The Truth About Franchise Earnings
Why franchises play it so close to the vest when it comes to money--and what it means to youBy Jeff Elgin
The first question that every prospective franchisee asks a franchisor is, "How much money can I make in this business?" Since the FTC passed the franchise compliance rules in 1979, the most common answer to this question has been, "We can't tell you because the FTC won't allow us to." This statement is simply not true and never has been.
In the original 1979 FTC regulations governing the sale of franchises, the guidelines specifically allowed franchise companies to make what were called "earnings claims" as long as a specified set of rules was followed. In the revised FTC rules adopted in 2007, they again allowed for what they are now calling "financial performance representations" to be made by franchise companies under specified parameters. In fact, under the current rules, if a franchise company elects not to provide financial performance representations to a prospective franchisee, they must make a disclosure to the candidate stating that the FTC does permit them to do so in Item 19 of their Franchise Disclosure Document.
A company may make any financial representation it wants as long as it complies with the FTC rules, which aren't really tough to meet. Most franchisors that publish an Item 19 disclosure provide at least basic sales revenue information because they already collect this data from their franchisees on their royalty payment reports. Some go further and provide basic cost-of-goods-sold data because it is fairly easy to determine and is usually pretty uniform among all franchisees. A few also provide specific information on typical expenses incurred by a unit, usually in fairly broad expense categories (rent, labor, etc.) in order to produce a typical gross margin or cash flow type of report. A very small number provide a full profit and loss income statement (usually from data on company-owned units) to provide as much information as possible.
Even given the amount of flexibility that franchise companies are allowed in terms of the types of data they may present, it is estimated that only about 30 percent of them provide financial performance information to prospective franchisees as allowed under the regulations. The obvious questions are: 1) Why so few? and 2) What should it mean to you when a company chooses not to?
I can suggest five reasons why a franchise company might choose not to provide any financial performance information:
1. They're so new that they simply don't have enough of a track record of unit operations
In other words, they don't really know what the financial performance will be like until they have more units operating for a longer period of time. For such a new company to put forth any numbers would potentially raise questions about whether or not there was a "reasonable basis" for the information, so it is safer for them not to publish anything for the time being.
In other words, they don't really know what the financial performance will be like until they have more units operating for a longer period of time. For such a new company to put forth any numbers would potentially raise questions about whether or not there was a "reasonable basis" for the information, so it is safer for them not to publish anything for the time being.
2. They don't want to invest the time and effort to collect and organize the information so that it can be provided in the FDD
There are many franchise companies that don't collect specific financial information--especially about operating expenses--from their franchisees on a regular basis. It can be quite time consuming and expensive for a franchise company to collect and collate this information if they are not already doing so for other purposes. Though it seems like it would be easy to at least provide revenue data in such cases, it may be that there are issues with it or that the company does not feel like the performance of the existing units is representative of what might happen to a new franchisee.
There are many franchise companies that don't collect specific financial information--especially about operating expenses--from their franchisees on a regular basis. It can be quite time consuming and expensive for a franchise company to collect and collate this information if they are not already doing so for other purposes. Though it seems like it would be easy to at least provide revenue data in such cases, it may be that there are issues with it or that the company does not feel like the performance of the existing units is representative of what might happen to a new franchisee.
3. They're unable to collect data in what they believe is a reasonably dependable manner, so they don't feel comfortable with the accuracy of the data that might be available for publication
Even if a franchisor decides to make the effort to collect revenue and expense data from all franchisees to publish a summary in their Item 19, they run the risk that the data may not have been prepared by the franchisees on a uniform basis, that it might not be reported accurately or that it might not have been assembled into a composite report correctly. Any of these problems could end up producing data that might be challenged later as misleading and therefore become the basis for litigation. That is a risk most franchisors don't want to take.
Even if a franchisor decides to make the effort to collect revenue and expense data from all franchisees to publish a summary in their Item 19, they run the risk that the data may not have been prepared by the franchisees on a uniform basis, that it might not be reported accurately or that it might not have been assembled into a composite report correctly. Any of these problems could end up producing data that might be challenged later as misleading and therefore become the basis for litigation. That is a risk most franchisors don't want to take.
4. They say that their franchise attorney told them not to
This excuse doesn't work as well as it used to because most of the best-known franchise attorneys in the country openly advocate for franchisors to include at least the sales and revenue information in their Item 19. They believe that the positives almost always outweigh any risks associated with the disclosure, unless of course the information would look lousy to a prospective franchisee.
This excuse doesn't work as well as it used to because most of the best-known franchise attorneys in the country openly advocate for franchisors to include at least the sales and revenue information in their Item 19. They believe that the positives almost always outweigh any risks associated with the disclosure, unless of course the information would look lousy to a prospective franchisee.
5. They don't want to disclose their numbers because they are bad and would not be attractive to potential franchise buyers
Ouch. This is obviously a problem at many levels. There is no way to know how often this is the real reason for not publishing an Item 19, but it is safe to say that you won't hear this excuse from a franchise company. You will have to discover this tidbit for yourself.
Ouch. This is obviously a problem at many levels. There is no way to know how often this is the real reason for not publishing an Item 19, but it is safe to say that you won't hear this excuse from a franchise company. You will have to discover this tidbit for yourself.
Our second question was what should it mean to you when a company you're investigating doesn't provide a financial performance representation in its Item 19? The answer doesn't have to be sinister or negative, but the question does need to be addressed. You need to find out, to your complete satisfaction, why the company didn't publish such data. The company may give you any of the reasons listed above but you still have to dig and determine for yourself what you think is going on.
If you decide that the company is not publishing an Item 19 because it is too new or because the information would show that the opportunity isn't very attractive, you should immediately stop your research into this company and go find a different franchise opportunity. There are lots of reasons for this advice, but the bottom line is that it is the safest approach if you are trying to minimize your risk.
If you decide that the company isn't providing a financial performance representation because it is too hard to gather the necessary data on an accurate basis, then you need to attempt to find out the answers for yourself by contacting existing franchisees. Keep in mind that you need to take everything you hear with a larger "grain of salt" in this situation, because if the franchisor wasn't comfortable with its ability to collect accurate information, then you should probably question your ability to as well.
In any case, you will get a strong sense from the existing franchisees you visit with. The impression will either be that everything in this area is great or it will be something else--mixed or negative. If you don't have Item 19 data to rely on, then you should probably walk away from any opportunities with mixed or negative feedback because the risk is simply too hard to quantify with any degree of certainty. If the franchisees you visit with are happy and profitable and excited about their future, then that is a strong sign that you have found a wonderful opportunity even if the franchisor doesn't publish an Item 19 in its FDD.
Jeff Elgin is the "Buying a Franchise" coach at Entrepreneur.com and has 25 years of experience in franchising, both as a franchisee and a senior franchise company executive. He's currently the CEO of FranChoice Inc., a company that provides free consulting to consumers looking for a franchise in the United States that best matches their needs.
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