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Alpine, Utah 84004-5618

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2017 New NASAA Franchise Disclosure Document Item 19 Requirements:

October 27, 2017

On May 8, 2017 the North American Securities Administrators Association ("NASAA") adopted a Franchise Commentary with new requirements and restrictions for disclosure of historical and projected financial information in the offer of franchises. Phase-in of this new rule on Financial Performance Representations means most franchisors will have to revise their operational performance information and earnings disclosures in the 2018 updates to their Franchise Disclosure Document ("FDD"). Typically updates and revisions must be made no later than 120 days after their fiscal year-end.

 

The Federal Trade Commission's Franchise Rule and the NASAA Franchise Registration and Disclosure Guidelines give the same definition of a "Financial Performance Representation" ("FPR): 

 

"(A)ny representation, including any oral, written or visual representation, to a prospective franchisee, including a representation in the general media, that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits, or net profits. The term includes a chart, table, or mathematical calculation that shows possible results based on a combination of variables."

 

A franchisor is permitted but not required to deliver FPRs to prospective franchisees. If a franchisor does not place FPRs in Item 19 of its FDD, then under federal and state law it is prohibited from giving any historical or projected financial operational performance information to prospective franchisees. And if the franchisor does include financial performance representations in its disclosure document, then generally it may not furnish any additional financial operations data to the prospective franchisee and obviously could not furnish inconsistent or contradictory FPRs.

 

Virtually every franchise prospect has two important sets of questions: 

  1. How much will the franchise cost me? This question is required to be answered in depth in Items 5, 6, and 7 and to a lesser degree in Items 8 and 11 of the FDD. In addition, realistic and accurate operating expenses and startup and ongoing costs, standing alone, may be provided apart from the FDD.
  2. How much can I make? What are the historical and projected sales, revenues, and net profits of company-owned and franchised units? These questions can always be answered at any time by existing franchisees in the subject system – at least so long as the existing franchisees have not been coached to or rewarded for giving incomplete or inaccurate or "cherry picked" information and so long as the franchisor does not specifically refer prospective franchisees to "shills." These questions can only be answered by a franchisor in Item 19 of its FDD.

 Under federal and applicable state laws, nothing may be given to a prospective franchisee regarding financial performance representations "including past or projected sales, income, or profits of company-owned or franchised outlets" - unless specifically contained in Item 19 of the franchisor's FDD. There are two allowances: 

  1. If the franchisor offers a specific operational unit for sale, the actual operating results of that unit may be disclosed apart from the FDD, so long as this data is given solely to potential buyers of that unit. This data must include the name and last known address of each owner of the unit during the prior three years.
  2. A franchisor that makes FPRs in its FDD may independently supply a "supplemental earnings claim" directed to a particular location or circumstance. 

And there are three specific proscriptions: 

  1. While operating expenses and startup and ongoing costs, standing alone, may be provided to a prospective franchisee independent of the FDD, none may be stated as a percentage of a stated or assumed level of revenue unless these percentage cost metrics are contained in FDD Item 19.
  2. A blank "pro forma" may not be included in a Franchise Disclosure Document and may never be used as a financial performance representation. The new rule allows a franchisor to supply a blank pro forma to a prospective franchisee, but may never include it in its FDD. Section 19.2 of the 2017 NASAA FPR Commentary cautions that a blank pro forma, or a pro forma that contains cost information alone, may constitute franchise advertising under some state franchise laws (some states even require filing with the state before such an "advertisement" may be used).
  3. There is specific cautionary language that must be included in Item 19 related to historical financial performance data and to financial performance projections. Further, a franchisor is prohibited to add language that "disclaims" the given FPRs or to the effect that the prospect may not rely upon the data presented. 

The new requirements are based upon the following defined terms (which do not directly correspond to the GAAP, FASB and AICPA definitions) and related disclosure requirements:

 

"Company-owned outlet" is not only a unit of the type being franchised that are owned directly or indirectly by the franchisor, by an affiliate of the franchisor, by any person required to be identified in FDD Item 2; but also any unit that: 

  • is operated as a joint venture owned in part by the franchisor, any of its affiliates, or any person required to be identified in FDD Item 2, and
  • is managed by the franchisor, by one of its affiliates; or by such person. 

Therefore, a unit joint venture in which the franchisor contributes only money and grants (either expressly or by implication) a franchise is not a "company-owned outlet." Similarly, a unit joint venture in which the franchisor contributes financially, grants a franchise, and also manages (itself, through an affiliate, or through one of its officers/directors/key management employees) is a "company owned outlet." This distinction is important since FPRs solely for company owned outlets is not allowed when independently owned franchises also exist to be disclosed : typically the operational results of franchisees' is more relevant to a prospective franchisee.

 

If there are no operational franchises, one may disclose gross sales, costs, net profit, and gross profit from company-owned outlets so long as there is a reasonable basis for doing so and any financial and operational characteristics of the company-owned outlets that differ from prospective franchise outlets is described. While the rules do not mandate a minimum number of company-owned units or related length of operating history to make a FPR, the reasonable basis requirement means a franchisor must determine whether its company history is sufficient to be included in the disclosure document.

 

For profit disclosures one must include gross sales data, actual costs incurred, and adjustments to reflect financial (i.e. royalty and advertising fees) and operational (e.g. management and costs of goods) differences from franchise outlets.

 

"Gross profit" is gross sales minus cost of goods sold, or minus the cost of providing services for a franchise system that offers services.

 

"Gross sales" is the total revenue derived from the sale of goods or services less sales tax, discounts, allowances, and returns. If applicable, one must define "gross sales" (or similar terms) in Item 19, e.g. "all revenue except sales tax, discounts, allowances, returns, refunds or credits."

 

The FTC Rule Commentary states that a franchisor who discloses gross sales in Item 19 may not separately provide additional cost information to a prospective franchisee to determine typical net profits.

 

"Managed outlet" means any outlet that:

 

(i) is owned by a person that is not a franchisee, the franchisor, an affiliate of the franchisor, or a person required to be identified in Item 2 of the FDD; and

(ii) is managed by the franchisor, an affiliate of the franchisor, or by a person required to be identified in Item 2.

 

Managed outlets are often found in the hotel industry where some properties are not franchise licenses but rather owned by an independent third-party and then managed by the owner of the brand name and the related franchise system. The basic difference between a "franchised unit" and a "managed unit" relates to the definition of "franchise" which always includes the grant of a trademark or service mark license to an independent third-party franchisee. Managed outlets do not have the license of a mark. Rather, the franchisor/manager undertakes by contract to manage the hotel property owned by the third party, affixes its own mark to the unit, and never licenses use of that mark to the owner of the hotel.

 

The NASAA Commentary provides:

 

"if managed outlets are included in an FPR, the franchisor must disclose the existence of managed outlets in the FPR and identify how they are characterized. As long as the results of managed outlets are not materially different from the results of other outlets included in the FPR, a franchisor may characterize a managed outlet as any of the following in an FPR: 

  • as a company-owned outlet;
  • as a franchise outlet; or
  • in a separate "managed outlet" category. 

If the results of managed outlets are materially different from the results of other outlets included in the FPR, the franchisor may not include results from managed outlets in the FPR."

 

"Median" means the data point that is in the center of all data points used. That number is found by examining the total number of data points and finding the middle number in that set. In the event the number of data points is an odd number, the median will be the center number. If the dataset contains an even number of data points, the median is reached by taking the two numbers in the middle, adding them together, and dividing by two.

 

While a FPR may include averages of data, it also must include the median and highest and lowest of the numbers that make up the data. On the other hand, if a franchisor discloses the median of a range of numbers, the average must also be disclosed, and if the median is of gross sales, the highest and lowest numbers in the range must follow.

 

"Net profit" is gross profit typically minus ordinary and recurring operating expenses, interest, income taxes, depreciation, and amortization. In Item 19 the franchisor must disclose specifically what it is deducting from "gross profit" to arrive at "net profit."

 

"Operational Franchise Outlet" which includes franchised units managed by a franchisee or by the franchisor (or by its affiliate or by a person required to be identified in FDD Item 2) but is owned exclusively by the franchisee and operated under a franchise agreement. Generally, the FPRs for an operational Franchise Outlet can be disclosed in Item 19 so long as it has been fully operational for one full year or operating season.

 

Unless there are so few (perhaps 10 or less) franchised units that a prospective could potentially identify specific franchises from the disclosed information, data for company-owned and franchised outlets may not be combined or merged and must designed to avoid potential distortion.

 

One must plainly list the sources of all FPR data. If an FPR is based both on franchise unit and company-owned outlet data, each data set must be clearly identified. When adjustments or supplements to actual cost data are made, actual costs versus adjusted or supplemental costs must be identified along with the method and rationale for determining the adjustments or supplements.

 

For systems that have 10 or more operating units, subsets of these outlets may be included in a FPR. A subset will share common characteristics (e.g. type of location, geography, interval of operation, etc.). Dividing an FPR into subsets is allowed only so long as the characteristics are defined, there is a description of how each subset varies, there is a reasonable basis for the disclosure as structured, and it is accurate and not misleading. For example if a subset of the best performing units is created, it must be balanced by a subset of the worst, etc.

 

While the safest and most common form of FPR reflects measures of past performance, the rules allow the use of effectively documented forecasts and future projections that have a reasonable basis: prepared in good faith by qualified staff and management, following accepted accounting standards using the best data available, consistent with the current plans for the system, denoting appropriate assumptions and potential deviations, and adequately compared to and based upon historical system/brand specific results.

 

Finally, every FPR must "clearly and conspicuously" contain one of these disclaimers verbatim:

 

For past performance:

"Some [outlets] have [sold] [earned] this amount. Your individual results may differ. There is no insurance that you'll [sell] [earn] as much."

 

For forecasts and future projections:

"These figures are only estimates of what we think you may [sell] [earn]. Your individual results may differ. There is no assurance that you'll [sell] [earn] as much."

 

In either case nothing may be added that tends to contradict, disclaim, mitigate, contradict, or varies from any part of the financial performance representation or states that a franchisee should not rely on the data presented.




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