Under Item 19 of the Franchise Disclosure Document (FDD), if a franchisor makes financial performance representations (FPR) to prospective franchisees in the sale of a franchise, it must disclose such FPRs. Franchisors are not required to make FPRs to prospective franchisees. For these franchisors, Item 19 only requires a prescribed statement. Still, disclosing FPRs under Item 19 is a helpful means of providing prospective franchisees with an idea of the sales, income, or profits that they can expect to achieve upon entering the franchise system. Our knowledgeable attorneys could discuss the information a franchisor must disclose, the format it must take, and the best practices for drafting, under Item 19 of the FDD.
The disclosure requirements for Item 19 are set forth under C.F.R 16 §436.5(s). These requirements vary depending on the nature of the information underlying the FPR, and whether a franchisor wants to make FPRs to its prospective franchisees.
The FTC Rule defines a “financial performance representation” (FPR) broadly and is better understood by breaking it up into pieces. An FPR is an (i) oral, written, or visual representation, (ii) that is made to a prospective franchisee or in the media, and (iii) that states expressly or implies a specific level or range of actual or potential sales, income, gross profits or net profits. FPRs typically include, charts, tables, and mathematical calculations that show possible results based on a combination of variables. If a franchisor makes a FPR to a prospective franchisee in the offer or sale of a franchise, that FPR must be included under Item 19.
Franchisors are free not to make any FPRs to prospective franchisees if they so choose. However, every franchisor must begin its Item 19 disclosures with the following statement:
“The FTC’s Franchise Rule permits a franchisor to provide information about the actual or potential financial performance of its franchised and/or franchisor-owned outlets, if there is a reasonable basis for the information, and if the information is included in the disclosure document. Financial performance information that differs from that included in Item 19 may be given only if: (1) a franchisor provides the actual records of an existing outlet you are considering buying; or (2) a franchisor supplements the information provided in this Item 19, for example, by providing information about possible performance at a particular location or under particular circumstances.”
If a franchisor elects not to make any FPRs to its prospective franchisees or in the media, it need only include one more prescribed statement to satisfy the disclosure requirements under Item 19:
“We do not make any representations about a franchisee’s future financial performance or the past financial performance of company-owned or franchised outlets. We also do not authorize our employees or representatives to make any such representations either orally or in writing. If you are purchasing an existing outlet, however, we may provide you with the actual records of that outlet. If you receive any other financial performance information or projections of your future income, you should report it to the franchisor’s management by contacting [name, address, and telephone number], the Federal Trade Commission, and the appropriate state regulatory agencies.”
For franchisors that do make financial performance representations to prospective franchisees, they must have a reasonable basis and written substantiation under Item 19 of the FDD. A “reasonable basis” for an FPR will vary from franchisor to franchisor, but generally, it is information that reasonably supports the representation made, such that a prudent businessperson would rely on it in making an investment decision. For each FPR, a franchisor must state under Item 19 whether it pertains to a historic performance or a forecast of future potential performance. The disclosure requirements under Item 19 vary based on whether the FPR is historic or a forecast.
For historic FPRs, franchisors must disclose the material facts underlying the FPR, which are broken down into six categories:
For the group measured, franchisors must state whether the FPR relates to the performance of all of the franchise system’s existing outlets or only a subset of those sharing a particular set of characteristics, such as geographic location, type of location, degree of competition, or length of time the outlets have operated. For the time period measured, franchisors must state the dates when the reported level of financial performance was achieved. Franchisors have discretion to use any reasonable time period, but should do so carefully. A time period that is not relatively recent may initiate performance results that are inconsistent with the current market and may be misleading to prospective franchisees.
For the number of outlets measured, franchisors must state the number of franchisees that were in the group measured during the relevant time period, as well as how many of those franchisees supplied their actual financial performance data underlying the FPR. Franchisors must also state the number and percent of franchisees who supplied their actual financial performance data, actually attained or surpassed the stated results in the FPR. Finally, franchisors must state any characteristics of the group measured that might set that group apart from the outlet being offered to the prospective franchisee.
For historic FPRs, franchisors must provide a clear and conspicuous admonition that a prospective franchisee’s individual financial results may differ from the results stated in Item 19. The specific language of the admonition is not prescribed by the FTC Rule, but the North American Securities Administrators Association (NASAA) suggests a qualifying statement.
For FPRs that are a forecast of future potential performance, franchisors must disclose the material facts, as well as any material assumptions, underlying the forecasted FPR. Unlike historic FPRs, the FTC Rule does not provide the specific material facts or assumptions that a franchisor should provide. Instead, they should provide sufficient facts that enable a prospective franchisee to make an independent judgment as to the validity of the forecasted FPR. This information typically includes a description of the information that the franchisor relied on in making the forecasted FPR. Market studies, statistical analyses, franchisee profit-and-loss statements are some common examples of information that franchisors typically rely on in making a forecasted FPR.
The material assumptions that should be disclosed for a forecasted FPR are the significant factors on which a franchisee’s future results may depend. The FTC Rule specifically states that these factors include economic or market conditions that are basic to a franchisee’s operation, and encompass matters affecting, among other things, a franchisee’s sales, the cost of goods or services sold, and operating expenses. Like for historic FPRs, franchisors must also provide a clear and conspicuous admonition that a prospective franchisee’s individual financial results may differ from the results stated in Item 19 for forecasted FPRs.
Franchisors that disclose financial performance representations under Item 19 are also permitted to furnish prospective franchisees with a supplemental FPRs pertaining to a particular location or variation, apart from the FDD. However, this can only be done if the supplemental FPR is in writing, explains the departure from the FPR stated in the FDD, contains all the information required of a FPR disclosure in Item 19, and is furnished to the prospective franchisee. Additionally, for franchisors that elect not disclose FPRs under Item 19, they are permitted to disclose the actual operating results for a specific outlet being offered for sale, so long as the information is given only to potential purchasers of that outlet.
Although not stated in the FTC Rule, franchisors may include a statement under Item 19 that they do not make any other FPRs, other than those disclosed in Item 19, and has not authorized its employees or representatives to do so. This statement must be provided in the following form:
“Other than the preceding financial performance representation, [name of franchisor] does not make any financial performance representations. We also do not authorize our employees or representatives to make any such representations either orally or in writing. If you are purchasing an existing outlet, however, we may provide you with the actual records of that outlet. If you receive any other financial performance information or projections of your future income, you should report it to the franchisor’s management by contacting [name, address, and telephone number], the Federal Trade Commission, and the appropriate state regulatory agencies.”
Additionally, the FTC’s FAQ webpage specifically states that all FPRs must be disclosed under Item 19; they cannot be attached as an exhibit.
Disclosure of FPRs under Item 19 is growing in popularity, particularly for startup franchisors or franchisors whose brand is not widely known. For these types of franchisors, disclosure of FPRs provides hesitant franchisees with a better idea of what their return of investment could be in the franchise system. In addition, the absence of any FPRs in Item 19 may serve as a disadvantage to franchisors, particularly if a franchisor’s competitors include FPRs in their FDDs.
All franchisors should be diligent that every FPR has a reasonable basis and written substantiation to back it up. It is best practice to present every FPR with ample information explaining the foundation for the data presented, so as to prevent the potential risk of fraud or misrepresentation. The best practice is to contact a seasoned franchise attorney to discuss the advantages and disadvantages of including financial performance representations under Item 19 of the franchise disclosure document. Our team could also ensure that any FPR is disclosed completely, accurately, and in the best possible light for the franchisor. Reach out to learn more about this step in the process.