very successful franchisees can inflate the average. Third, gross sales. These figures don’t really tell about the franchisees’ actual costs or profits. An outlet with a high gross sales revenue on paper may be losing money because of high overhead, rent, and other expenses. Fourth, net profits. Franchisors often do not have data on net profits of their franchisees, so if anyone presents such, a red flag is raised.

Fifth, geographic relevance. Earnings may vary with geography. The disclosures should be made on geographic or other differences among the group of franchisees whose earnings are reported and a franchisee’s likely location. Sixth franchisees’ backgrounds. Franchisees have different skill sets and educational backgrounds. The success of some franchisees doesn’t guarantee success for all.

Lastly, reliance on the earnings claims. Franchisors may ask a franchisee to sign a statement— sometimes presented as a written interview or questionnaire—that asks whether a franchisee received any earnings or financial performance representations during the course of buying a franchise.

Item 20 discloses a list of franchise outlets, current and past and franchisee information. Terminated, cancelled and unrenewed outlets will easily tell the kind of franchisor you are dealing with. Some franchisors buy back failed or failing outlets and list them as company-owned outlets, only to offload them to new franchisees. In such a case the franchisee must be told who owned and operated the outlet for the last five years. Several owners in a short time may indicate that the location isn’t profitable or that the franchisor hasn’t supported that outlet as promised. Many franchisees in an area may mean more competition for customers. Some of the former franchisees may have signed confidentiality agreements that prevent them from speaking. Franchisors practicing franchise fraud may have a high number of former franchisees under a gag order.

Item 21 discloses the franchisor’s financial statements, including audited books. Notes thereto can revel certain key information. Investing in a financially unstable franchisor carries a real risk of the franchisor going out of business into bankruptcy, sometimes no sooner than a franchisee invests. Franchisees are advised to seek professional help to determine if the franchisor has steady growth, has a growth plan, makes most of its income from the sale of franchises (which is some form of franchise fraud) or from continuing royalties or devotes sufficient funds to support its franchise system.

Item 22 discloses the franchisor’s current and past contracts, all which have a bearing on the running of the franchise network. Some contracts might be detrimental to the franchise system, franchisees should be spared this. Finally, Item 23 is a section for acknowledgement of receipt.