Reasons To Disclose 2020 Data When Selling Franchises

By Rochelle Spandorf
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Law360 (January 11, 2021, 4:20 PM EST) --
Rochelle Spandorf
Rochelle Spandorf
Franchisors may want to lean on their franchise system's pre-pandemic financial results in marketing new franchises in 2021 without mentioning 2020 outcomes due to the aberrational year that everyone knows 2020 to be. Any franchisor considering this strategy should know the perils of this plan. 

Federal and state franchise sales laws strictly regulate the content and manner in which a franchisor may make a financial performance representation, or FPR, in selling franchises. 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 presentation or something else.

Although FPR disclosures are the most important piece of information for a prospective franchisee to consider in making an investment decision, current law leaves FPR disclosures optional. A franchisor that wants to make an FPR disclosure must do so in its franchise disclosure document, or FDD, a government-mandated, presale prospectus that is franchising's equivalent to a public company's Form 10-K. 

Why Make an FPR?

According to a recent study of more than 3,000 franchise brands across all industry sectors over a four-year period from 2012 to 2016, franchisors that make an 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?[2] This explains why two-thirds of all franchisors today make an FPR compared to just 20% in 1995.

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

In June 2020, franchise regulators in the 14 states that regulate franchise sales issued new guidance for making FPRs based entirely on data covering the period before COVID-19.[3] Based on this guidance, in 2021, franchisors may assume that they will not be able to register to sell franchises in these states or lawfully sell franchises anywhere else in the U.S. using an FDD with an FPR that omits 2020 data.

A lawful FPR requires more than just disclosing historically accurate financial results of all, or a representative sample of some, branded outlets. A franchisor must be able to say that the branded outlets profiled in the FPR performed under operating and economic conditions comparable to those that a new franchisee is likely to experience.[4]

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-19 revenues and profits.

Consequently, without 2020 financial data, a franchisor will not be able to convince state 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.

The FTC, which administers the federal franchise sales law applicable in all 50 states, has informally indicated that it shares the same view as state franchise regulators: An FPR disclosure that omits 2020 data is potentially misleading and illegal under federal law.

Of course, not all businesses were negatively affected by COVID-19. The quick service restaurant industry, pizza in particular, saw business boom during COVID-19 lockdowns by pivoting to contactless payment and delivery. However, even those franchisors that experienced lower 2020 networkwide 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 branded outlets 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 franchise system that outperforms its peers according to a reliable industry resource may showcase comparative peer data in its FPR.[5]  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.

Self-help articles that coach prospective franchisees on what to look for in buying a franchise advise prospects to compare multiple franchise opportunities at a time so it is likely that a prospect will evaluate a franchise system's 2020 financial performance not just against the same system's prior year results, but also comparatively against at least a few other franchises.

All in all, a franchisor that has a 2020 storyline supported by real financial performance results may be better off than one unwilling to share 2020 outcomes. Declining to disclose 2020 results will leave prospective franchise buyers on their own to seek answers from existing franchisees about their 2020 financial results and existing franchisees are often not forthcoming.

In the end, a franchisor unwilling to make an FPR in 2021 may find it difficult to attract franchisee candidates and sell new franchises in the coming year.

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 top-line sales or revenue, although prospects prefer receiving some type of profit metric.

However, FPRs must explain facts about the profiled branded outlets 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 by federal and state franchise sales laws — 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 Federal Trade Commission recently invited the public to comment on a proposal to modify the federal franchise sales law by making FPR disclosures 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.



Rochelle Spandorf is a partner at Davis Wright Tremaine LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.


[1] See Anya Nowakowski, Financial Performance Representation: Market Demand Pushing Higher Levels of Transparency, 14 (IFA Education and Research Foundation, 2017).

[2] A franchisor that chooses not to make an FPR must affirmatively disclose in its FDD 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" branded outlet that it is offering for sale, but only to potential purchasers of that outlet. Existing franchisees may share their own financial results with candidates without implicating the franchisor in making an FPR, but they are not legally obligated to open their books and most franchisees consider their financial results to be too competitively sensitive to share with strangers. Consequently, existing franchisees are not a reliable source of feedback regarding the financial results that a franchise buyer may expect. In any event, franchisors may not direct prospects to their top performers and away from poor performers and malcontents. 

[3] Disclosing Financial Performance Representations in the Time of COVID 19, NASAA (June 17, 2020). California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin have their own franchise sales laws that require a franchisor to register with a state franchise agency before offering to sell franchises in the state. For the federal franchise sales law, the FTC has not formally adopted the new COVID-19 FPR guidance, but has informally signaled a willingness to do so.

[4] Until a franchisor has at least one franchisee-owned outlet operating throughout the time period profiled in an FPR, a franchisor's FPR may be confined to the financial results of branded outlets that it and its affiliates own.

[5] While a peer group need not be comprised of other franchise chains that are its immediate competitors, it makes the most sense for a franchisor that wants to use an FPR to attract potential franchise buyers to benchmark its network against the franchise brands that its candidates most frequently mention they are also considering.

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