An “earnings claim” is any information given by or on behalf of a franchisor to a prospective franchisee from which a specific level or range of actual or potential sales, costs, income or profit of franchisor-owned or franchised outlets may be readily ascertained. Every North American jurisdiction that regulates franchise sales also regulates the use of earnings claims, although some of them use the term “earnings projections” or “financial performance representations” instead of “earnings claims”.
1. Types of Earnings Claims
There are two main types of earnings claims: future-oriented financial information and historical financial information.
Future Oriented Financial Information
Future-oriented financial information comes in three different flavours: forecasts, projections and pro-forma information. The Handbook of the Canadian Institute of Chartered Accountants defines each of these terms, essentially as follows.
A “forecast” is future-oriented financial information that is based on assumptions which reflect the franchisor’s planned courses of action for the period covered by the forecast, given management’s judgement of the most probable set of economic conditions. Since the quality of the forecast depends on the reasonableness of these assumptions since and assumptions are usually interdependent, management must ensure that the assumptions are both internally consistent and reflect the expected economic effects of planned or anticipated actions.
A “projection” is also future-oriented financial information based on assumptions which reflect the franchisor’s planned courses of action for the period covered. Unlike a forecast, however, a projection is based on assumptions (called hypotheses) about economic conditions or courses of action which are not necessarily the most probable in management’s judgement. To be reasonable, these hypotheses must represent plausible circumstances and be consistent with the purpose of the claimed results.
“Pro forma information” is financial information based on the actual operating results of one or more franchisor-owned or franchised units (or both), but which has been adjusted to show the effect of actual or anticipated events as if they had occurred at a different time, in order to assist a prospective franchisee to understand the effect of those events (in other words, “What if, instead, this happened then?”).
Historical Financial Information
Historical financial information is financial information that is presented either as the actual operating results of a single, specific franchisor-owned or franchised unit, or as a range, summary or other compilation of data based on actual operating results of several franchisor-owned or franchised units (or a mix of both).
2. Proper Disclosure of Earnings Claims
If a franchisor wishes to make an earnings claim to prospective franchisees then we recommend that the earnings claim:
- appear in full in at least one place in the disclosure document,
- state the period that it covers,
- state that it is a forecast or projection of future potential earnings performance, or is pro forma information, or that it summarizes historic performance of all or some subset of existing franchisor-owned units, franchised units or both,
- state the basis for the claim and its preparation and presentation, that is, the factually significant information that a prudent business person would rely on if making an investment decision,
- state the material assumptions (other than matters of common general knowledge) that underlie the claim and its preparation and presentation,
- state that both the basis of the claim and the assumptions made are reasonable,
if based on actual results of existing franchisor-owned or franchised units or both,
- state the locations and markets of those units, and
- state the percentage of units (separately by types) that actually achieved or surpassed each claimed result during the period covered,
and if based on a subgroup, also state
- the nature and number of units forming the subgroup,
- the number of units in the subgroup that were selected for the claim, and the basis for selecting them, and
- any characteristics of the selected units that differ materially from the franchised unit being offered to the prospective franchisee,
- if the claim is based wholly or partly on units owned by the franchisor (or its affiliate), state reasonable details of the adjustments necessary to make the claim relevant to the franchised units being offered,
- state that the actual operating results of a particular franchised unit may vary from those claimed, and
- state that the franchisor has data that substantiates the claim, and that it will make this data available for inspection upon reasonable notice provided that the prospective franchisee first signs a reasonable confidentiality covenant.
The earnings claim should also include a clear disclaimer that the results claimed are not an assurance of future operating results for any actual or proposed unit.
3. Reasonable Basis
Many factors can materially affect the reasonableness of the basis for an earnings claim. Examples include:
- the degree to which the underlying assumptions are reasonable,
- the quality of the underlying data, and whether they are the best information reasonably available when the claim is actually made to the prospective franchisee,
- whether the claim was prepared appropriately by a qualified person,
- the degree to which a forecast is the single most probable result, given the information and assumptions used, and
- the degree to which previous forecasts or projections have been accurate in predicting subsequent events.
Of course to be reasonable the information presented must be geographically relevant to the anticipated location of the prospective franchisee’s unit: information that is based on data from one geographic area may not be relevant to a franchisee who will be located in a different area having significantly different economic, cultural or political demographics. Data are geographically relevant if the experience of the units that provided the data will likely be enjoyed by the prospective franchisee in his proposed market. Factors to be considered in determining geographic relevance would include demographics, socio-economic characteristics, climate, location, degree of competition in the market area, differences in goods or services being sold or supplied, and similar factors which would likely affect the prospective franchisee’s chances of achieving results similar to those claimed.
To assist in establishing the reasonableness of an earnings claim basis a franchisor should keep copies of the data on which the claim is based. For a historical earnings claim the franchisor must also ensure that the data gathered for the claim was prepared in accordance with generally accepted accounting principles applied on a uniform basis. The comparability of data provided by two different franchisees will depend greatly on the assumptions they or their professionals made in compiling that data: different choices of professional financial advisor lead to differences in general ledger charts of accounts, income statement groupings and other methodologies that may not be applied uniformly across the franchise system. This can result in significant distortions between the reported results of franchisees within the same system, and usually the franchisor does not have the information it needs to adjust the raw data appropriately to permit valid comparisons of franchisee operating performance.
4. Underlying Assumptions
The earnings claim must provide sufficient information to allow a prospective franchisee to make an independent judgment about the validity of the claim, which requires management to exercise fine judgement in determining what to include in the claim. For example, if the operating results of actual units were used to compile a projection of future sales, then assumptions which could affect the probability of a prospective franchisee achieving similar results should be disclosed.
Earnings claim data, like any other data, is inherently neutral: it is the spin which one puts on the data that causes the problems. Therefore a franchisor must take care to shield itself from potential liability for any reader spin on the earnings claim (“I’m likely to do as well”) by including with the claim a clear warning that the reader must not rely on the results claimed as an assurance of his or her future results. Such a disclaimer, however, can never shield the franchisor from liability for the “spin” which its sales force may put on an earnings claim. It is vital, therefore, to adequately instruct the franchise sales force both in the proper use of an earnings claim and in their personal liability as franchisor associates should they misuse the claim.