FDD FRANCHISE DISCLOSURE DOCUMENTS, FRANCHISE INVESTMENTS AND THE NEW FTC FRANCHISE DISCLOSURE RULE – REQUIREMENTS, TIPS AND FDD ITEM 19 FINANCIAL PERFORMANCE REPRESENTATIONS. 1-415-225-3010 FDD Evaluator(sm) – Review Your Franchise Disclosure Document FDD for a fixed price (limited time offer) by a franchise attorney, MBA and former, successful franchise owner who has actually walked the walk and doesn’t just talk the talk. click here to schedule your FDD Review by email Have a franchise legal issue, question about your FDD or franchise relationship? Want a list of FDD registration states? Click on the Franchise Attorney link and send Mr. Franchise an email or contact the Franchise Legal Help Hotline at 1.800.942.4402.
FDD Franchise Articles – Learn More About Franchise Disclosure Documents FDD Checklist Learn about the new FTC Franchise Rule, new FDD Item 19 Financial Performance Representations – the place to find franchise earnings information, an FDD checklist – and more. GET YOUR FDD EVALUATED FOR A FIXED PRICE WHERE YOU DON’T WORRY ABOUT TOTAL LEGAL HOURS NEW FTC FRANCHISE RULE – FRANCHISE DISCLOSURE DOCUMENTS (FDD) FRANCHISE DISCLOSURE DOCUMENTS (FDD) – MISSION ACCOMPLISHED? – ITEM 19 FINANCIAL PERFORMANCE REPRESENTATIONS
Copyright 1990-2016, Kevin B. Murphy, B.S., M.B.A., J.D. – all rights reserved
Have a franchise company’s Franchise Disclosure Document FDD and want to begin your franchise due diligence? FDD EVALUATOR is the perfect choice. A review of the disclosures in the FDD and major franchise contract provisions through the lens of a franchise attorney, MBA, court-accepted franchise expert and former, successful franchise owner. Mr. Franchise gives you an overall thumbs up or down on the franchise investment. Also included: a summary of franchise risk factors as well as critical provisions in the contract you definitely want to negotiate or consider further. Contrary to what franchise companies say initially, their contracts are negotiable – especially when it comes to blatantly unfair provisions that happen to be in a lot of them these days.
Don’t less this happen to you: I completed a comprehensive FDD Evaluator some time ago and unfortunately (and rarely) it was a “two-thumbs down, way down” for some issues that there so serious they couldn’t be dealt with. The client wisely took my advice and walked away. Then, a couple weeks later, I get a call from another lady who bought this exact franchise two years ago and encountered the same issues I found for my client, but at a cost to her of over $450k by the time she was “all-in,” which included all of her savings and retirement accounts. Turns out, the recommended “prominent franchise attorney” she used didn’t mention any of what I found – just recommended some tweaking of a couple provisions in the contract, like changing a notice period from 30 days to 45 days, etc. Again, very few franchise attorneys have an MBA and virtually none have ever owned and operated a franchise before – so their review focus is just on the legal, which is a lot less than half the story. Critical business and financial issues just don’t hit their radar. That’s not what they’ve been trained to do or have experience in.
“One word reaction from me:
Thank you for a very thorough review of this and for enlightening me to things that I need to be aware of and far many more things that I was not even aware of! It just goes to show that the buyer (me) can easily be persuaded to see what he wants to see and not be thinking about many of the pitfalls that can come with it. Being new to the idea of franchising, your review is going to be very helpful to me.
“I spoke with some franchisees that I’m close to and brought up what you said. They paid more than I did and wish they had used you; their attorneys didn’t mention the things you brought up. Thanks again for all the help.”
“I’m so glad I hired you. Although I’d paid another so-called franchise attorney, she didn’t have an MBA nor did she ever own a franchise before. Without these critical perspectives, all I got was “let’s try to negotiate the notice period from 20 days to 30 days,” etc. – just a bunch of legal technicalities. No evaluation or review of business, financial and other much bigger-picture issues, like you did in detail, which literally means the difference between success and making just minimum wage, or even failure. Now I know why you’re called Mr. Franchise.”
Getting started with FDD Evaluator is as easy as 1, 2, 3 . . .
(1) Email the FDD to Mr. Franchise so he can spend about 30-minutes looking through the FDD – at no charge – then get back to you with a fixed-price quote;
(2) make payment based on his fixed-price quote by direct bank (or wire) deposit (details will be provided);
(3) review Mr. Franchise’s personally-written detailed FDD review notes when emailed about a week later and schedule the included, follow-up call to discuss his findings and recommendations.
Turnaround time for completing FDD Evaluator is currently about 6 working days after payment is received. FDD Evaluator can be expedited to within 3 business days, but an extra charge applies.
Based on Mr. Franchise’s review of over 1,000 FDD’s (formerly called UFOC’s), the key with any Franchise Disclosure Document is to realize a critical fact. When it comes to franchise contracts, you don’t get what you deserve or even what’s fair – you only get what you negotiate. Contractual fairness in franchising isn’t something that just happens to fall in your lap – you have to open your eyes . . . and your mouth to get it. And contrary to what many franchise companies say, there’s a lot that can be negotiated, especially these days and even more so when backed up by an internationally-recognized franchise expert, former franchise owner and MBA attorney, like Mr. Franchise.
Especially in these days of boilerplate that bites, a surprising number of uninformed, first-time franchise buyers sign up without seeking legal advice. After the window on franchise negotiations slams shut (when the contract is signed), they ultimately discover down the road just how onerous and unfair some of the contractual provisions are. A disconcerting wake up call and it’s usually too late to do anything about it. Fine print that’s not very fine when it comes to the rights of a franchise owner. By then it’s an uphill, high stakes, expensive legal battle. Hiring a franchise attorney, spending $10,000 or more on just a legal retainer to get started, usually with long odds and slim chances of prevailing.
One couple invested over $1 million in an ill-founded franchise that (not surprisingly) proved to be never, ever, profitable. If this wasn’t bad enough, they also found themselves needing a franchise litigation attorney to defend against an aggressive franchise company that wasn’t satisfied with their operating methods and was exercising rights to acquire their business for pennies on the dollar. Turns out, the couple didn’t invest a dollar in up-front franchise legal or business advice going into a $1 million-plus investment. Their remark is both telling and a learning lesson for every franchise buyer:
“I can’t believe we were so naïve and stupid.”
That’s certainly one way to make a $1 million-plus franchise investment decision – but definitely not the recommended approach.
A much better strategy is to have a strategic plan that begins with investing in our proprietary FDD EVALUATOR (sm) before signing long-term franchise contracts and real estate leases, spending large sums of money up-front, and a much greater multiple of the initial investment amount during the course of a ten to twenty year franchise relationship. For a limited time, FDD EVALUATOR is available for a fixed price.
How much do franchise lawyers attorneys currently charge and what do you (not) get? Other franchise lawyers attorneys charge a “retainer”(= pay now, plus more later) of $2,000 to $8,000 applied against hourly rates of $350 to $800 per hour to review the FDD, etc. Odds are they’re not MBA’s and haven’t reviewed over 1,000 FDD’s. And it’s just about a 100% bet they’ve never owned a franchise before; they may talk the talk, but have never actually walked the walk (which gives an incredible perspective on everything). And they also aren’t recognized, court-accepted franchise experts on franchise business and financial issues. Last, but certainly not least, you get less than half the story – the legal perspective only. The business and financial aspects are almost always more important than the legal aspects. Without the business and financial perspectives, it’s like trying to run a car on less than half its cylinders – you won’t get very far, and it will be a very rough ride.
And here’s a big “secret” law firms don’t like to share. Usually the attorney doesn’t even review the FDD or write the report – it’s farmed out to a paralegal paid $30 to $50 an hour, then the paralegal’s report is placed on attorney letterhead. So even if you’re dealing with a franchise attorney having respectable qualifications, he or she isn’t doing the work, other than a simple edit here or there in these situations.
Also included in the fixed contract price is a follow-up 30-minute call with Mr. Franchise to review his findings and recommendations.
So, in comparing Mr. Franchise’s quote to other franchise attorneys, you definitely need to compare apples with apples. At a minimum, the attorney who reviews your FDD must meet all of the following:
1. Has actually owned and operated a very successful franchise.
2. They have an MBA.
3. His or her legal practice is restricted exclusively to franchise law and has been for at least 10 to 20 years. (“How long have you been practicing franchise law exclusively? “What’s most of your franchise practice devoted to?”)
4. They’ve reviewed over 500 FDD’s for prospective franchise buyers. (“How many FDD’s have you reviewed for clients considering a franchise?”)
5. They’ve qualified in court as a franchise expert and testified on franchise business and financial issues.
6. They personally review the FDD and write the report; and not use a paralegal for these functions.
With our FDD Evaluator, you get both halves: the legal and business perspective from someone who has actually walked the walk, owning a very successful franchise AND being a franchise attorney with an MBA, who is also an internationally-recognized and court-accepted franchise expert who has testified on franchise business and financial issues. And, Mr. Franchise personally reads the FDD and and writes his own report.
Don’t miss the chance to join the ranks of smart franchise buyers who have used our eye-opening FDD EVALUATOR.
If Mr. Franchise’s FDD EVALUATOR review is positive and you decide to move forward with the franchise investment, you can either negotiate directly with the franchise company (which many clients do) or, in high investment franchise models, hire Mr. Franchise to handle sophisticated contract negotiations. It’s entirely your choice, but remember don’t give up your right to negotiate the FDD. Investing in FDD EVALUATOR (sm) first before signing long-term franchise contracts and real estate leases, spending large sums up-front, and a much greater multiple amount during the course of a ten to twenty year franchise relationship, is good business and common sense.
And contrary to what a lot of franchise companies say at the beginning – that they don’t negotiate the contract – our decades of experience shows this is simply not true. Don’t believe it. Especially in these economic times, franchise companies are very willing to negotiate certain things, especially unfair provisions. But they won’t do anything unless the unfair provisions are pointed out and negotiated BEFORE the contract is signed. After you sign on the line, all negotiation is over.
In April, 2012 Mr. Franchise reviewed an FDD and drafted his report with many pages of areas and provisions in the contract that were blatantly unfair. Faced with a report by Mr. Franchise, the company amended its FDD and contract to address all points raised in his report.
For high investment franchises and a more detailed analysis of all franchise agreement provisions, you can use our FRANCHISE CHECKER service.
Send your FDD to Mr. Franchise for a firm fixed-price quote. If you do not accept this quote (via payment) within 48 hours, a 20% increase applies.
©2008 -2009, Kevin B. Murphy, B.S., M.B.A., J.D. – all rights reserved
Since the new (and some say, improved) FTC Franchise Rule became effective in 2007, its first overhaul since 1979, many persons wonder what the major differences are between the old Uniform Franchise Offering Circular (UFOC) and the new FTC Franchise Disclosure Document (FDD). The new FDD format is sometimes referred to as UFOC-Plus due to added disclosures. Of particular interest to franchise companies is how long it takes to convert their old UFOC to the new FDD format to comply with the new FTC Franchise Disclosure Rule.
FDD vs. UFOC
In summary, what the FTC’s new Franchise Disclosure Document or FDD format does is take the prior Uniform Franchise Offering Circular disclosures, modify them in certain respects and rename the document. After the face lift, it’s now called a Franchise Disclosure Document or FDD. There are still 23 individual Items (chapters) and about a third of these chapters have revised titles. Although the revisions within the entire FDD are not that substantive, they are numerous. Some disclosure areas are expanded, others are contracted and some are new altogether. A franchise attorney familiar with the new FDD format and using their own work product (old UFOC they’ve drafted) should be able to convert the old UFOC to a new FDD within ten to twenty hours, plus or minus. The Table of Contents template for an FDD can be found within the information at the how to franchise a business page of this website.
FDD Phase In Period – Hello FDD, Goodbye UFOC
The phase in period for the FDD is now over. The new FDD format was permissive starting July 1, 2007. It became mandatory starting July 1, 2008. So franchise companies can no longer make any franchise offers or sales using the old UFOC. The new FDD was the required format in all states starting July 1, 2008.
New FTC Franchise Rule Transactional Changes
A significant transactional change with the new FDD rules and regulations relates to the manner and time a prospective franchise buyer must have the franchise disclosure document in-hand before contacts can be signed or any money paid. The former rule said the UFOC had to be delivered at the “first personal meeting” and in-hand for at least ten business days. A separate, completed franchise agreement (with all negotiated areas and blanks completed) also had to be delivered to the prospective franchise buyer for at least five business days to comply with the old FTC rule.
Under the new FTC franchise rule, the first personal meeting requirement is eliminated entirely. Instead, a fourteen calendar day minimum review period allegedly simplifies the complexity of completing franchise transactions. But does it really? One important exception to the 14 calendar day rule minimum review period that actually expands the old “first personal meeting” requirement is the rule about a reasonably requesting franchise buyer. Upon a “reasonable request” (which is a defined term) franchise companies must give a complete FDD to a prospective franchise buyer earlier in the sales process than 14 calendar days before the franchise buyer signs or pays. This circumvents the ploy used by many franchise companies who require a visit to corporate headquarters before giving out their FDD. Failure to comply with a reasonable request for an FDD is an independent violation of the FTC Franchise Rule.
There’s another seven calendar day contract review period that applies if the franchise company makes unilateral and material changes to the franchise contract or other agreement attached to the FDD. Sounds easy enough, but the kicker here is the FTC’s definition of “unilateral material modifications.” These include terms like specifying the protected territory, the number of stores to be opened under an area development agreement or “other contractual terms that were not previously disclosed in the basic disclosure document.” If these happen, and they will in most cases, the additional 7 calendar day review period kicks in. But even here, there are exceptions to the exceptions under the new FTC Rule. Don’t you just love the FTC? Seems they are always looking to keep franchise attorneys gainfully and fully employed.
Electronic Delivery of FDD
Stepping into the 21st century, the new FTC Rule permits delivery of the Franchise Disclosure Document by electronic means, such as by email or downloading from a website. The cover page of the FDD now contains the franchise company’s website and email address, if the company has these. Finally, the new Rule allows a prospective franchise buyer to “sign” a FDD receipt electronically.
There are some FDD electronic prohibitions: Disclosures must not include electronic features such as pop-up windows, audio, video, and links to external documents. However, features that enable a prospective franchise buyer to review the FDD efficiently are allowed – things like scroll bars, search features, and internal links (for example, links between the Table of Contents and the specific FDD items).
FDD Record Keeping Requirements
Under the new FTC Rule, for every completed franchise sale, franchise companies must keep a copy of the signed receipt page (Item 23) of the FDD for at least three years. Franchise companies are also required to retain a sample copy of each materially different version of their FDD for at least three years after the close of the fiscal year when the FDD was last used.
FDD – Mission Accomplished?
Unfortunately, due to successful lobbying efforts by the franchise industry the new FTC Franchise Rule misses the full disclosure mark – again. Critical, material disclosures (as discussed in the next article) needed to make an informed franchise investment decision are still not required. Once again history repeats itself and the ultimate winners under the new FDD Franchise Rule are – not surprisingly – the franchise companies. Maybe next time around? If history is any predictor, the next major FTC Rule revamp would not be until the year . . . 2037 – but don’t hold your breath.
© 2007 – 2009, Kevin B. Murphy, B.S., M.B.A., J.D. – all rights reserved
Franchise Disclosure Documents (FDD) and the new FTC Franchise Rule that were supposed to “level the playing field” after 29 years of regulatory status quo are a good concept in theory. Unfortunately, reality plays a more important role and reveals an entirely different picture.
Here are some of my observations, based on three decades of experience in the franchise industry as a franchise attorney, franchise expert and former franchise owner. During this time, I’ve drafted, reviewed and negotiated over 500 Franchise Disclosure Documents (formerly called UFOC’s).
Franchise Disclosure Goals
A Franchise Disclosure Document or FDD (formerly known as a Uniform Franchise Offering Circular or UFOC) is a document containing twenty-three chapters of information. These twenty-three chapters of disclosure are intended to give prospective franchise buyers enough pre-sale information so an intelligent franchise investment decision can be made before long-term contracts are signed, money changes hands and sizable financial commitments are made. In most cases, a franchise investment has significant, long-term financial consequences. It usually means putting everything on the line – savings, retirement accounts, home equity, etc. to make the investment AND hopefully make it to the break even point and beyond to profitable franchise operations. It’s a long road fraught with pitfalls where failure means losing everything. Just reaching the break even point can take years. With all this at stake, it’s easy to see why material disclosures in the FDD are absolutely critical.
Aura Of Credibility
Attached as exhibits to the FDD are the franchise company’s audited financial statements, franchise agreement, operations manual table of contents and a list of operating and departed franchise owners. If the company elects to make franchise earnings information available (now called a Financial Performance Representations in the new FDD Item 19) it will be set forth in Item 19 or attached as an exhibit to Item 19. The entire FDD document is quite lengthy and can exceed several hundred pages. In certain states (known as FDD franchise registration states like California, New York, Illinois, etc.) the FDD makes reference to being registered with the state. All these formalities create an aura of credibility. Many franchise buyers mistakenly assume a regulatory agency has reviewed and approved the franchise offering. Unscrupulous franchise companies and franchise brokers engage in blatant misrepresentation, referring to their franchise registration with a state as that state’s “stamp of approval.” Nothing could be further from the truth.
FDD Franchise Registration Realities
First of all, registration of a company’s Franchise Disclosure Document only means they’ve paid an initial franchise registration fee to a governmental agency and submitted their FDD. There are no standards a franchise company must meet before it can sell franchises, such as business experience, financial stability, operating a successful prototype for a certain period of time before franchising efforts begin, etc.
No Business Experience Or Financial Stability Required
You and I could have no experience in a business concept, and never operated a prototype. All we have is an idea to franchise, letting other people – franchise buyers – risk their savings, 401k plans, homes, etc. to see if our idea pans out in the marketplace. Franchising an idea is relatively easy. We only need to put together a Franchise Disclosure Document, and capitalize our new franchise corporation or LLC. Let’s say we don’t want to risk any capital, so we capitalize our new franchise corporation or LLC with only $1. We produce an audited financial statement – an opening balance sheet showing $1 cash as our only asset and stock or other owner’s equity issued for $1. After including this financial in our Franchise Disclosure Document, we’d be able to sell franchises with impunity and collect our $50,000 franchise fee every time we sell a franchise.
Franchise Registration States
Of course, in the U.S. there are about 14 franchise registration FDD states, like California, Illinois, New York, etc., where we’d have to pay a franchise registration fee and file the FDD with the appropriate state agency. But that’s just a rubber stamp and no registration state will refuse to register our franchise offering. Because our franchise company is “thinly capitalized” with only $1 in assets, the registration states may require an escrow condition where the $50,000 franchise fee goes into an escrow account and we don’t get it until our franchise buyers sign off that they have received training, etc. from us. Or these franchise registration states may require posting a bond or just say we can’t accept payment of the $50,000 franchise fee until the franchise opens, and have us insert a simple amendment to the payment section of our franchise agreement to reflect this condition. That’s the trend here in many franchise registration states like California. The bottom line is we’d get “registered.”
Even franchise examiners (who are usually attorneys) in franchise registration states issue registration renewal orders to franchise companies who have been operating a couple years and whose audited financial statements say (in a brief footnote): “Since its inception, the franchise company has incurred a net loss of $X million. These and other factors indicate substantial doubt the Company will be able to continue as a going concern.” Translation: the auditors are saying the franchise company is ready to go broke. Result: Not to worry, the franchise examiners issue renewal orders allowing these companies to continue selling franchises to unsuspecting buyers. It’s not right, in fact it’s outrageous, yet it happens.
Franchise Non-Registration States; FTC To The Rescue?
In the balance of the non-registration states (36) we’d be able to sell franchises with impunity and no state regulatory oversight (which, as mentioned, is not an effective safeguard anyway). But what about the Feds? There’s the Federal Trade Commission’s FTC Franchise Rule that applies in all states and sets minimum disclosure standards. But this only requires producing a Franchise Disclosure Document – FDD – and giving it to a franchise buyer at least 14 calendar days before signing up. There’s no registration process with the FTC and they rarely get involved in franchise complaints. A 1993 government report found the FTC acted on less than 6% of all franchise complaints. It’s a business decision. They only get involved if there are enough resources in their budget and there’s a deep enough pocket to target in an enforcement action. The U.S. General Accounting Office reports that franchise complaints to the FTC from franchise owners increased ten-fold from 1997-1999. This dramatic rise is profound considering complaint data was only available through June 30, 1999. Since 1998, according to the FTC’s website, only one franchise enforcement action was taken against a franchise company. There’s just not enough money or resources available to the FTC, a situation that will only grow worse in the current economy.
My point here is registration of a Franchise Disclosure Document with a governmental agency only means the franchise company paid a filing fee and forwarded its FDD. There is no due diligence undertaken by examiners in franchise registration states or any real safeguards. So the real guardian of the franchise investment must be you – the franchise investor. Because of the complexities of franchise agreement provisions and disclosures in the FDD, the need for competent, professional advice is critical. Many of the critical disclosures are required only in a table, where the relevant contract sections of “boilerplate that bites” are listed, without going into any details of the biting process. If you’re not a franchise attorney looking for red flags, it easy to get duped.
Break Even Point
Returning to the Franchise Disclosure Document, critical business information is NOT disclosed in the document, principally due to successful lobbying by the franchise industry. For example, the time it takes to reach the break even point – where revenues cover expenses – is not required disclosure in any franchise disclosure document. A bank would never loan money without this critical financial milestone, yet franchise companies are allowed to let franchise buyers invest hundreds of thousands (and in some cases, millions) of dollars, often mortgaging their homes and tapping into savings and retirement accounts until even these are completely exhausted, hoping against hope to reach the break even point. What type of financial milestone must franchise companies disclose before franchise buyers risk what is often everything they have?
The relevant financial disclosure, Item 7, only requires an estimate of what is called Additional Funds, a mere 90-day estimate of working capital needs. Because many new franchises can take a year, two years or more to reach the break even point, knowing only what it’s going to take to get you through the first 90 days of business life is not helpful. In fact, it may set you up for financial suicide. If you don’t have enough working capital reserves to reach the break even point, which can be a year, two years, or more down the road, your entire franchise investment, savings, retirement accounts – everything – will go down the drain trying to get there.
Financial Performance Of Franchise Owners – Item 19 Financial Performance Representations: “We don’t have to show you no stinking badges.”
Another major shortcoming of disclosures in the Franchise Disclosure Document is not telling you how much money the franchises or company-owned locations in the network are making (or losing). Instead of answering what is the most important, basic question in a franchise investment decision (franchise earnings information) the franchise disclosure laws make this “optional” for the franchise company. They can tell you, but only if they want to. If a franchise company decides to answer this critical question, it will be found in Item 19 of the FDD called “Financial Performance Representations.” But don’t hold your breath. Most franchise companies (about two-thirds) opt not to answer this question. It’s another bizarre reality in the world of franchising. Complete monthly (and in many cases, weekly) financial profit and loss statements from franchise owners are required under the terms of their franchise contacts. So franchise companies know exactly how much their franchises are making (or, more likely, losing). But most elect not to say anything before you buy one of their franchises. They’d rather you jump into a big black hole – after all it’s not their savings, assets and retirement accounts on the line. This all reminds me of the famous line in “The Treasure of the Sierra Madre,” John Huston’s 1948 classic movie: “Where are our badges? We don’t need no badges. . . We don’t have to show you no stinking badges.” A word to the wise: insist on seeing their stinking badges. Jumping into a big, black financial hole never makes any sense, except to unscrupulous franchise companies that are not forthcoming about franchise earnings information.
One relatively new restaurant franchise with an investment of $2 million, operated five company-owned restaurants yet said nothing in Item 19 about the financial performance of their restaurants. They were trying to close a ten restaurant franchise development deal with two individuals who had no experience in the food industry or in operating any business. This total void of experience didn’t concern the franchise broker representing the company. When I asked him why there was no information about the company-owned restaurants in Item 19, first he said it was because of the high cost of auditing the restaurant financials as required by the FTC Franchise Rule. When I corrected this misinformation (there is no absolutely no requirement that Item 19 data be audited), he changed gears. The new reason became “they just don’t want to, but I wish they would because it looks great.” My common sense follow up – if the company-owned restaurant financials look so great, and are just a computer keystroke away, why are they missing in Item 19? He switched back to “they just don’t want to.”
What About Asking Current Franchise Owners?
Of course, current franchise owners are a potential source of information and a list of these are found in an exhibit to Item 20 of the Franchise Disclosure Document. Media articles and franchise brokers hype contacting franchise owners as the best way for someone to quickly and inexpensively conduct their franchise due diligence. However, my experience over three decades is most franchise owners exaggerate their financial performance or decline to share their finances or franchise financials with a stranger. Many of them I’ve spoken with claimed they were making “good money.” But a studied, follow-up examination of their financial statements (made possible by the fact they were trying to sell their existing franchise) revealed an entirely different story – they were either losing money or operating at or below minimum wage performance. One couple invested $200,000 in a pizza franchise and desperately wanted out of their franchise and commercial lease eighteen months later. Their financial statements showed they were making about $0.50 (fifty cents) per hour – a good result only if you happen to live in China, Vietnam or India. Fortunately, my client, who was on the verge of taking it over before hiring me, promptly lost interest in buying the franchise after listening to the results of my analysis. The incredible thing is I discovered the franchise was subsequently sold to another person who operated the business for a year then filed for bankruptcy when his financial resources were exhausted and the sinking ship finally sank.
Back to the new $2 million new restaurant franchise mentioned above, the one trying to sell a 10-unit franchise development deal to persons with no background in food or in operating any business. The franchise broker had sold, not surprisingly, another 10-unit franchise development deal. He just loved selling those 10-unit deals and earning a fat commission. The good news was the first franchise of ten was open. Bad news was it had been over a year and the franchisee wasn’t doing well at all. But the franchise broker said that was due to “a lot of reasons.” He didn’t go into any further detail. Need I say more? Beware of any franchise company (or their franchise broker) trying to get sell a multiple franchise deal when you haven’t demonstrated competence or a track record operating even one of their franchises. Reputable franchise companies would never, ever consider doing this. But franchise brokers looking to earn a fat commission on nonrefundable multiple franchise fee deals obviously have a different mind set and motivation.
Franchise Resales – The Existing Franchise Marketplace
There are many more examples of these franchise nightmares. One increasing segment includes franchise “resales” where unprofitable, existing franchises are sold over and over to new buyers who believe they can change history, turn things around and transform an unprofitable franchise into a cash cow. It just doesn’t happen, except in very rare cases – like the odds of being struck by a lightening bolt walking down the street.
One former franchise owner with an undergraduate business degree and an MBA was another victim to the blinding franchise light where up is easily confused with down. He purchased a second generation, existing franchise resale for $340,000 confident his business acumen and skills would create a six-figure cash cow. The franchise never made money under his tenure and he was very lucky to unload it for $170,000. Besides losing $170,000 plus the negative cash flow spent to keep the ship from sinking during his ownership, the departing owner of the franchise resale had another problem. The landlord kept him on the financial hook for the lease payment obligations when his franchise was sold to the next, third generation franchise gambler. Landlords insist on tenants honoring their five to ten year commercial real estate lease obligations, even when the lease is assigned to a new buyer. If the new tenant doesn’t pay the rent, the landlord keeps the selling tenant on the financial hook. Try getting a good nights sleep every month when the rent becomes due if you’re the departing franchise owner under these circumstances. The next proud owner of the existing franchise resale was, not surprisingly, also unsuccessful in turnaround efforts. After bleeding more money into the business for another year, it was Miller Time after finding another fourth generation existing franchise risk taker. This time the purchase price came down to $68,000. A franchise that never has (or ever will) make money is sold over and over again to individuals who lose sizable investments each time it changes hands. It will never be counted as a “franchise failure” because it hasn’t technically gone out of business. This happens all the time and is yet another bizarre reality in the world of franchising.
For a good FDD Franchise Disclosure Document checklist, read our informative article Evaluating Franchise Investments – tips from a Franchise Attorney and Franchise Expert. Have a quick question about an FDD? Click on the Franchise Attorney page and send Mr. Franchise your FDD question. For more details and franchise tips on FDD Item 19 Financial Performance Representations, read the article below.
Subject: FDD Item 19 Financial Performance Representations – Mr. Franchise Weighs In
Question: I am reviewing various FDD’s. One surprised me since in Item 19 , where financial performance information is provided, it provided none! No presentation of revenue and expenses. Did the FTC establish some rules obliging information concerning financial performance to be included in the FDD? Should I be concerned that this information is not provided
Mr. Franchise, Kevin
Most franchise companies that elect not to provide Item 19 financial performance information used to say “the franchise laws don’t allow me to give you this information.” That statement was patently false – the franchise laws always allowed this as long as there was a “reasonable basis” and the financial information was contained in the FDD, along with substantiation for the information (i.e. where it came from).
Under the new FTC Rule, Item 19 of the FDD must now begin with a REQUIRED STATEMENT, that sets the record straight:
“THE FTC FRANCHISE RULE PERMITS A FRANCHISOR TO PROVIDE INFORMATION ABOUT THE ACTUAL OR POTENTIAL FINANCIAL PERFORMANCE OF ITS FRANCHISE AND/OR FRANCHISOR-OWNED OUTLETS IF THERE IS A REASONABLE BASIS FOR THE INFORMATION AND IF THE INFORMATION IS INCLUDED IN THE DISCLOSURE DOCUMENT.”
To be fair, it’s quite understandable why franchise companies don’t like to make POTENTIAL financial performance representations. These are financial projections, a guess of future potential that may or may not happen in most cases. Predicting the future, after all, is the forte of fortune tellers . . . and investment bankers.
But it’s important to remember there are two alternate prongs: potential financial performance or ACTUAL financial performance. The reason not to make actual financial performance data available, when they know to the dollar what their franchises and company-owned outlets are making (or losing), is highly suspect. That is, unless the financial picture is not very rosy – then it makes a lot of sense not to include this information in Item 19. Who is going to buy their franchise and invest hundreds of thousands of dollars to try and get it profitable if the actual financial results showed most franchise owners were barely breaking even and making less than the minimum wage? That would be a very hard sell and the reasoning becomes “better not tell them that” So Item 19 is silent – a big, black hole.
If I’m buying a franchise, and a franchise company refuses to provide the most basic financial information for me to make an informed investment decision, that’s a huge red flag. It tells me a lot about them and about the financial condition of their franchise network. Would anyone with common sense jump into a big, black hole? Surprisingly, a lot of first-time franchise buyers, influenced by the emotional ploys of the franchise salesperson, don’t see the need to spend any money on up front business or legal advice. They jump right in.
Most franchise companies who don’t share financial information in Item 19 point to the list of their franchise owners in the FDD as the “best way” to get the information they refuse to provide. The big problem with this approach is most franchise owners either don’t give financial information to a stranger, or exaggerate their performance. I’ve talked with hundreds of franchise owners over the years who all say they’re making “good money” when a studied examination of their actual financials shows below minimum wage performance or operating in the red. It’s human nature – people don’t like to admit they made a mistake and are a failure.
Wait a minute, the franchise industry says they’re not failures because they haven’t gone out of business. They’re hanging in there, depleting the last of their assets, retirement accounts, etc. in a frantic effort to keep the sinking ship afloat. Incredibly, many will be able to find another franchise gambler to buy their opportunity of a lifetime at a deep discount before the ship sinks. Unprofitable or barely profitable franchises change hands over and over. Of course, the franchise companies don’t want to miss out on this action. They collect a “transfer fee” (that approximates the franchise fee) each time the unprofitable franchise changes hands as well as their constant royalty based on whatever gross sales happen to be. There are a number of articles on the Franchise Foundations website that address these topics.
I hope I don’t need to tell you at this point to use a franchise attorney BEFORE making any franchise investment decision. There are a host of other traps and pitfalls an unwary franchise buyer can fall into besides the Item 19 black hole.
Kevin B. Murphy, B.S., M.B.A., J.D.