ASC 606: Franchise Fee Reporting Change Seen as a Positive
The upcoming adoption of ASC 606 ("Revenue from Contracts with Customers") and its impact on the financial reporting of revenue from initial franchise fees has, understandably, been a hot topic recently. It affects every franchisor that collects an initial franchise fee (IFF), so almost everyone. Its real impact depends on how much of your reported revenue is generated by IFFs today. Here is how we at NRD Capital Management view it as investors in franchisors and related businesses.
Please note that we are not accountants or lawyers, so nothing here should be regarded or relied upon, in any way, as accounting or legal advice. Please consult your qualified professional advisors before making any decisions.
At a high level, ASC 606, when adopted, states that you must now recognize the revenue from IFFs over the life of the franchise contract. For example, today, if you sell a 10-year franchise agreement and collect an IFF of $50,000, you can recognize the entire $50,000 as revenue upon opening of the franchise unit and reflect it as such on your financial statements. After ASC 606, you would be required to report $5,000 of revenue a year for 10 years. As always, there are ways to offset the impact and recognize more of the IFF as revenue sooner, but all else being equal, that is what would be required. ASC 606 does not affect revenue recognition for the periodic royalties collected once the franchise unit is in operation.
If your documents are drafted such that the IFF is completely non-refundable, you can still use the cash to fund your business. That's the "good" news. But you will be restricted to reporting only a portion of the IFF on your income statement in any given year.
If you are a franchisor that has not reached royalty self-sufficiency and are, therefore, reliant on recognizing your IFF in full to bridge the gap to profitability, then the impact is potentially very dramatic. You might change from being a "profitable" and growing franchisor to being an "unprofitable" but growing franchisor (although possibly still cash-flow positive because of the IFFs you've collected).
This could potentially affect your ability to attract qualified, experienced, high-quality franchisees; to secure lending relationships for yourself and your system; to secure good terms from vendors, suppliers, and professional advisors (or to secure their services at all); and may limit the universe of potential equity capital partners to more sophisticated investors.
At best, you have some explaining to do. At worst, this change could dramatically affect the growth and success of your business. Who really wants to partner with an unprofitable franchisor with no clear path to profitability?
Adapting to the change
Recent clarifications from the Financial Accounting Standards Board (FASB) suggest you can offset the impact of ASC 606 in ways that are fair, justifiable, and straightforward. Your professional advisors should be able to help you identify, and quantify the value of, specific performance obligations that would allow you to recognize portions of the IFF as these obligations are satisfied. That will certainly help. But more important, you need an achievable, executable plan to get to royalty self-sufficiency as expeditiously as possible.
And that comes back to the fundamentals: Is your franchise opportunity a sufficiently compelling investment, with sufficiently compelling risk-adjusted returns at the individual unit level to be attractive to potential franchisees? If so, you will be able to attract franchisees to help grow your system. In addition, you should be willing to actively develop company-owned units to demonstrate performance, and the profits from those units should help fund your business. If you aren't willing to develop company-owned units, why should you expect franchisees to develop theirs?
At NRD, we are maniacal about franchisee success, which is ultimately driven by demonstrated unit-level returns. Unit-level performance is our "true north." Although we review a range of metrics to assess the attractiveness of investing in a franchisor, as experienced multi-unit franchisees and operators ourselves, we intimately understand that attractive cash-on-cash returns (both levered and unlevered) are critical to growing and sustaining a strong franchise system.
If you have demonstrated unit-level performance (perhaps clearly disclosed in your Item 19), along with a well-articulated plan to achieve royalty self-sufficiency, then the adoption of ASC 606 should hold no concerns for you. Its impact might be dramatic on the face of it, but the strength of your concept, along with your plan and pipeline of new company-owned units, should enable you to attract strong franchisees and value-added capital from both lenders and investors.
For us, ASC 606 was more of a useful 411 call than an emergency 911 call. For many reasons, not least of which is the increased transparency and explicit clarity brought by ASC 606 into a franchisor's financials, we regard its adoption as a positive change for franchising.