Franchise and Business Opportunities

EARNINGS CLAIMS:
SHOULD A FRANCHISOR MAKE ONE?

Brian Schnell. Attorney
Gray Plant Mooty

It should come as no surprise that prospective franchisees often request financial performance information about the franchise opportunity they are considering. The request may be in the form of average gross sales for the existing locations in the system, breakeven points, or profit and loss numbers. These are just a few examples, but the point is that prospective franchisees want financial performance information as they do their due diligence in making their informed investment decision about the franchise.

It is important to note that neither the UFOC Guidelines, the FTC Rule nor any state law mandates or prohibits a franchisor from making an earnings claim. The one general rule is that any earnings claim made in connection with the offer of a franchise must be included in full in the UFOC. If a franchisor does not include an earnings claim in its UFOC, then neither it nor any of its agents can provide financial performance information, oral or written, to a prospective franchisee.

1. Definition

Item 19 of the UFOC Guidelines defines an earnings claim as “information given to a prospective franchisee by, on behalf of, or at the direction of the franchisor or its agent, from which a specific level or range of actual or potential sales, costs, income or profit from franchised or non-franchised units may be easily ascertained.”

A substantial danger with respect to making any type of financial representations to a prospective franchisee is that the UFOC Guidelines definition of an earnings claim is very broad. The following statements would be considered earnings claims for which a franchisor would be subject to liability:  

• “Our franchises usually earn around $2,500 weekly”
• “I’m confident you will have a 10% return on your investment”
• “Our average cost of sales is 60% and average labor is 22%”
• “Approximately 1/3 of your sales will be gross profit”
• “I reviewed the financial projections which you prepared—they look fine”
• “What kind of profit do you have in mind—I can tell you if you are thinking along the right lines”
• “You should be able to break even in 18 months”

2. Rules for Making An Earnings Claim

If a franchisor desires to make an earnings claim in its offering circular, the UFOC Guidelines and the FTC Rule (depending on the offering circular format a franchisor uses) should be reviewed closely because they have slightly different requirements with which the earnings claim and the franchisor must comply. A number of general rules, however, apply to any earnings claim.

General rules to follow in preparing an earnings claim include the following:

A. The earnings claim must have a reasonable basis at the time it is made. The franchisor has the burden to show that it did have a reasonable basis for the earnings claim at the time the claim was made. Any data used in preparing the earnings claim must be available for review by a prospective franchisee.

B. The earnings claim must include a description of its factual basis – i.e., significant matters upon which a franchisee’s future results are expected to depend. Examples noted in the UFOC Guidelines are economic or market conditions that are basic to a franchisee’s operation and that may affect franchisee’s sales, the cost of goods and services sold and operating expenses. The claim must include a concise summary of the basis for the claim. The claim also should state whether the claim is based upon actual experienced franchised outlets and/or company outlets and the number and percentage of outlets meeting the stated claim.

C. The earnings claim must include the material assumptions underlying the claim. The earnings claim also should include a number of warning or cautionary statements and disclaimers.

D. A franchisor must determine whether the necessary data for an earnings claim is available and whether the claim can be made in a manner that is not misleading to prospective franchisees. The franchisor also must analyze and test the earnings claim in a variety of ways and with a variety of sources to ensure its accuracy, meaningfulness to prospective franchisees and compliance with all legal requirements.

One exception to the general rule that an earnings claim must be included in full in the UFOC is a franchise sale where the franchisor is selling an existing unit to a prospective franchisee. In this case, an earnings claim limited solely to the actual operating results of the specific unit being sold need not comply with Item 19 if the information is given only to potential purchasers of that unit and is accompanied by the name and last known address of each owner of the unit during the prior three years. A franchisor may provide the actual operating results for the specific unit being sold even if it has not made an Item 19 earnings claim.

3. Alternatives to Formal Earnings Claims

A. Refer Prospects to Existing Franchisees

Most franchisors who do not make an Item 19 earnings claim will refer a prospective franchisee to existing franchisees in the system. Many franchisors follow this practice because they believe that prospects should contact existing franchisees as part of their due diligence in considering the franchise opportunity and the existing franchisees are generally reliable sources for the type of financial performance information that a prospective franchisee wants to know regarding the day to day operation of the franchised business.

B. Refer Prospects to Independently Published Industry Data, Articles or Other Sources

Some franchisors will refer prospective franchisees to independent sources like industry trade journals which may publish information that contains industry wide information regarding sales and other financial performance indicators for the businesses in the industry. If a franchisor distributes these types of articles to prospective franchisees, it is making an earnings claim and would need to comply with the earnings claims rules and requirements. Although some franchisors simply may refer a prospective franchisee to these types of articles or publications, even the referral may be a problem given a 1997 FTC Advisory Opinion, in which the FTC stated that a franchisor encouraging a prospective franchisee to read specific news articles containing earnings claims information may be an earnings representation under the FTC Rule.

C. Provide Financial Information to Lending Institutions

The earnings claims rules apply to financial performance information given to prospective franchisees. The rules do not apply to financial performance information given to third parties like banks or lending institutions. For example, many banks will request financial information from a franchisor to allow the bank to make a decision on a potential loan to the prospective franchisee for the franchised business. Providing this information to a bank will not be an earnings claim, however, the franchisor should consider asking the bank to sign a confidentiality statement and notifying the lender that the information is provided to the lender solely to assist the lender in making its decision and the information may not under any circumstances be given to the prospective franchisee.

4. Earnings Claims—Best Practices

Franchisors must warn and educate its franchise sales staff of the dangers associated with making statements that might fall under the definition of an earnings claim. Left unguided, these individuals may make claims which expose the franchisor’s business to substantial liability or other remedies available to franchisees for this type of sales violation. Individual liability for people making an unlawful earnings claim also exists.

To avoid many of the pitfalls associated with making misleading, unlawful or unsubstantiated earnings claims, franchisors should consider the following steps:  

• adopt a policy requiring that any claims or representations pertaining to earnings, sales or profits be in writing and limited to Item 19 of the UFOC;
• carefully substantiate and document any earnings claims;
• reinforce the company’s earnings claim philosophy by conducting related training sessions with sales personnel as often as is needed and, if necessary, by making changes in personnel;
• the training sessions should include an explanation of the rules and do’s and don’ts of earnings claims; and,
• upon learning of any earnings claim violation, immediately seek the advice of in-house counsel or experienced franchise counsel.

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