FDD Item 19: Understanding the Financial Performance Representations in the Franchise Disclosure Document
If you’re an entrepreneur looking to purchase a franchised business, you’ve most likely heard of a Franchise Disclosure Document (FDD)—the legal document franchisors must provide to potential franchisees. Mandated by the Federal Trade Commission (FTC), it covers critical information about the franchise system and an overview of the financial viability.
The FDD is organized into sections that cover specific elements of the franchise agreement and the business relationship between the franchisor and the franchisee. For example, Item 19 of the FDD focuses on earnings claims, now called Financial Performance Representations (FPRs).
Let's now narrow our focus to Item 19 and explore how it can help you better understand the Financial Performance Representations in the FDD.
What Is an Item 19 Financial Performance Representation?
Item 19 in a Franchise Disclosure Document is the Financial Performance Representations (FPRs) section. The purpose of Item 19 is to disclose the financial data of a franchise to any potential new owner.
This section is where franchisors present a snapshot of the financial performance of other franchised units. It will provide insight into what you can expect financially, like potential gross sales, overall costs, and net profits.
What Should Prospective Franchisees Look for in Item 19?
If you’re considering a new franchise opportunity, doing your due diligence is critical. When reviewing the FDD, Item 19 can reveal whether a franchise is a financially sound investment or a potential drain on your bank account.
Item 19 can help you figure out the payback period and number of years it might take for you to turn a profit.
Look for the number of franchises included in the profit-and-loss statement and if they represent a healthy cross-section of company-owned and franchised outlets. Check that salaries align with the local cost of living and that fixed costs are accurately represented, as these will impact your margins.
This is your investment, so don’t be afraid to scrutinize everything. And if a franchisor chooses not to include earnings claims in the franchise sales process, that may be a sign it’s not a profitable franchise.
Can a Franchisor Exclude Item 19 in the FDD?
Yes, the franchisor can exclude Item 19 from the FDD. A few reasons they may choose not to disclose FPRs in their FDD include:
- Inconsistent franchise performance: If performance varies widely among locations, providing a single set of financial figures might not accurately represent the potential financial outcomes for franchisees.
- The franchise is new: New franchisors have limited historical data and will want to wait until they have a more established track record.
- Changes to their business model: Historical financial data may not accurately reflect the future performance of the franchise system.
- They’re worried about competition: Some franchisors may be concerned about disclosing sensitive financial information if they believe competitors could use the information against them.
- Legal and regulatory risks: Providing accurate and supportable financial information is a legal requirement, and some franchisors may be concerned about potential legal and regulatory risks associated with disclosing financial performance representations.
What Information Does Item 19 Disclose?
It's important to note that franchisors are not required to include Item 19 in their FDD. However, if they choose to include it, they must follow FTC regulations and accurately represent all financial information.
Although information disclosed in Item 19, Financial Performance Representations, can vary from franchise to franchise, it is commonly based on historical data from the previous year.
It can include:
- Revenue and gross sales data
- Costs and expenses, including gross margins and cost of goods sold
- Gross profits and net profits for a clear picture of profit margins
- Breakdown of operating expenses
What Are the Legal Requirements of Item 19?
Because franchised businesses follow a different business model than most startups, any financial information disclosed must comply with the Federal Trade Commission Franchise Rule requirements at the federal level and the North American Securities Administration Association (NASAA) at the state or provincial levels.
The FTC emphasizes providing accurate and verifiable information to avoid misleading prospects. This means franchisors must have a reasonable basis and substantiation for their present figures. Data should be consistent with other parts of the FDD to avoid any red flags.
Franchisors are also legally obligated to update Item 19 if there are any changes to the financial performance. Failure to comply with these legal requirements can result in fines and penalties.
As a prospective franchisee, you are encouraged to review Item 19 carefully. And if you have any questions or concerns, seek advice from legal and financial professionals with expertise in franchise law. A franchise consultant can also be a valuable resource in helping you navigate the FDD.
6 Main Categories of Item 19
There is no standardized format for presenting financial performance representations, so franchisors have some flexibility. However, if a franchisor chooses to include Item 19, the information is typically measured in the following six categories.
1. Group Measured
This category may specify the groups or types of franchise outlets included in the financial performance data. For example, it might contain information for all franchise outlets, only company-owned outlets, or outlets that have been open for a specific duration.
2. Time Period Measured
Franchisors will usually specify the period of the financial performance data presented. This could include historical data for the past year, two years, or longer. The time period selected provides context to understand financial performance trends better.
3. Number of Outlets Measured
Outlining the total number of outlets or units included in the financial performance representations helps prospective franchisees understand the scope of the data and whether it represents a significant portion of the franchise system.
4. Number of Outlets Reporting
This metric indicates the number of franchise outlets or units that have provided financial performance data for consideration in Item 19. It provides transparency regarding the scope and representation of the data.
5. Number and Percentage of Outlets That Achieved Stated Level of Performance
As suggested, this category specifies the number and percentage of franchise outlets that have achieved a particular level of performance. For example, it might highlight the number of outlets that surpassed a certain sales threshold or achieved a specified profit margin.
6. Distinguishing Characteristics
Any traits or features that set franchise outlets apart provide context. Examples of distinguishing characteristics are geographic location, size of the outlet, or other relevant disparities.
It’s All in the Details
Understanding Item 19 in the FDD is critical to purchasing a franchise. It can serve as a valuable tool to assess the financial viability of a franchise investment.
A combination of variables like the payback period, expenses specific to your area, and the subset of outlets included all contribute to a nuanced understanding of the franchise's financial health.
Be thorough in scrutinizing Item 19 and seek professional guidance if necessary to ensure you are well informed and confident in your investment decision. Visit the BizBuySell Franchise Directory to request information about franchises you’re interested in.