Impacts of the New Revenue Recognition Rules on Franchising So Far

By: Darrell Johnson | 5,123 Reads | 16 Shares

%3Cp%3EFranchisors+are+mandated+by+the+FTC%26rsquo%3Bs+Franchise+Rule+to+include+GAAP-based+financials+in+their+FDD.+As+franchisors+have+started+to+experience%2C+FASB+changed+what+most+franchisor+financial+statements+look+like+because+of+the+new+revenue+recognition+rules%2C+and+we+are+now+starting+to+see+how+financials+are+changing.+By+next+year+we+should+be+able+to+draw+some+conclusions+about+whether+these+changes+are+having+a+material+impact+on+those+who+are+using+the+financials+for+decision-making.%3C%2Fp%3E%0D%0A%3Cp%3EWhile+we%26rsquo%3Bre+waiting+for+that+assessment%2C+now+is+a+good+time+to+understand+how+various+stakeholders+use+%28or+should+use%29+franchisor+financial+statements.+Although+layers+of+analysis+can+be+considered%2C+we+can+at+least+be+reminded+of+some+basic+factors.%3C%2Fp%3E%0D%0A%3Cp%3EAs+with+anything+in+an+FDD%2C+there+is+a+natural+friction+between+the+legal+and+accounting+professions+on+the+one+side%2C+and+the+stakeholder+desires+on+the+other.+This+friction+is+generally+described+by+one+side+saying+as+little+as+necessary+to+meet+the+regulatory+requirements%2C+and+the+other+side+trying+to+read+between+the+lines+to+make+business+decisions.%3C%2Fp%3E%0D%0A%3Cp%3ELet%26rsquo%3Bs+start+with+prospective+franchisees%2C+which+is+the+group+the+FTC+Rule+was+designed+to+inform.+What+should+they+care+about%3F+One+of+the+more+significant+factors+is+whether+the+franchisor+has+sufficient+financial+strength+to+last+as+long+as+the+prospective+franchisee%26rsquo%3Bs+investment+horizon.+That%26rsquo%3Bs+primarily+a+balance+sheet+issue.+An+undercapitalized+franchisor+puts+additional+risk+on+franchisees%2C+both+in+an+absolute+sense+%28the+franchisor+runs+out+of+cash%29+and+in+a+relative+sense+%28a+cash-strapped+franchisor+is+far+more+likely+to+under-support+its+franchisees%29.%3C%2Fp%3E%0D%0A%3Cp%3EEach+year+FRANdata+identifies+more+than+300+new+franchise+brands+coming+to+market.+Many+are+undercapitalized.+For+that+group+there+is+a+disproportionate+reliance+on+fee+income.+The+new+revenue+recognition+rules+are+making+it+harder+for+those+franchisors+by+significantly+lowering+the+amount+of+revenue+they+can+recognize.+That%2C+in+turn%2C+will+drive+equity+lower+and+put+many+into+negative+equity+positions.+Not+only+will+that+taint+prospective+franchisee+assessments+of+franchisor+viability%3B+it%26rsquo%3Bs+likely+to+draw+the+attention+of+state+regulators%2C+who+are+more+likely+to+require+escrow+accounts+for+initial+fees+and+put+other+requirements+on+franchisors+with+weak+balance+sheets.+Perhaps+we%26rsquo%3Bll+start+seeing+better+capitalized+franchisors+come+to+market.+Perhaps+we%26rsquo%3Bll+just+see+fewer+companies+starting+to+franchise.+We+should+start+seeing+the+impact+soon.%3C%2Fp%3E%0D%0A%3Cp%3EAnother+financial+statement+consideration+for+prospective+franchisees+is+whether+the+franchisor+is+a+good+steward+of+its+own+money.+Showing+losses+is+never+a+good+message+for+prospects.+Neither+is+making+a+lot+of+money.+However%2C+neither+is+at+the+heart+of+what+a+prospect+should+consider.%3C%2Fp%3E%0D%0A%3Cp%3EThe+fundamental+question+the+income+statement+should+answer+for+a+prospect+is+how+much+a+franchisor+is+spending+to+support+the+system.+Are+there+a+lot+of+%26ldquo%3Baffiliate%26rdquo%3B+activities+influencing+the+financial+results+and+potentially+representing+a+distraction+to+a+pure+focus+on+their+franchisees%3F+Are+they+spending+a+lot+on+corporate+overhead%3F+Is+it+possible+to+determine+if+a+particular+franchisor+is+%26ldquo%3Bsignificantly%26rdquo%3B+investing+in+the+system%3F+The+good+ones+yes%3B+others+not+much%2C+if+at+all.%3C%2Fp%3E%0D%0A%3Cp%3E%26nbsp%3B%3C%2Fp%3E%0D%0A%3Ch2%3EWhat+do+people+want+from+an+FDD%3F%3C%2Fh2%3E%0D%0A%3Cp%3EWe+tend+to+look+at+various+parts+of+an+FDD+as+separate+topics.+They+are+not.+If+an+FDD+were+a+painting%2C+the+subject+would+be+a+landscape+scene%2C+not+a+group+of+individual+trees+or+people.+Other+items+in+an+FDD+and+in+the+franchise+agreement+describe+%28however+sketchily%29+various+types+of+support.+How+much+of+a+franchisor%26rsquo%3Bs+expenses%2C+individually+or+even+collectively%2C+go+toward+training%2C+field+support%2C+site+selection%2C+and+so+forth%3F+These+should+matter+to+a+prospect.+That%26rsquo%3Bs+what+they%26rsquo%3Bre+expecting.+Good+financial+disclosures+make+it+easier+to+connect+the+dots.%3C%2Fp%3E%0D%0A%3Cp%3EExisting+franchisees+have+some+additional+reasons+to+examine+franchisor+financials.+What%26rsquo%3Bs+the+marketing+budget+contribution+by+the+franchisor%3F+If+there+are+rebates%2C+are+they+revealed+in+the+financial+statements%3F+Does+the+royalty+rate+align+with+the+comparative+level+of+support+compared+with+other+brands%3F+Just+because+financial+statements+are+provided+in+an+FDD+doesn%26rsquo%3Bt+mean+there+is+enough+transparency+to+see+these+things.%3C%2Fp%3E%0D%0A%3Cp%3ELenders+are+a+necessary+party+to+the+franchise+business+model+for+most+franchise+brands.+Most+of+the+above+considerations+are+also+lender+considerations.+Until+franchisors+reach+recurring+revenue+self-sufficiency%2C+many+lenders+are+hesitant+to+put+money+to+work+in+a+franchise+system+because+of+the+risk+that+a+franchisor+will+not+make+a+sufficient+investment+in+support+systems%2C+particularly+during+the+most+vulnerable+two+to+three+years+after+a+loan+is+closed.+A+stronger+balance+sheet+can+compensate+for+some+of+the+deficiency+here.+Having+a+lot+of+extraneous+activities+referenced+in+the+footnotes+also+can+be+a+flag+for+lenders.%3C%2Fp%3E%0D%0A%3Cp%3EWhen+dramatic+change+is+forced+upon+a+business+model%2C+as+the+FASB+rule+is+doing%2C+it+presents+an+opportunity+to+reassess+the+fundamental+reasons+such+information+is+being+provided+in+the+first+place+and+perhaps+make+other+improvements.+Being+mindful+of+some+of+the+points+noted+here+may+actually+result+in+more+transparency+and+lead+to+better+financial+disclosures.%3C%2Fp%3E%0D%0A%3Cp%3E%3Cem%3E%3Cstrong%3EDarrell+Johnson%3C%2Fstrong%3E+is+CEO+of+FRANdata%2C+an+independent+research+company+supplying+information+and+analysis+for+the+franchising+sector+since+1989.+He+can+be+reached+at+703-740-4700+or+%3Ca+href%3D%22mailto%3Adjohnson%40frandata.com%22+target%3D%22_blank%22+rel%3D%22noopener%22%3Edjohnson%40frandata.com%3C%2Fa%3E.%3C%2Fem%3E%3C%2Fp%3E

Published: September 17th, 2019