Franchise Disclosure Documents (FDD) under the FTC’s new Franchise Rule continue to be a good concept in theory. Unfortunately, reality plays a more important role and reveals an entirely different picture.
Here are some of my observations, based on twenty-eight plus years of experience in the franchise industry as a franchise attorney, franchise expert and former franchise owner. During this time, I’ve drafted, reviewed and negotiated over 500 Franchise Disclosure Documents.
Franchise Disclosure Goals
Franchise Disclosure Documents or FDD (formerly known as Uniform Franchise Offering Circulars) are a document containing twenty-three chapters of information. These disclosures are intended to give prospective franchise buyers enough pre-sale information so an intelligent franchise investment decision can be made before long-term contracts are signed, money changes hands and sizeable financial commitments are made. In most cases, a franchise investment has long-term financial consequences. It means putting everything on the line – savings, retirement accounts, home equity, etc. With all this at stake, it’s easy to see why the disclosures in the FDD are so important.
Aura Of Credibility
Attached as exhibits to the FDD are the franchise company’s audited financial statements, franchise agreement, and a list of operating (and departed) franchise owners. If the company elects to make a franchise "Earnings Claim," that information will be set forth either in Item 19 or attached as another exhibit. The entire document is quite lengthy and can exceed several hundred pages. In certain states (known as franchise registration states like California, New York, Illinois, etc.) the FDD makes reference to being registered with the state. All these formalities creates an aura of credibility. Many franchise buyers assume a regulatory agency has reviewed and approved the franchise offering. Unscrupulous franchise companies engage in blatant misrepresentation, referring to their franchise registration with a state as that state’s "stamp of approval." Nothing could be further from the truth.
Franchise Registration Realities
First of all, registration of a company’s Franchise Disclosure Document only means they’ve paid a registration fee to a governmental agency and submitted their document. There are no standards a franchise company must meet before it can sell franchises, such as business experience, financial stability, operating a successful prototype for a certain period of time before franchising, etc.
Business Experience And Financial Stability?
You and I could have no experience in a business concept, and never operated a prototype. All we have is an idea to franchise, letting other people (franchise buyers) risk their savings, homes, etc. to see if our idea pans out in the marketplace. All we need to do to franchise is put together a Franchise Disclosure Document, and capitalize our new franchise corporation or LLC. Let’s say we don’t want to risk anything ourselves, so we decide to capitalize our new franchise corporation with only $1. After producing an audited financial statement (showing $1 cash and stock issued for $1), and including this financial in our Franchise Disclosure Document, we’d be able to sell franchises with impunity and collect our $50,000 franchise fee every time we sell a franchise.
Franchise Registration States
Of course, in the U.S. there are about 14 franchise registration states where we’d have to pay a registration fee and file the document with the appropriate state agency. But that’s just a rubber stamp and no registration state will refuse to register our franchise offering. Because we’re “thinly capitalized” these states may require an escrow condition where we don’t receive the franchise fee until the franchisee opens for business. Or these registration states may just say we can’t accept payment of the franchise fee until the franchisee opens, and require a simple amendment to our franchise agreement to reflect this condition. That’s the trend here in California and the bottom line is we’d get “registered.”
Even franchise examiners (who are usually attorneys) in registration states issue registration renewal orders to franchise companies who have been operating a couple years and whose audited financial statements say (in an brief footnote): "Since its inception, the franchise company has incurred a net loss of $X million. These and other factors indicate substantial doubt the Company will be able to continue as a going concern." Translation: the auditors are saying the company’s ready to go broke. Result: Not to worry, the franchise examiners issue renewal orders allowing them to sell franchises to unsuspecting buyers. It’s not right, in fact it’s outrageous, yet it happens.
Franchise Non-Registration States; FTC To The Rescue?
In the balance of the non-registration states (36) we’d be able to sell franchises with impunity and no regulatory oversight. Of course, there’s the Federal Trade Commission’s FTC Franchise Rule that applies in all states. But this only requires producing a franchise disclosure document – FDD. There’s no registration process with the FTC and they rarely get involved in franchise complaints. A 1993 government report found the FTC acted on less than 6% of all franchise complaints. The U.S. General Accounting Office reports that franchise complaints to the FTC from franchise owners increased ten-fold from 1997-1999. This dramatic rise is profound considering complaint data was only available through June 30, 1999. Since 1998, according to the FTC’s website, only one franchise enforcement action was taken against a franchise company. There’s just not enough money or resources available to the FTC, a situation that will only grow worse in the current economy.
My point here is registration of a Franchise Disclosure Document with a governmental agency only means the franchise company paid a filing fee and forwarded its document. There is no due diligence undertaken by examiners in a registration state. So the real guardian of the franchise investment must be you – the franchise investor. Because of the complexities of franchise agreement provisions and offering circular disclosures the need for competent, professional advice is critical. Many of the critical disclosures are required only in a table, where the relevant contract sections of "boilerplate that bites" are listed, without going into any "details." If you’re not a franchise attorney looking for red flags, it easy to get duped.
Breakeven Point
Returning to the Franchise Disclosure Document, critical business information is NOT disclosed in the document, principally due to lobbying by the franchise industry. For example, the time it takes to reach the break even point – where revenues cover expenses – is not required disclosure in any franchise disclosure document. A bank would never loan money without this critical financial milestone, yet franchise companies let franchise buyers invest hundreds of thousands of dollars, often mortgaging their homes and tapping into savings and retirement accounts. What type of financial milestone must franchise companies disclose before franchise buyers risk what is often everything they have? The relevant disclosure, Item 7, only requires an estimate of what is called “Additional Funds,” a 90-day estimate of working capital needs. Because many new franchises can take a year, two years or more to reach the break even point, knowing only what it’s going to take to get you through the first 90 days is not helpful – in fact it may set you up for financial suicide. If you don&
rsquo;t have enough working capital to reach the break even point, which can be a year or more down the road, your entire franchise investment will go down the drain.
Financial Performance Of Other Franchise Owners
Another major shortcoming of disclosures in the Franchise Disclosure Document is not telling you how much money the franchises in the network are making. Instead of answering what is the most important question in a franchise investment decision, the franchise disclosure laws make this “optional” for the franchise company – they can tell you if they want to. If they decide to answer this critical question, it will be found in Item 19. But don’t hold your breath – more than 90% of franchise companies opt not to answer this question. It’s another bizarre reality in the world of franchising. Because they require complete monthly (and in many cases, weekly) financial profit and loss statements from their franchise owners, the franchise companies know exactly how much their franchises are making (or losing). But more than 90% decide not to say anything before you buy one of their franchises.
Asking Current Franchise Owners
Of course, current franchise owners are a potential source of information and a list of these are found in an exhibit to the Franchise Disclosure Document. My experience is most franchise owners exaggerate their financial performance or decline to share their finances with a stranger. Many of them I’ve spoken with over 28-plus years claimed they were making good money, when a studied examination of their financial statements revealed they were either losing money or operating at or below minimum wage performance. One couple invested $200,000 in a pizza franchise and were desperate to sell it eighteen months later. Their financial statements showed they were making about $0.50 (fifty cents) per hour. Fortunately, my client promptly lost interest in buying the franchise after listening to my analysis. The incredible thing is I discovered the franchise was subsequently sold to another person who operated the business for a year then filed for bankruptcy. There are many more examples of these franchise nightmares. Franchise "resales" where unprofitable franchises are sold over and over are another bizarre reality in the world of franchising.
Copyright 2007-2009 Kevin B. Murphy, B.S., M.B.A., J.D. – all rights reserved
For more informatiion, visit the Franchise Foundations website.