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The Profile of Franchising, Series VI (January 2007)
Increasing Number of Franchise Systems Provide “Earnings Claims” to Franchise Candidates Historically, franchisors have faced many challenges when attempting to answer the question “How much can I make?” from franchise prospects. First and foremost, how reliable can the past performance of any business be as an indicator of future performance? Within the same line of business, and even within the same franchise system, there are so many variables due to location, market size, population and economic changes that many franchisors are reluctant to provide a “crystal ball” view of future unit performance. In addition, the Federal Trade Commission requires that franchisors who do make “earnings claims” (or “financial performance representations”) follow very strict guidelines. As a result, many franchisors have adopted not to make any claims at all. However, a careful analysis of the franchisors who are making earnings claims reveals some important trends: • Nearly 500 – or 18.3 percent of all active franchise systems – make earnings claims.
Characteristics of Franchise Systems That Make Earnings Claims The lodging industry has by far the highest percentage of franchise systems with earnings claims. Generally, the lodging industry seeks a highly-sophisticated prospective franchisee. Perhaps because of this, the lodging industry has created some standard unit measurements, including revenue per available room, which is often used in lodging earnings claims. (Click here for Chart 1) Another factor that may influence whether franchisors make earnings claims is the life cycle of the franchise system. In early stages, many franchisors with few units have very little data on which to base earnings claims. From the “emerging stage” to the “rapid growth stage” the number of franchisors making earnings claims may increase. Typically, as franchise systems reach the fourth to eighth year in their growth cycle, they go through a more rapid expansion period of adding more units. Exactly half of all franchise systems that make earnings claims are in the eight to 25-year-old category. However, one in five franchise systems with earnings claims has been franchising for three years or less. System size is also a factor that may influence whether a franchisor will make earnings claims or not. The group of franchise systems that is making earnings claims has more units than the franchise system population on the whole. The median total units for all franchise systems, including new concepts, is approximately 41 units and the median total units for franchise systems that are making earning claims is 100.
Characteristics of the Types of Earnings Claims Made Franchisors with both franchised units and company-owned units face a choice of which type of unit, or combination of unit types, on which to base earnings claims. Nearly 60 percent of franchise systems making earnings claims use franchise unit performance. About 44 percent use company-owned units as the basis for making earnings claims. The 4 percent overlap represents systems that use both types of units in earnings claims. Finally, many franchisors offer more than one type of franchise program within a brand. For instance, in the retail sector a single brand may actually include programs for stand-alone units, in-line store units and kiosks. Nearly 20 percent of all franchisors making earnings claims offer claims for more than one program in the same brand.
FTC Rule Revision of Item 19 “Earnings Claims” • The title “Earnings Claims” is replaced with the more general term “Financial Performance Representations” in order to more accurately reflect the contents of Item 19. Source: Bret Lowell, CFE Partner, DLA Piper US LLP
“How much can I make?” That’s often the first and most persistent question that franchisors get asked by their franchise prospects. In recent years, an increasing number of franchisors have begun providing “Earnings Claims” to address that question. (Note: In the coming revisions to the FTC Rule “Earnings Claims” are more accurately being referred to as “Financial Performance Representations.” See FTC Rule Revision of Item 19 “Earnings Claims” below.)
• Setting aside the many new franchise concepts that have entered the market in the past few years, the percent is even greater (24.4 percent)
A number of franchise sectors are well above the 20 percent mark, including the lodging industry (63%), Baked Goods (32%), Printing (28%), Full Service Restaurants (24%), Retail Food (20%) and Child-related franchises (23%).
The level of detail that franchisors provide in earnings claims varies widely. While 99 percent of all systems making earnings claims provide sales/revenue data, only 49 percent give some type of expense data and only a few provide what is essentially a complete franchise unit income statement.
The Federal Trade Commission has announced a proposed major revision to the FTC Franchise Rule. The proposed rule, when adopted by the FTC (and the registration states), will modify the disclosures required by the UFOC Guidelines. Item 19 of the UFOC (currently entitled Earnings Claims, and referenced as “Item 19” below) deals with any disclosure that a franchisor might wish to make about the actual or potential financial performance of the franchised and/or company-owned outlets. Some of the changes to Item 19 include the following:
• Item 19 must begin with a paragraph containing specific language set forth in the UFOC Guidelines, even if the franchisor elects not to include any information about financial performance.
• Information about “costs” no longer constitutes a “Financial Performance Representation.”
• The proposed rule omits the current permissibility of allowing franchisors to include (with certain caveats) financial results in Item 19 that are based upon substantially similar businesses operated by affiliates. As there is no guidance provided, it is unclear whether such practices will continue to be permitted.
• Franchisors must describe any special characteristics (i.e. geographic location, type of unit, area competition, and services/goods sold) of the units included and excluded from the reported results.
• The current presumption that a reasonable basis exists for any forecasts of future financial performance prepared in accordance with the standards of the American Institute of Certified Public Accountants Inc. is eliminated.
• Finally, a franchisor will be able to show, as supplemental information, the operating results of a specific unit offered for sale by the franchisor without the need to disclose the identifying information about the prior owners of such unit.
