For prospective franchisees researching potential brands, the Franchise Disclosure Document (FDD) is a key component in the decision-making process and Item 19 is perhaps the most important piece of that puzzle. Item 19 answers the all-important question for investors: How much money can I make?
Under Item 19 of the FDD, a franchisor can make financial performance representations (FPR) to prospective franchisees in the sale of a franchise. Although franchisors are not required to make FPRs to prospective franchisees, between one-half and two-thirds of franchisors now include FPRs in their FDDs.
This is not surprising as many prospective franchisees want a clear financial picture of the franchise business under consideration and want to have a better idea of what their return on investment could be in the franchise system.
A franchisor without an Item 19 disclosure may be at a competitive disadvantage and more at risk for the disclosure of unauthorized FPRs.
For franchisors that do make FPRs to prospective franchisees, they must have a reasonable basis and written substantiation at the time the FPR is disclosed under Item 19. A “reasonable basis” for an FPR will vary from franchisor to franchisor, but generally, it is information that reasonably supports the representation made, such that a prudent businessperson would rely on it in making an investment decision.
A franchisor must state whether the FPR reflects a historic performance of its franchised outlets or a forecast of future potential performance. The franchisor must also possess written factual information that reasonably supports the FPR, and the Item 19 disclosure must expressly state that written substantiation for the FPR will be made available upon the request of a potential franchisee. The Covid-19 pandemic has affected franchise systems in different ways in different industries, also varying by location, business model, and other factors.
On June 17, 2020, the North American Securities Administration Association (NASAA) posted a commentary addressing concerns that FPRs which are based on historic performance may not accurately represent a franchise system’s current position in light of the COVID-19 pandemic. NASAA stated that if franchise outlets represented in an FPR have experienced “material changes” in financial performance, franchisors may not make historical FPRs unless they are updated to reflect those changes.
In renewing their FDDs, franchisors must now evaluate whether a material change has occurred in their historic FPRs. Franchisors must also comply with anti-fraud provisions in state franchise registration and disclosure laws in states where those laws apply. These state franchise laws make it unlawful for a franchisor to make an untrue statement of material fact or exclude a material fact that would make a statement misleading when offering or selling a franchise.
Since COVID-19, regulators in states with anti-fraud provisions have heightened their level of review of FPRs to ensure a “reasonable basis” exists for the information contained in a
franchisor’s Item 19.
Franchise strategies are best made after reviewing and analyzing Item 19 in an FDD. Contact Greg Schreiber at [email protected], if you would like to discuss the financial information a franchisor must disclose in the FDD or need assistance in analyzing the FPRs contained in Item 19 of a Franchisor’s FDD.