FPR: The New (Amended) Deal
A primer on providing earnings claims in the new world
As the Amended FTC Rule on Franchising became a reality over the past 12 months, many franchisors have tried to understand the consequences, particularly as they relate to the law on earnings claims, now called Financial Performance Representations ("FPRs").
We've said all along that federal and state regulators love Item 19 FPRs (and their predecessors, "earnings claims") and have been trying to make them mandatory since 1995. Well they still aren't mandatory, but the million-dollar question is, Did they make it easier for smaller systems or systems with less operating history to make FPRs?
The Amended FTC Rule clears obstacles to making FPRs by 1) permitting historical FPRs to be based on subsets of franchisor-owned or franchised outlets and 2) eliminating the requirements that FPRs are geographically relevant to the franchise offered for sale or are based on information prepared in compliance with GAAP. These changes, particularly with respect to GAAP, were made to encourage franchisors to make FPRs, remove impediments to a franchisor's ability to disclose performance information, and to provide franchisors flexibility to formulate such representations provided that they are truthful and reasonable.
The Amended FTC Rule expressly permits an FPR based on a subset of outlets that share a particular set of characteristics and limits disclosure of outlets that meet or exceed the stated result to only those outlets used in arriving at the representation. Under the prior rule, you had to present information for all new units and, more importantly, disclose the number of units that met or exceeded the stated averages.
Franchisors ran into trouble when the information was based on the data collected from a limited universe of franchisees; or more commonly, when disclosing cost percentages achieved at company locations, or in a limited number of franchisee locations, a franchisor was incapable of stating the number of franchisees who met or exceeded the amount system-wide.
For example, if the current franchise offer is different in some way from those offered in the past, a franchisor can draft an Item 19 FPR with respect to the then-current type(s) of unit(s) being offered only, and need not state whether the franchisor's other types of units meet or exceed those results (as exists currently). In the context of multi-unit franchising, the Amended FTC Rule permits franchisors to highlight the performance of multi-units, mall stores, or in-line stores, rather than all units. This allows you to present data from your top performers stating the number of franchisees in that subset that exceeded the average, rather than the percentage of the total system.
Franchisors have long feared the "geographic relevance" requirement, and interpreted it far too narrowly to refer to only geographic proximity. The FTC Rule defines geographic relevance as "relevant to the geographic market in which the franchisee is to be located." By "relevant," the FTC means that the experience of outlets in one geographic market area is likely to be predictive of the prospective franchisees' experience.
The more similar the market conditions between the geographic areas (e.g., demographics, socioeconomic characteristics, climate, location, free-standing versus shopping center, etc.), the more predictive the experience of the outlets in the other geographic market is likely to be. Any factors that are different and/or likely to affect a prospective franchisee's chances of achieving similar results should be disclosed. Even though the FTC has eliminated the geographic relevance requirement, franchisors must still have a reasonable basis and disclose all factors and assumptions relevant to the claim, including any variations in demographics, socioeconomic characteristics, climate, or location in their FPR.
The Amended FTC Rule eliminates the requirement that information franchisors collect from franchisees be prepared according to GAAP, a change permitting prospects to use the best information available, so long as the franchisor reasonably believes the information to be true and correct. A franchisor still must have a reasonable basis and must disclose: 1) the nature of the universe of outlets; 2) the total number of outlets in the universe measured; 3) the number of outlets from the universe that was actually measured; and 4) any characteristics of the measured outlets that may differ materially from the outlet offered to the prospective franchisee (e.g., location, years in operation, franchisor-owned or franchisee-owned, and likely competition). Prospects can then assess for themselves what weight to give the FPR.
The Amended FTC Rule exerts subtle pressure on franchisors who never made earnings claims and instead told prospects that it is illegal to provide them with this information, by making franchisors tell prospects—in bold print—that they are permitted to provide FPRs but chose not to.
Rocco Fiorentino, president of United Financial Services, is pleased with the new rule, believing that it "should enhance the due diligence process for most franchisors, specifically the more mature franchisors," he says. "Under the Amended FTC Rule, there are a number of options that could be tailored to the franchisor, and I am glad to see that the changes have moved us away from the 'one size fits all' rule."
This viewpoint is consistent with that of Scott Haner, vice president of franchise development for Yum! Brands. "A key part of the prospect's due diligence process is their creation of pro forma financial projections. Our financial performance claims provide them with historical results that can serve as initial building blocks in that process," he says. "We see them as one input and recommend that prospects validate them by calling other franchisees in the system."
II. Presenting an FPR
FPRs can show gross sales, costs, gross profit, or other industry-specific measures of unit performance. They can be limited to units that have been open for some period of time, classified by state or region (including sub-regions defined by advertising co-ops, or media efficient markets), type of unit (kiosk, inline, pad site or mall/food court), those of a particular size or shape (by building design or layout), or those units with a particular capacity (in terms number of seats, desks, customers, or students), units with a particular volume of business (in terms of the number of rooms, vehicles, students, volume of checks cashed, or any other measure of unit performance), units that have been open a particular length of time (which are sometimes defined as mature vs. ramping up), or units that have been open during a recently concluded period (the last year). Claims can state the results of specific franchisee, company, or affiliate-owned units expressed in terms of averages or ranges, and report the results of multiple-unit operators separately.
Measures of productivity/frequency
In our perspective, it is nearly always appropriate for a franchisor to make an Item 19 financial performance representation. Certainly, if there is insufficient operating history or data to make a Gross Sales or Gross Profit representation, or if the supporting data is corrupt or there are reasons to question its reasonableness, such data cannot be used to formulate an Item 19. However, it is our experience that there are other measures of productivity or frequency that can be used to provide important performance information to prospects.
For example, representations can also be based on 1) productivity (achievable work day per technician, average annual revenue per sales day, average of revenue per van or kiosk, average commissions or co-op advertising credits, value of national accounts, sales closing rates, vacancy/occupancy rates, and yield from a particular amount of product or service); or on 2) customer frequency (percentage of re-bookings, percentage repeat business, average backlog, average number of customers, or average price per service).
Other information (such as units necessary to achieve media efficiency, or a claim that analyzes the effect on Gross Sales for units adding new equipment) may demonstrate the cost-effectiveness of making an additional investment in equipment or space.
Some information (such as closing rates or average price per service) on its face does not appear to be a representation. However, if anyone during the sales process gives the prospect the additional piece of information of the average number of customers or average number of jobs, then the prospect can combine that data to form an illegal representation.
The fact is that, along the way, information comes from many sources, and as a practical matter you are counting on the franchise candidates to separate what they learned from you from the information they learned from your existing franchisees. If you have a written representation containing this information, then there is an active barometer against which to measure the information obtained from within or from outside of the organization.
If a franchisor makes a compliant FPR in its Franchise Disclosure Document (FDD), then it may also make a supplemental FPR about a particular geographic location or apart from the FDD, so long as the supplemental FPR is: 1) in writing; 2) explains any departure from the FPR in the FDD; 3) is prepared in accordance with the requirements of the Amended FTC Rule; and 4) is furnished to the prospective franchisee.
As long as the FPR contains the same data points for the control group presented, a franchisor can prepare a supplemental claim showing the compiled results of certain subsets, including by way of example: units near schools or public transportation; units with outside salespeople; units within a particular region; units with a particular-sized territory, a certain number of trucks, or a certain volume of business; units offering a particular product or service; units offering a particular service or utilizing certain equipment; units of particular size, shape, dimensions, or building type, or those with drive-thrus; units owned by multi-unit operators; units in unique co-branded pairing combinations; or units operated by a like ethnicity, a particular educational level, or by those who have served in the military. Supplemental FPRs may also help a franchisor to define its target market, such that the general FPR can be tailored in the future to exploit areas that represent the highest potential for growth.
FPRs as a defensive strategy
Most often, franchisors don't make FPRs for fear of liability to a prospect who doesn't do as well, when in fact, franchisors that make FPRs are far less likely to get sued for common law fraud than those that don't. In reality, an FPR (and compliance statement) provides an effective means to refute a prospect's alleged reliance on statements made by franchisor employees engaged in the franchise sales process. For example, a prospect would have a hard time proving that he relied on a statement made by the franchisor's salesperson that the unit in question would earn $1 million in gross sales, when the published FPR shows an average unit volume of $250,000. Therefore, it is our view that making a legally compliant FPR may be the best protection against the very liability that franchisors are concerned about.
Exemptions under the Amended Rule
The Amended FTC Rule also provides exemptions for certain transactions, which means that the FTC Rule, including that those parts that pertain to an Item 19 FPR may not apply.
- Existing outlet for sale. If a franchisor wishes to disclose only the actual operating results for a specific outlet being offered for sale, it need not comply with the Item 19 requirements, provided the information is given only to potential purchasers of that outlet.
- Sophisticated investor exemptions. The Amended FTC Rule creates three exemptions, collectively referred to as the "sophisticated investor exemptions": 1) the large investment exemption, where the prospective franchisee makes an initial investment totaling at least $1 million, excluding the cost of unimproved land; 2) the large franchisee exemption, in which the franchisee (or its parent or any affiliates) is an entity that has been in business for at least 5 years and has a net worth of $5 million; and 3) an exemption for franchisor officers, owners, and managers, which exempts certain franchise sales to qualifying officers, owners, and managers of a franchisor.
In creating these exemptions, the FTC acknowledged that "franchising today often involves heavily negotiated, multimillion-dollar deals between franchisors and highly sophisticated individuals and corporate franchisees with competent counsel." In the course of such deals, prospective franchisees often demand and obtain material information from the franchisor that equals or exceeds the FTC's disclosure requirements.
- States with franchise registration laws. Generally, states that require pre-sale registration of the FDD do not recognize the sophisticated franchisee exemptions. Those that do, such as California, Maryland, and New York, which recognize in some form sophisticated or experienced franchisee exemptions, require that the franchisor file for and be approved for the exemption.
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