Should Franchisors Use Financial Performance Representations in the Franchise Sales Process?

As anyone who has ever been involved in the franchise sales process knows all-too-well, the single most frequently asked question in franchising is “How much can I make?”

Today, according to various sources, between 18% and 24% of franchisors choose to make a financial performance representation in Item 19 of their Disclosure Document. This leaves over 75% of franchisors to reply something like this:

“The success you have within our system will be affected by a variety of factors, including the location you choose, the competition in your territory, and the skill set that you bring to the table. For that reason, we do not provide earnings information to our prospective franchisees, but instead suggest that you do your own due diligence to determine what you believe you can achieve in this market by talking to our franchisees, doing market surveys, and conducting your own competitive analysis in your local territory.”

That answer or its many variations, of course, often goes over like a lead balloon, and just as often leads to the inevitable next question, “Why?”

Some franchise salespeople have, in the past, relied on half-truths to avoid this discussion and simply stated that “We are not allowed to comment by law.” However, under the amended Franchise Rule, Item 19 will begin by stating, “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 reasonable basis for the information, and if the information is included in the disclosure document…”

The inclusion of this new disclosure language will certainly make it more difficult for franchisors to duck the question of why they fail to provide financial performance information. On the other hand, as part of the new Franchise Rule, the disclosure of cost information alone will no longer constitute a financial performance representation, providing the franchise salesperson some additional latitude to discuss financial performance without the use of an “Earnings Claim.” The jury is still out on the question of whether these changes will make financial performance representations more or less important to franchisors in the franchise sales process, or if it changes their importance at all.

Intuitively, it would appear that a financial performance representation would be an invaluable tool in the sales process, especially for the new franchisor that has no franchisees to otherwise provide validation. Yet, there are some indications that these performance representations have little bearing on success in the franchise sales process. FRANdata’s “Fast 55,” for example, attempts to identify young franchisors that are achieving the fastest growth in terms of franchise sales. Curiously, when looking at last year’s Fast 55, the number of franchisors that actually use earnings claims is relatively consistent with the franchise universe as a whole, with only 12 of the 55 – or about 22% -- using an earnings claim.

Why this logical disconnect?

As most veterans of the franchise sales process will tell you, numbers don’t sell. The story does.

Sure, great numbers are a part of some great stories and being able to use numbers in the franchise sales process certainly makes the job easier, but the fact that so many franchisors have sold so many franchises without the use of an Earnings Claim in the past just reinforces this point. It is the story that sells.

From the outside looking in, this is beyond belief for many new franchisors. Why would anyone buy into a business without knowing what they would earn? This concept is often difficult for entrepreneurs to grasp, until they recall their own start-up days. If they were like most new start-ups, no one ever told them how much they could earn. In fact, each year, about seven percent of the working age population in the United States is actively trying to start a business, and each year over 600,000 new businesses are formed. And with the exception of perhaps 10,000 franchises that received Earnings Claims, none of these new business owners was told how much they could earn.

So if the new franchisor does not need financial performance representations to sell, why should they even consider using them?

One of the primary reasons for the franchisor to use a financial performance representation is that it makes the story easier to tell. Especially for inexperienced franchise salespeople and new franchisors that do not have the ability to fall back on franchisee validation, a financial performance representation can be a significant help in the franchise sales process. Franchisors with direct competition that make performance representations may also find themselves at a disadvantage in the sales process if they fail to use them.

But for many, the biggest reason to use financial performance representations is their ability to reduce the potential for liability. Again, this may at first seem counter-intuitive. In making these representations, one might think that the franchisor is opening the door for potential lawsuits if franchisees failed to achieve the financial performance discussed in the disclosure document. But the fact is that I cannot remember a single incident of a lawsuit based on a franchisee’s failure to attain the numbers provided in a well-documented, properly-prepared, historically-based Earnings Claim. At the same time, financial performance representations will largely eliminate the “back-of-the-cocktail-napkin” claims that can often be the basis for an allegation of an improper earnings disclosure. Given the increased latitude that will be granted to franchise salespeople to discuss “costs” in the sales process, the prescient franchisor might choose to disclose these costs at a minimum, if only to avoid a dispute about what might be said at some point in the future.

The overall liability issue becomes even more important for faster growing franchisors and for franchisors that rely on independent salespeople, area reps, business brokers, lead referral networks, or an outsourced franchise sales organization to “touch” their franchise prospects – as the franchisor will typically have a diminished capability to control the actions of these outside channels.

Of course, financial performance representations are not for everyone. In some instances, they are simply not representative of what a franchisee can realistically hope to achieve – perhaps because of a unique location, a long tenure in a community, or modifications to the business model which makes company operations atypical. In other cases, perhaps the franchisor desires to keep their financial performance out of the public domain for fear that competitors (or potential future competitors) who saw this information would gain a competitive advantage or might be encouraged to join the fray.

And, of course, some franchisors may choose not to use them because their financial performance simply does not stack up well against their competitors. This is not always a bad thing. For example, these franchisors may have lower revenues accompanied by a lower level of investment -- which could result in a better return on investment, or, at a minimum, an ability to get into a marketplace that might otherwise be financially beyond their reach. Other franchisors may offer incremental services, support, or financing, which might reduce the franchisee’s return, but might make the business more manageable from an operational or financial perspective.

The bottom line is that the bottom line is not always the bottom line. And while it is certainly a part of any franchise story, it is up to each franchisor to decide how they can best tell the story of what it is that makes them unique – and better – than the myriad of choices available to today’s prospective franchisees.