Leveraging your FDD during COVID-Chaos

Operations & Training
fdd

Thoughts on preparing and presenting your Franchise Disclosure Document in these most challenging of times.

By Keith Gerson, CFE, FranConnect

In an interview I conducted back in 2019 with Gordon Logan, the legendary Founder and CEO of Sport Clips for my book, The Franchise Book of Mentors, he shared very sage observations about the what prospects should be on the look-out for when reviewing a brands Franchise Development Disclosure (FDD). His advice to smart, driven new franchisees about to enter the world of franchising, was to:

  • Pay particular attention to the experience of the people behind the franchise, their track record and their reputations.
  • Carefully study the Item 19 and to not even consider a brand that doesn’t offer one
  • And that the real story is in Item 20 (Outlets and Franchisee Information) where an astute buyer needs to calculate the continuity rate and to run away from any franchise that has an excessive closure rate

Of course, Gordon was right. But now as we fast forward to August 2020, little did we know that so many brands, including those with an extensive and proven history of strong sales and franchise stability would be unable to pass this litmus test resulting from government closures combined with buyer fear and uncertainty. Clearly many franchisors no longer bare a resemblance to what they were achieving in 2019 and the years preceding.

In the aforementioned interview with Sport Clips Gordon Logan, he offered that “prospective franchisees need to talk to more than one or two existing franchisees to get a flavor for their relationship with the franchisor, and to ask about the culture the franchisor has established.

Some may assume that with the declines in revenues and profitability, that it would adversely impact validations from existing franchisees. While there has been an overall decline of 39 percent in 2nd quarter total referrals, FranConnect’s report shows that one category of Franchisor - Enterprise Brands (those with 200+ locations), sold more referral deals in the second quarter of 2020 than in the first quarter. In total, Referrals represented 17 percent of all closed deals in our study.

This could very well be an expression of appreciation for the significant efforts that many Franchisors have undertaken to help their franchisees secure necessary cash through programs such as the PPP, EIDL, and various State programs. Some Franchisors even went so far as helping their franchisees complete the documents, and for those systems that were the most impacted even suspended, reduced or forgave royalties for a duration of time. The point here is that “if you ask not, you have not”. Don’t assume that you’re imposing on your Franchisees. They too have a vested interest in the growth of your system, and many would be more than willing to sing your praises if you were to make the request.

The fact is that 17.2 percent of all deals achieved in the months of April – June 2020 and with an impressive lead to deal closing rate of 4.9 percent.

The prevailing sales question is “how does one effectively convey the most recent state of the business in a truthful and transparent way that is easy for a prospective buyer to look beyond the moment to a brighter future?

For those that might be new to franchise development, the Federal Trade Commission requires a franchisor to issue a franchise disclosure document (FDD) a legal disclosure document that must be given to individuals interested in buying a U.S. franchise as part of the pre-sale due diligence process. It contains information essential to potential franchisees about to make a significant investment divided up into 23 sections that the potential franchisee must review before signing. The point of the document is to allow the potential franchisee to make an honest and informed decision about their making an investment in the business.

In discussions I’ve held with dozens of Franchisors, there has been a concern around how others are revising or supplementing their FDD’s so as not to create unrealistic impressions or expectations of the current state of franchise performance as represented in Item 19 (Financial Performance Representations).

Beyond Item 19, there are many areas of the business where franchisees are being tested such as through:

  • Declining sales
  • Store closures
  • Disruptions in the supply chain
  • Discontinuation or deferral of royalty payments

Brian Schnell, well respected Franchise Attorney from Faegre Drinker, states that franchisors need to carefully consider how to address COVID-19 pandemic related issues in their FDD, including any Item 19 financial performance representations.  Simply saying that the franchisor is unable to predict how COVID-19 may impact unit level performance or other aspects of the franchise system or brand is inadequate and will not pass the scrutiny of the regulators” said Schnell.   Rather, a franchisor should consider updating Item 19 so a prospective franchisee understands how the franchise system/units performed during the pandemic and also describe any other changes to the business model (for example, noting that under certain state or local executive orders restaurants may have limited indoor seating).   Schnell notes that with the Item 19 updates, franchise salespersons then can discuss with a candidate how the brand performed during the pandemic.

Picking up where Brian left off, it would make sense to consult with your Franchise Attorney or in-house council where there may be a need to disclose changes beyond Item 19. These areas could include Item 7 (e.g. dramatic changes with indoor seating in restaurants); Training where components are being conducted virtually; Section 6 where royalties, marketing fees or development fees may have been deferred; or a change to Item 12 where you disclose that you are not enforcing the area development agreement requirement at this time. 

So how can a Franchisor “sell through” the adverse impacts that the COVID-19 Virus has brought upon many unfortunate brands based on their industry sector? My answer is with truthfulness, transparency and by hyper-vigilant focus on improving the execution and results of their existing Franchisees.

Let’s be frank with one another – even going back to the “good-old-days” of 2019, there were a fairly substantial number of franchisors that have not made an Item 19 disclosures. As of September, 34.6 percent or 484 of 1,400 brands that have filed their FDD’s have chosen not to make financial performance representations.

The way I see it, the Pandemic has served as a “reset” button in franchising pressing franchisors to reassess their business models and to focus on what’s most important – unit level profitability.

If you’ve been unable to make an Item 19 representation heretofore, and if your franchisees have limited cash to weather what many experts are indicating the need to weather the next six (or more) months – then now is the time to double-down on concentrating on your business model and addressing unit level profitability. I’m of the mind that if you had a good story to tell, you’d be making a financial business representation.

By April 2021 once those annual FDD’s are filed, I plan on publishing a correlation between Item 20 franchisee continuity rates of brands that make Item 19 representations vs. those that don’t. I have a sneaking suspicion that the pandemic has simply forced into the light the weaknesses that already existed prior to the Pandemic.

This article will hopefully serve in speaking to what a franchisor can do now to ensure that prospective franchisees are given an accurate picture of what doing business with you means in the age of Corona Virus. This is essential as, at the heart of the matter, prospective franchisees are already consumed with fear and uncertainty regarding their health and that of their family, their economic well-being, their job stability, the political environment, civil unrest and so much more. What resonates today is trust and transparency.

 

Keith Gerson is president of franchise operations at FranConnect, a recognized leader in franchise management software. For the past decade, he has worked closely with executive boards and leadership teams that are part of the company’s portfolio of more than 800 brands and 150,000 locations, with a focus on helping franchisors achieve their desired goals in sales, operations, and marketing. For more information, best practices, and guides, visit the company’s Resources Page