The North American Securities Administrators Association’s (NASAA) most recent commentary on the disclosure of financial performance representations (FPRs) within item 19 of a franchise disclosure document (FDD) is now being enforced by state franchise examiners. The commentary imposes rules for making and substantiating an FPR and ensuring compliance with the fundamental requirement that the seller have a “reasonable basis” for making any FPR. As NASAA explains, “written factual information in the seller’s possession must reasonably support the representation, as the FPR is likely to be understood by a reasonable prospective franchisee.” The commentary also provides specific guidance on what information can and must be disclosed in connection with an FPR to ensure the information provided is not misleading. Importantly, NASAA also acknowledges that its new guidance does not imply that any FPR contained in an FDD issued before the effective date of these new rules is necessarily deficient or unlawful.
An FDD serves multiple purposes in the franchise business model. The document is generated not only for the purpose of compliance with federal and state law, but it is also the primary sales tool used to attract and sign potential franchisees. While sellers are not required to make any FPRs, those made must be “based on the sort of factual information upon which a prudent businessperson would rely in making an investment decision.” Because FPRs can play such a significant role in the sales process, franchisors understandably want to highlight the strength of their system through the use of FPRs. The commentary provides some additional guidance that, when understood and applied, will help franchisors put their best (but transparent) foot forward.
In general, the commentary’s specific rules all support the fundamental requirement that each FPR be substantiated by actual data and contain information that makes the data not misleading and explains how the data is calculated. Some highlights of the commentary (and a few reminders of existing FPR rules):
- An FPR disclosing gross sales must define how it is calculated. Gross sales means total revenue derived from the sale of goods or services less sales tax, discounts, allowances and returns. The FPR must disclose which of these items, if any, is being deducted from total revenue.
- An FPR disclosing net profit (or net income) must define how it is calculated. Net profit means all ordinary and recurring operating expenses, interest, income taxes, depreciation and amortization. The FPR must disclose which items are being deducted from gross profit.
- A franchisor with franchisee outlets may not make a gross sales FPR based on company-owned data alone.
- An FPR must clearly identify the sources of all data used in the FPR (i.e., if an FPR uses both franchisee and company-owned outlet data, the use of these different types of data must be clearly identified; an FPR that uses adjustments to actual cost data must clearly identify which data are adjusted and the method and rationale for the adjustment).
- While cost or expense data by itself is not an FPR, if an FPR discloses gross sales alone, then cost or expense data cannot be separately provided outside of the FPR if that would allow for calculation of average net profit.
- When disclosing gross or net profit based on company-owned data alone, the FPR must make specific disclosure of information that shows material financial and operational differences between company-owned and franchisee outlets.
- If an FPR includes data from both franchisee and company-owned outlets, that data must also be disclosed separately.
- An FPR that discloses average must also disclose the corresponding median, and vice versa.
- If an FPR is based upon a subset of outlets, there must be a reasonable basis for the subset, and the FPR must be accurate and not misleading.
- An FPR based upon a subset of best-performing outlets must include one or more corresponding subsets of lowest-performing outlets (i.e., if an FPR discloses the top 20 percent, the corresponding bottom 20 percent also must be disclosed).
- Any projections must be based on historical data from the brand being offered and outlets substantially similar to the type of outlet being offered and may not be based on hypothetical situations or expectations.
This is by no means a full analysis or review of the commentary, but an overview of the themes NASAA, and by extension the state franchise examiners, may be focused on as franchisors strategize and hone their latest (and even more transparent) FPRs.