“Using Earnings Claims to Market Your Franchise ”		«BACK
	by James A. Wahl
	from December 2005 Franchising World - Reprinted with Permission of the International Franchise Association.

Much has been written and discussed on the subject of franchise earnings claims.  Should they be made?  Should they be mandatory?  Do they increase or decrease liability exposure for the franchisor?  What form should they take?  What information should be included?  And so on. 

While franchise disclosure laws mandate providing prospective franchisees with information regarding fees, expenses and initial investment requirements, representations regarding the earnings potential of the franchise are optional, both under current law and the proposed revisions to the Federal Trade Commission’s Franchising Rule.

What is not subject to debate is that information on earnings potential is crucial to prospective franchisees. 

“How much money can I make …?” is at or near the top of every franchisee’s list of due diligence topics for evaluating and comparing the wide variety of franchise opportunities available today.  Given this fact, franchisors should consider including a properly drafted earnings claim in their UFOCs to give them a competitive advantage in marketing their franchise to potential purchasers.

Legal Requirements

The legal requirements for making an earnings claim under Item 19 of the UFOC Guidelines are relatively straightforward.  Item 19 states that an earnings claim made in connection with the offer of a franchise must be included in full in the offering circular and must have a reasonable basis at the time it is made.  The factual basis and material assumptions underlying the claim’s preparation and presentation must be described, including information on the type of units covered by the claim and the percentage of units that attainted or surpassed the stated results.  The franchisor must provide substantiating data to a prospective franchisee upon reasonable request.

Several modifications will take place upon adoption of the proposed revisions to the FTC Rule, including a change in terminology to “Financial Performance Representations.”  The FTC gave consideration to making financial performance representations mandatory, but elected to continue the existing practice of keeping earnings disclosures optional.  Consistent with current Item 19 requirements, the revised FTC Rule would require the franchisor to have a reasonable basis and written substantiation for the information.  The franchisor will also be required to disclose whether the information is historical or a projection.  If the information is based on historical results, the franchisor must state whether the results describe all or a subset of outlets, the dates when the stated performance levels were achieved, the number of outlets used to arrive at the representation, and the number and percent of outlets that attained or surpassed the stated results.  Material bases and assumptions must be disclosed for any forecast of future financial performance. 

Both Item 19 and the revised FTC Rule require the franchisor to include a conspicuous admonition that the franchisee’s results are likely to differ from the results disclosed.  This type of disclaimer would be recommended even in the absence of a legal requirement.  Both laws also permit a franchisor that does make a written earnings disclosure to provide supplemental earnings disclosures to address a particular location or circumstance.

Forms of Earnings Claims

Given the basic “reasonable basis” requirement for earnings disclosures, the format and information provided by franchisors can and does vary significantly.  Earnings claims range from simple disclosures of average unit gross revenues to detailed pro forma income statements describing unit financial performance.  Food and labor cost averages are frequently stated for restaurant franchises.  Lodging systems typically provide information such as average occupancy rates, room rates and revenue per available room.

Depending on the various factors that can influence unit performance, stated results can be categorized according to various demographic criteria such as the population in the unit’s trade area and household income levels.  Some systems group information based on geographic regions of the country if performance tends to vary by region.  Many retail concepts provide separate disclosures of results from mall, strip center and free-standing units.  Breaking results down according to the length of time units have been in operation is sometimes used to show the effects of unit maturity or changes in concept design on financial performance.

Earnings Claims as Marketing Tools

If we take as a given that earnings potential is of paramount importance to prospective franchisees and that there are many competing franchise opportunities, then it follows that franchisors that provide information to address questions of financial performance will put themselves at a competitive advantage.  In its analysis of comments and information compiled for purposes of revising its Franchising Rule, the FTC found that approximately 20% of franchisors provide a written earnings claim.  Obviously, a franchisor that puts itself in that minority will differentiate itself from a competitor that does not provide earnings information.

It is true that information on financial results can be obtained in the absence of an Item 19 disclosure.  If the franchisor has company-owned stores, some rough information on store level revenues can be derived from the franchisor’s audited financial statements by calculating a per store average by dividing total company store sales by the number of company-owned units.  Information from this type of calculation will never be entirely accurate, and results may differ in any event between company and franchised operations.  Additionally, prospective franchisees can and should question existing franchisees about financial performance.  However, the accuracy and quality of information will depend on the willingness of existing franchisees to share their financial results, duration of their operations, market penetration variations in different markets, and a variety of other factors. 

Collecting and cataloging this information into a useful format will be a difficult and time consuming task.  As a result, a franchisor that provides at least some basic financial performance information will make the financial analysis due diligence process easier and more reliable for its prospective franchisees.

For a franchisee that needs equity or debt financing from an outside source, a written UFOC earnings claim will be of considerable assistance.  The prospective lender or investor will be able to base its analysis not just on information compiled by the franchisee, but on information the franchisor has put in writing as well.  The lender or investor will have the assurance that the franchisor had enough confidence in the accuracy of this information that it was willing to make written disclosures as part of a publicly-filed document.  Thus, the written earnings claim will not only facilitate the lender or investor’s due diligence, but will provide an official baseline or reference point from which to validate assumptions contained in the prospective franchisee’s business plan or loan application.

Enabling a lender or investor to more quickly finalize its decision whether to finance the prospective franchisee will aid the franchisee in securing a site, scheduling training and moving forward with other pre-opening steps, all of which should translate into economic benefits to the franchisor from shorter franchise sales cycles and earlier unit openings.

Liability Concerns

Concerns over potential legal liability have kept many franchisors from making written earnings claims.  If a franchisee does not attain the level of results stated in the UFOC, does that alone give rise to a valid legal claim?  Without question, the Item 19 disclosure and supporting information will be highly scrutinized if litigation ensues.  However, the nature and focus of such scrutiny will necessarily be much different than would be the case were there allegations of earnings claims provided orally or through documentation other than the UFOC.

Legal challenge of an Item 19 disclosure would have to focus on whether the information was accurate, whether it was somehow deceptive or misleading, whether material bases and assumptions were properly described, and whether the substantiating data was sufficient and correctly interpreted.  A much different, and no doubt more problematic inquiry would ensue if there were allegations of oral or “cocktail napkin” disclosures.  In that case, the actions and credibility of individual salespeople, as opposed to documentation of financial data, would be under scrutiny.

A review of reported decisions in earnings claims cases shows that few cases focus on written Item 19 disclosures.  Rather, the issues litigated most often are fraud and misrepresentation claims arising from earnings information given verbally or contained in advertisements, pro formas or other non-UFOC documentation.  Defending claims that earnings representations were in fact made, and were moreover misleading, has proven to be a difficult exercise for many franchisors whose UFOCs stated that no earnings information would be provided.

By taking care that an Item 19 disclosure accurately summarizes the supporting data and presents it in a way that is not misleading, and by including appropriate disclaimer language, a franchisor may actually lower its potential for legal exposure.

Constructing an Earnings Claim

For a franchisor to meet the legal requirement of a “reasonable basis” for the earnings claim, it must be able to base the claim on reliable information.  While information derived from franchisees need not be audited or independently verified, the franchisor will have to state that franchisees maintain standardized bookkeeping, accounting and record keeping systems and that to the best of its knowledge the information is accurate.

This may present a challenge for systems in which record keeping and reporting discrepancies exist.  Accordingly, the starting point for any franchisor considering making or expanding upon an earnings claim should be an analysis of the available base of data from which the representation could be assembled.  If existing data is insufficient or if the franchisor is not confident in its accuracy or reliability, then the franchisor will need to implement procedures to address those shortcomings.

The franchisor must keep in mind that it will have to produce substantiating data to prospective franchisees upon request.  This substantiating data will need to be accurate and complete enough to support the written summary contained in the UFOC.

An effective earnings disclosure requires the franchisor to carefully evaluate the type of information that will be meaningful and useful to its prospective franchisees.  Although a “more is better” approach is not necessarily best, there are situations where a simple disclosure of only average gross revenues will not give an adequate picture of the financial results of the business. 

In those cases, the franchisor should consider including additional information such as average operating expenses to better represent results.  If properly drafted, supported, and qualified, a written earnings claim should enhance a franchisor’s ability to market its franchise without increasing legal exposure.