Making a Financial Performance Representation (Item 19 Disclosure) in 2021

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Why Make an FPR?

According to a recent study, franchisors that make a Financial Performance Representation (FPR) sell more franchises than those that choose not to.1 The study found that brands that are transparent about some aspect of their system's financial performance are overall better performing systems and attract more candidates.

Franchisors that opt not to make an FPR are hamstrung in trying to answer a candidate's most pressing question—how much money can I make? This explains why two-thirds of all franchisors today make an FPR compared to just 20 percent in 1995.

Beware of Making an FPR Based Solely on Pre-COVID-19 Data

In June 2020, state franchise regulators issued new guidance for making FPRs based entirely on pre-COVID-19 data.2 Franchisors may assume that in 2021 they will not be able to register or lawfully sell franchises using Franchise Disclosure Document (FDD) with an FPR that omits 2020 data.

A lawful FPR requires more than just disclosing historically accurate financial results of all, or representative sample of, profiled units. A franchisor must be able to say that the profiled units performed under operating and economic conditions comparable to those that a new franchisee is likely to experience.

Franchise regulators are leery of FPRs based entirely on pre-COVID-19 data because no one knows how long businesses will continue to feel the effects of the pandemic. Even after mandatory shutdowns end and vaccines are rolled out to the general public, economists say it may be years before businesses return to pre-COVID revenues and profits.

Consequently, without 2020 financial data, a franchisor will not be able to convince franchise regulators that a new franchisee coming on board in 2021 will experience the same kind of operating and economic conditions enjoyed by franchisees before March 13, 2020, when the U.S. national emergency was declared and we began a year like none other.

Of course, not all businesses were negatively affected by COVID-19. However, even those franchisors that experienced lower 2020 network-wide financial results than in 2019 should consider making an FPR in 2021.

Prospects realize that businesses across all industry sectors experienced unique challenges in 2020. Candidates will not be surprised that franchises in nonessential sectors saw a drop in their financial performance—their question will be how much of a drop. Even franchises in essential sectors experienced disruption from supply shortages and delays, reduced consumer spending, and the need to accommodate social distancing rules and government-mandated curfews.

Candidates may be impressed by a franchise brand's actual 2020 month-by-month results that show that existing franchisees partially or fully recovered from an initial drop in topline revenue or profits following the national emergency declaration. A two-year month-by-month comparison profiling units operating throughout all of 2019 and 2020 may provide a franchisor with a good storyline to pitch about the brand's resilience and management's leadership and dedication to supporting its franchisees.

A network that outperforms its peers according to a reliable industry resource may showcase comparative peer data in its FPR. For franchisee candidates looking for more control over their economic future, 2020 financial statistics may be impressive enough even if results are below 2019 levels. Furthermore, prospects are coached to evaluate and compare multiple franchise opportunities at a time so a franchise system's 2020 financial performance will not just be evaluated against the system's prior year's results, it will be evaluated comparatively against at least a few other franchises.

All in all, having a 2020 storyline supported by real data in Item 19 may be preferable to having nothing to say about actual 2020 performance and leaving candidates on their own to seek answers from existing franchisees about their 2020 results.3

Legal Standard for Making an FPR

The updated FPR guidance did not change the rules for what a franchisor must include in an FPR, which remain very open-ended. A franchisor may confine its FPR to topline sales or revenue, although prospects prefer receiving some type of profit metric.

However, FPRs must explain facts about profiled units so that prospects can understand operational typicality. Further, franchisors must provide candidates with written back-up for the FPR upon request.

Franchisors may not lace their FPR with caveats or disclaimers. While they must explain the material assumptions underlying their data, only one disclaimer without variation is permitted (and mandatory): "Some outlets have earned this amount. Your individual results may differ. There is no assurance that you'll earn as much."

Consequences of Violating FPR Disclosure Rules

A franchisor that denies making an FPR, but makes one anyway outside of the FDD—or discloses false or misleading data—violates federal and state franchise sales laws, which can potentially result in civil, administrative and criminal liability, personal liability of the franchisor's management, and rescission of franchise agreements. The franchisor's FDD will have to disclose FPR sales violations for 10 years or longer, potentially scarring the franchisor's standing in the franchise community and making it harder to sell new franchises.

What's Ahead With FPRs?

The FTC recently invited the public to comment on several proposed adjustments to the federal franchise sales law, including whether FPRs should be mandatory. Predictably, franchisee advocates want the FTC to require all franchisors to disclose some type of actual financial results for their franchisees, while franchisors want to keep FPR disclosures optional.

It may be years before the FTC announces a decision and bets are the FTC will retain the status quo. Data shows that market regulation—competition among franchise firms for the best candidates—works to increase financial transparency, and so far, no one has presented solid evidence of a law enforcement problem with the current system of optional FPRs.

Conclusion

The year 2020 was disruptive for practically everyone. Nonetheless, franchisors should consider making a historically accurate FPR in 2021 if they have a reasonable basis for doing so because, without one, they are competitively disadvantaged in vying for qualified franchisee candidates.

Fair or not, candidates assume that a system's existing franchisees must be losing money when they receive an FDD without FPR disclosures. By including 2020 financial data in their 2021 FDD, franchisors express confidence in the strength of their brand and their network's future, which should attract inquiries from prospective franchisees.

FOOTNOTES

1 See Anya Nowakowski, Financial Performance Representation: Market Demand Pushing Higher Levels of Transparency, 14 (IFA Education and Research Foundation, 2017). What qualifies as a Financial Performance Representation or FPR? An FPR is broadly defined as any information that represents, suggests or implies the actual or potential sales, income or profits of franchisee-owned or company-owned businesses, regardless of the format of the information (whether oral, written, electronic, visual presentations or something else). Under current law, FPR disclosures are optional. However, a franchisor that chooses not to make an FPR must affirmatively state in FDD Item 19 that it does not make an FPR and franchisees should not rely on any statements about actual or projected sales, income or profits made by any representative of the franchisor. A franchisor without an FPR may disclose the actual operating results of a specific "company-owned" outlet that it is offering for sale, but only to potential purchasers of that particular outlet.

2 Disclosing Financial Performance Representations in the Time of COVID 19, NASAA (June 17, 2020).

3  Existing franchisees may share their own financial results with candidates without implicating the franchisor in making an FPR, but will they? Most franchisees consider their financial results to be too competitively sensitive to share with strangers. Franchisors may not direct prospects to their top performers and away from poor performers and malcontents.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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