How franchisors disclose earnings potential and offer franchises
The offer and sale of franchise opportunities in the United States are governed primarily by the federal Franchise Rule. Under the Franchise Rule franchisors must prepare and disclose a franchise disclosure document (“FDD”) to prospective franchise buyers. Every FDD contains 23 separate areas of disclosure, each is referred to as an Item. Item 19 is one of the most important as this item contains any financial performance representation – or earnings claim – made by the franchisor.
Earning Potential is disclosed at Franchisor's Option
Franchisors can choose to make an earnings claim or they can choose not to disclose any financial data. If the franchisor chooses to make an Item 19 disclosure, the financial information included may be based off company owned or franchisee owned outlets.
The federal Franchise Rule establishes certain criteria and governs what and how information may be disclosed. Regardless, all earnings claims must be contained in Item 19 of the FDD. So what exactly qualifies as an earnings claim?
What is an Item 19 financial performance representation?
The federal Franchise Rule defines Financial Performance Representation to include:
any representation, including any oral, written, or visual representation, to a prospective franchisee, including a representation in the general media, that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits, or net profits. The term includes a chart, table, or mathematical calculation that shows possible results based on a combination of variables.
Franchisors may only make earnings claims if they are included in Item 19 of their FDD.
This means that Item 19 of the FDD must contain each and every financial performance representations that the franchisor desires to make to a prospective buyer during the franchise sales process.
It is vital that Franchisors ensure brokers, sales agents, and marketing collaterals do not unintentionally make representations not contained in Item 19 Likewise, prospective buyers should be wary of any franchisor making claims not contained in the FDD.
What is the purpose of item 19?
The purpose of Item 19 is to provide insight into the potential financial aspects of purchasing a specific franchise opportunity. Prospective buyers want to know what they can make as a franchisee. Projecting a return on investment is a critical part of the diligence process.
Where does the data in item 19 come from?
Data reported in Item 19 may be based on actual historical performance of certain outlets or may be based on a projection. However, the vast majority of Item 19 disclosures contain information on the actual historical performance of existing franchisees. Historic data is typically compiled from the franchisors records.
Franchisors track revenue to collect royalties and often require reports to be completed so they have better insight into unit level performance. Item 19 often does not contain all the information known by the franchisor.
What can be included in Item 19?
Making an Item 19 financial performance representation is optional. Deciding whether to make any disclosure or determining the extent of a disclosure is largely within the discretion of an individual franchisor.
Generally speaking, a franchisor has two choices when it comes to Item 19:
- The Franchisor can elect not to make any financial performance representation and use specific language provided by the Franchise Rule to alert prospective franchisees that there are no representations; or
- The Franchisor can include a financial performance representation based upon the (a) actual historical financial performance or (b) potential financial performance.
The Underlying Data
When a franchisor chooses to make an Item 19 franchise disclosure, they must be diligent to ensure all Item 19 financial performance representations are reasonable, appropriately tailored, and accurate. The franchise rules often prevent attempts to narrow or disclaim reliance on the data presented. Inaccurate or misleading data can lead to serious allegations of fraud and intentional misrepresentation. Prospective buyers can request the data used to compile the FDD Item 19 representation.
What Outlets are Included in the earnings claim?
The federal franchise rule requires Item 19 disclosures to identify whether it is basing its representation on historical information or a forecast of future performance.
If the Item 19 Financial Performance Representation is based on actual performance, Item 19 must provide certain information, such as:
- An explanation of whether the disclosure is compiled based on a particular set of characteristics (for example, all locations within a geographical region, all locations of a particular type, all locations open for at least X years, or all company owned or all franchisee owned locations);
- Identify when the results were achieved (for example, between January 1, 2023 and December 31, 2023);
- Identify the total number of outlets existed during the disclosure period, and if different, the number of outlets who met the characteristics of the group being disclosed (for example, we had 100 outlets as of December 31, 2023, but 20 were excluded because they had not been open for business for at least one year during the measurement period);
- The number of outlets with the described criteria whose actual performance data was included;
- The number and percent of outlets that attained or surpassed the stated results (for example, when gross revenue is reported it is reported as min, max, average, median, and the franchisor identifies the percentage and number of franchisees that exceeded the average and median);
- A description of any characteristics of the outlets included in the study which may differ materially from those of the outlet being offered (for example, our study included franchisee outlets with a high concentration in New York City, which may not be representative of your market).
If the FPR is based on a forecast of future financial performance, the franchisor must provide details on the basis of the projection and the assumptions made in calculating the projection.
How are outlets Reported?
There are many ways a franchisor can report data. The franchisor will develop a set of criteria. Item 19 will then report the same data for all outlets that meet the criteria.
Groups within the earnings claim
Often times, franchisors will develop certain criteria to group franchisees. After describing and grouping franchisees based on characteristics, the franchisor will provide a financial performance representation for each group separately. There can be many separate FPR’s within Item 19, but each must comply with the federal franchise rules. Here are a few examples:
- A franchisor may have various outlet types with different physical characteristics, which often effect the financial performance. In the restaurant space, a location may include a drive-thru or may not. Likewise, a location may vary in square footage, may be stand-alone, may be in a strip mall, or may be operated out of a food truck. A franchisor could separate these outlets for disclosure in Item 19.
- A franchisor may perform differently depending on its concentration and brand recognition. Therefore, a franchisor may choose to disclose performance based on regions.
- A franchise location may take time to be established. Therefore, a franchisor may separate locations based on how long they have been in operation. For example, a franchisor could disclose locations in operation for two years or less separately than those in operation for more than two years.
- A franchise location may have company owned locations and franchisee owned locations. The franchisor cannot typically exclude either type of outlets, but they can disclose their performance separately.
Outlet Wide Vs. Quartile Disclosures
Within the Item 19 financial performance representation, franchisors may report system data in a single chart or may distribute data across quartiles. Prospective buyers should understand this may make the numbers look better. From a psychological standpoint, prospective buyers seldom expect to be a below average franchisee.
Time in Operation
Criteria will often include only franchised outlets that operate during a specific time period. The time period is often the prior fiscal year. However, some franchisors may limit the disclosure to only franchisees who have been operating for longer than that period. Prospective franchisees should be cognizant that this may be done because the ramp-up time is slow. Franchisors should ensure Item 19 is not misleading.
What type of financial information may be included?
The extent of information included in Item 19 will vary from franchisor to franchisor. Generally speaking, the franchise rules provide a few perimeters when disclosures are made. For instance, if a median is disclosed, an average is disclosed and vice-versa. Franchisors have flexibility in disclosing revenue, costs, and profits. Many disclosures will be limited to gross revenue. Others will include a ton of data (for example, see a copy of a College Hunks Hauling Junk’s 2023 Item 19 disclosure ).
Examples of Item 19 Data
Performance representations will often include gross revenues, but that only paints part of the picture. Franchisors can choose to provide much more detail, like customer acquisition costs, total cost of services, total gross profit, or EBITDA.
Other Reporting Rules
There are rules to help ensure data is not intentionally misleading. For instance, if a high is reported the corresponding low must also be reported. Likewise, a median must accompany an average. Franchisors also report the number and percentage of franchisees who fall below or above the mean or average.
Understanding Earnings Claims
As a prospective franchisee, it is essentially that you properly evaluate the FDD and take a careful look at any FPR. In regards to this Item, prospective Buyers should:
Carefully review the disclosure;
Understand the types of information contained in the disclosure;
Evaluate the level of detail provided;
Determine if the disclosure is based on actual or projected performance;
Pay attention to averages and percentages of outlets under or over performing;
Consider the time frames used to craft the disclosure;
Determine the scope of outlets included or excluded in the study;
Consider geographic or other criteria which may not apply to you;
Recognize disclaimers;
Ask for written substantiation;
Talk to existing franchisees ;
Ask questions;
Consult with legal and financial professionals.
What if a franchisor chooses not to make any earnings claim?
Generally speaking, a franchisor is prohibited from making any financial performance representation unless the information is included in Item 19 of its FDD. This means that a franchisor cannot disclose historical or projected gross sales, profit, or any similar financial data for its franchised or franchisor owned outlets unless that information is included in Item 19 of the FDD or an exception applies.
If a franchisor makes a verbal or written disclosure that is not also included in the FDD, they are likely in violation of the franchise rules.
Franchisors may choose not to make a financial performance representation for various reasons, but recent trend is to include a disclosure. Franchisors know that prospective buyers want an idea of their earning potential. If you are a prospective buyer and you are disclosed an FDD without an Item 19, you must determine if that is a deal breaker.
Buyer’s shouldn’t be afraid to ask tough questions and perform independent research. Likewise, a buyer should keep in mind that individual franchisees may be willing to share their own financial performance. Such individual information may not be indicative of the system as a whole, but it may assist you in evaluating the opportunity.
If there are similar concepts, you may also gain insight from a competitors disclosure.
Certain Exceptions Permit Limited disclosure of additional financial information
There are two exceptions that permit disclosure of financial performance data when it is not otherwise included in Item 19 of the FDD. In substance:
- A franchisor can disclose the actual records for an existing outlet that you are considering buying; and
- A franchisor can provide a supplement to the disclosure document in certain instances.
Why is This Item So Significant to franchise prospects?
Past behavior is typically the best indicator of future behavior. The same is true for success. Item 19 may demonstrate the success of current franchisees. This is particularly true when you compare competitors. Is one performing better than the other?
Disclosures often include average revenue, median revenue, and a range of gross revenue for franchise and company-owned outlets. Some include COGS, EBITDA, or other financial data. The financial representations, particularly when they are extensive, can help a prospective buyer determine if the potential financial outlook aligns with its expectations.
A well drafted Item 19 can also help you budget and plan for success.
Why is Item 19 significant for Franchisors?
Franchisors put a considerable amount of time and effort into the decision of whether to implement an Item 19 financial performance representation. The analysis requires an understanding of the legal risk and business implications. From a business standpoint, choosing to disclose creates an opportunity to demonstrate validation of the franchise system.
From a legal standpoint, a representation may increase the risk of litigation by disgruntled franchisees. Franchisors must be cautious in compiling and presenting its financial data to avoid any misleading claims or misrepresentations.
We counsel our clients on risk mitigation. No one can eliminate risk.
As a franchise law firm, we represent both franchisors and franchisees. We understand how significant an Item 19 disclosure can be to a prospective buyer. Franchisors cannot eliminate risk but they can mitigate risk by ensuring all financial disclosures are reasonable, appropriately tailored, and accurate. Likewise, franchisors avoid unnecessary risk by creating a culture of compliance.
Our attorneys provide sales leads and operational teams with the know-how they need to ensure they do not inadvertently violate disclosure laws. As a prospective franchise buyer, you likely should not be alarmed when a sales rep refers you to Item 19 any time you ask financial questions. Its far more concerning if a sales rep is making statements not included the Item 19 disclosure.
Need legal assistance with an FDD or want to learn more about item 19?
Waldrop & Colvin is a franchise focused law firm and the goal of this post is to provide an overview of the Item 19 Financial Performance Representation. It is important to understand what is included and what is excluded in an individual FPR. We counsel franchises as they evaluate franchise opportunities and we advise franchisors in drafting the FDD. The dual perspective comes in handy for both franchisors and franchisees. We have additional resources throughout our website. Please look around. Check out our page on federal franchise law for an overview of franchising from a legal perspective, see our list of state-by-state franchise laws, learn more about how we help franchisees, learn more about how we help franchisors, or learn more about the scope of our business law practice.
Whether you are a seasoned entrepreneur or new to business, we would love to help you succeed in franchising.
Meet the Author
Derek A. Colvin
Derek is a graduate of Penn State Law and Old Dominion University. He started his legal career in 2009 as a prosecuting attorney before entering private practice.
Derek currently serves business clients as a partner at Waldrop & Colvin, the law department for your business. His practice focuses on SMB client legal services and franchise law.
Derek is laser-focused on delivering efficient and effective solutions for business legal needs. As a seasoned litigator and experienced business attorney set on thinking critically and communicating effectively, Derek is well-suited to advise and protect your business.
Derek often serves as outside general counsel providing transactional support for business owners. He represents SMB independent owners, as well as franchisors, and franchisees as a franchise attorney.
Primary Practice Areas: Franchising | Franchise Law (Franchisor Legal Support & Franchisee Legal Support), SMB Mergers & Acquisitions, Entity Formation and Governance, Lease Negotiations, Trademark Registration, Dispute Resolution and Civil Litigation & Outside General Counsel Support
