Alert -New Disclosure Requirements For Franchise Financial Performance Representations

October 12, 2017

The North American Securities Administrator Association’s Commentary on the 2008 Franchise Registration and Disclosure Guidelines (the “Updated Commentary”) will substantially impact the manner in which certain financial performance representations (“FPRs”) may be calculated and portrayed.

The update consists of twenty “questions and answers” which provide specific guidance on a wide-array of issues, including, but limited to the expression of averages and medians, substance and form of disclaimers, use of data subsets, incorporation of forecasts and projections, and amalgamation of data from franchise and company-owned outlets.  Unchanged, however, is the form on which all FPRs are to be disclosed – the Franchise Disclosure Document (“FDD”) – as well as the requirement that franchisors possess a “reasonable basis” for disclosing each FPR.[1]  

While an exhaustive review of the entire update is beyond the scope of this memo, we have highlighted certain of the most significant revisions. 

We strongly encourage franchisors to review the Updated Commentary in its entirety, particularly with regards to the subtle definitional nuances contained therein, prior to the start of its enforcement by the California Department of Business Oversight (the “DBO”) on November 8, 2017.[2] 

Disclosures Generally – Source of Data

All FPRs must identify the source of the data from which calculated.  Any adjustments or supplements made thereto must be expressly noted and include the unadjusted values calculated therefrom. An explanation for effecting such adjustments and/or supplements must also accompany the FPR. In all circumstances, data collected from franchise outlets and company‑owned outlets must be separately disclosed prior to their representation in a combined format. 

Gross Sales, Gross Profits and Net Profits – Company Owned vs. Operational Franchise Outlets

Nearly 62 percent of all franchisors disclose information concerning gross sales.[3]  The Updated Commentary requires that representations of gross sales and net profits describe the elements and manner in which calculated, specifically as to the items deducted or otherwise excluded from such calculation.  Unlike gross sales, franchisors may represent gross profits and net profits based solely upon data derived from company‑owned outlets, even where data is available for operational franchise outlets.  To do so, the franchisor must disclose three items: (i) gross sales data from any operational franchise outlets; (ii) the actual costs incurred by the company-owned outlets; and (iii) the actual and reasonably expected material financial and operational differences between company-owned and operational franchise outlets.  As drafted, materiality remains undefined. 

Averages and Medians

Calculations of averages and medians must be reported together. That is, wherever a representation is expressed as an average it must also include the median of the same range of numbers (data) from which it was calculated.  Similarly, an average must accompany any representation expressed as a median.  If the representation concerns gross sales, the highest and lowest numbers in the data range must also be disclosed. The purpose of these requirements is to reduce the potential for misunderstanding among prospective franchisees.  

Data Subsets

Some flexibility is afforded to franchisors in making FPRs based upon subsets of data.  Data subsets refer to data collected from outlets sharing a common characteristic, such as geographic location and relative financial performance. However, if a franchisor wants to report the performance of its best performing outlets, it must also report the corresponding performance of the lowest performing outlets. For example, if a franchisor were to report the average and median sales of its highest performing 10% of outlets, it would also need to report the average and median sales of the lowest grossing 10% of its outlets. 

Financial Performance Projections

All financial projections must be founded upon historical data collected from outlets substantially similar to that offered in the FDD, franchisors cannot rely upon industry reports, hypotheticals or expectations.  However, historical data may be adjusted or supplemented to account for certain market fluctuations, such as higher or lower rental values.

Disclaimers

No language in the FDD may purport to disclaim or require the franchisee to waive any representation contained therein. Franchisors may, however, include two preapproved admonitions where appropriate, one for historical representations, and one for future projections. The admonitions must read exactly as in Item 19.3 of the NASAA Commentary, except where the representation does not relate to sales or earnings, and only to the extent necessary to conform the admonition to that type of representation made.  These admonitions must be clear and conspicuous, and, therefore, must be included as a separate paragraph and printed in bold typeface. 

This update represents the first and consequently, most significant revision since the adoption of the original 2008 Commentary.  As a consequence, franchisors should take care in familiarizing themselves with its particular requirements and relative intricacies in preparation for its enforcement starting on November 8, 2017.


[1] As the Updated Commentary reiterates, no single factor or circumstance is dispositive as to whether a franchisor possessed a “reasonable basis” for disclosing a particular FPR.  Such a determination will depend on the individual facts and circumstances surrounding the disclosure, but must be premised upon written factual information that a “prudent businessperson would rely in making an investment decision” and that a “reasonable prospective franchisee” would understand as reasonably supporting the representation. 

[2] Enforcement will begin on the later of November 8, 2017, or, if the franchisor has an effective FDD on file as the May 8, 2017, 120 days following the franchisor’s next fiscal year end.  Amended FDDs and registration renewals submitted on or after November 8, 2017 must comply with the Updated Commentary regardless of their status as of May 8, 2017.   

[3] According to a three-year study conducted by the International Franchise Association Educational Foundation in conjunction with FRANdata, approximately two-thirds (~66%) of franchisors make at least one FPR on the UFDD. See, Financial Performance Representation: Market Demand Pushing Higher Levels of Transparency, International Franchise Association & FRANdata (April 2017), available at http://franchise.org/sites/default/files/2017-Financial_Performance_Representations_final.pdf.  The study revealed that 94% of those franchisors who elect to make a FPR disclose data regarding “average unit revenues”.  


BUCHMAN PROVINE BROTHERS SMITH LLP provides its clients, professional advisors and its friends with up-to-date reports on recent developments in business, real estate, employment, estate planning and taxation. 

 

Authored by:

Stephen-Bela Cooper
T: (925) 944-9700
scooper@bpbsllp.com

 

CIRCULAR 230 DISCLOSURE – Pursuant to rules and regulations imposed by the Internal Revenue Service, any tax advice contained in this communication, including any attachments, is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding tax penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another person any transaction or matter addressed herein.

The summary which appears above is reprinted for information purposes only. It is not intended to be and should not be considered legal advice nor substitute for obtaining legal advice from competent, independent, legal counsel. If you would like to discuss these matters in more detail, please feel free to contact us so that we can provide the clarification and resources you need to make effective decisions.